Like Hungry Lions

(Preamble: This essay contains economic charts which are explanatory on a technical level but you can skip them without affecting general content as they are there to underpin technical validity.)

Government is often compared to a parasite in economic context. It produces nothing yet takes from the economy for its own needs and for the needs of voters. I believe that a better analogy for government’s presence in an economic system is that or a predator.

Prey gathers the resources of the earth and converts it into desirable protein. Predators hunt the prey and consume the proteins directly. A sustainable ecosystem in which there is dynamic harmony and balance between predator and prey ensures the survival of both hunter and prey within the boundaries of available resources of food and water. A sustainable dynamic harmony will survive the changing of the seasons, climate cycles and even some catastrophes.

A similar harmony exists inside an economic system between the private sector and the public sector.

Contemplate for a moment that the predators get access to a new refined hunting technique which turns natural prey into abundant “canned prey”. The predators will enter a growth phase that will vastly increase the numbers of predators. The harmony and balance of the ecosystem will slowly change. Initially the targeted canned pay will sustain the growth but the increased numbers of hunting predators will place pressure on the supply chain of prey. Growth of the prey population will contract in a dynamic exchange process relative to the growth of the predator population. This process will accelerate with the growth of predators’ numbers while dwindling numbers of natural prey will force greater harvesting of “canned prey” for predator growth and survival. Natural prey is overharvested and the renewal of the herds gets destroyed. In time natural prey will all but disappear. Hungry predators will hunt all remaining natural prey to extinction with the new irresistible hunting technique, while progressively starving on their way to their own extinction.

It is a somewhat nasty outcome as the change in “hunting technique” must be counterbalanced by a change in “escaping technique” for prey to restore a sustainable harmony in the ecosystem.

Modern monetary policy has handed to the governmental predator a new hunting technique on private sector prey. Digital monetary creation hides the overharvesting of production surpluses mostly manifested in savings and capital, the flesh that governments consume. Predatory government growth explodes and it hunts the production surpluses to extinction. Then it hunts all remaining capital and savings to extinction. Politicians throughout history have often claimed to be at war with the markets. To be at war with the markets or the economy generally is to be at war with one’s own citizens.


The predators in my analogy have a “licence to kill”. We know that as society we give to governments also a licence to kill. We know further that we must diligently watch and monitor government’s use of its licence to kill, for a government that develops an excessive appetite for killing is a dangerous and probably harmful government which will soon find itself at odds with its population. Voters in democratic systems will kick out and probably prosecute such a government in no time.

Society also grants governments a “licence to hunt” in the economy by way of taxation. We diligently watch government’s taxation for a government that similarly develops an excessive appetite for taxation is a harmful government and will soon find itself at odds with its population. Voters in democratic systems will similarly kick out such a government in no time.

Governments being predatory are always on the lookout for ways to grow its presence. It needs taxation or debt to fund its growth. Voters are not too diligent on government debt and if governments can hide debt growth in accounting practices then so much the better. Success means no general voters’ revolt against government debt formation. Government can grow somewhat but before long it vests the majority of economically available savings upon itself and voters get restless.




(Click on the chart for a larger image)

Predatory government then needs to find a new refined hunting technique. A technique that will allow it to continue to grow by way of debt, without causing a voters’ revolt.

It finds the refined new hunting technique in the creation of digital money with which it can increase the liquidity quantity of savings by counterfeiting money. It uses the central bank to achieve this objective and disguises its own hand in the arrangement in the pretence of an independent central bank. In modern monetary economics governments have realised that it need not arrange with the central bank to hand over all the counterfeit money, it only needs to have access to more-and-more debt without appearing to consume all the savings and liquidity for itself. By not claiming all the newly created liquidity governments successfully bribes the institutional economy and private sector leadership with early access to and super profits from the newly created liquidity.

“Money is the root of all evil”, is a general misquote from the Good Book. The more correct quote is "For the love of money is a root of all sorts of evil," [see Wikipedia on Root of all Evil.] Debt is not evil and very useful to the economy when it is utilised in a responsible and sustainable manner. Love of debt from liquidity creation is a root of all sorts of evil.

This sets into motion a process of unsustainable debt formation. A process that once started, is almost impossible to turn around. A process that will destroy the harmonious coexistence between predator and prey until both are extinct. A self destruction process unless the ecosystem/economic system finds a way to rebalance the coexistence between predator and prey.




(Click on the chart for a larger image)

The intervention and liquidity provision not only increase the amount of available debt, it also cause a reduction in interest rates. A fantastic outcome for the predators but for the unintended outcome on supply of savings from production surpluses.

The economic system can only generate sustainable debt at the lower savings supply level before the addition of liquidity provision and at the higher interest rate which sustains that level of savings formation. The new normal for sustainable debt at the lower interest rate is an even lower level of savings formation at that lower interest rate.

The new economic reality is that the economic system can no longer facilitate repayment of the debt levels unless some future external economic rescue happens, for example a major technological advance with significant economic benefits. Thus the system now generates unsustainable debt, not capable of repayment from savings. Debt not capable of repayment from savings is debt not capable of repayment at all. Thus this monetary model generates bad debts. Bad debts that the private sector users of debt will eventually find impossible to repay from private sector savings. Bad public debt that the governments will eventually be unable to repay from politically viable tax collections.

This process of liquidity creation will accelerate and feed upon itself until it drives the economy into zero interest rates and drive savings towards extinction. Zero interest rates are no impediment against further expansions of digital liquidity.




(Click on the chart for a larger image)

This process is hyperinflationary in the extreme but the hyperinflation can manifest in CPI or in asset bubbles. In fact, modern monetary policy prides itself on avoiding the CPI outcome. The most notable asset bubble is the overvaluation of debt based financial assets. The global economy discovered some of that overvalued private debt in 2007. Discovering the overvaluation of government debt lies at the end of this road. Discovering also that government will default on its obligations against all populist expectations is another systemic shock in waiting. Government debt default arrives first covertly, but eventually overtly. We have already seen the incremental defaults on pension liabilities by increasing the pension age. Proportional international debt default is usually achieved through currency devaluation, presently captured in the desperate race between governments towards having the weakest currency. Early signs of public default are governmental debt collapse around the fringes. Will Greek citizens be forced to repay in euro savings or will the Greek government be forced to abandon the euro and devalue a new Greek currency in partial debt default? The true nightmare is the reality of pension fund savings invested in mispriced, hyper inflated private and public debt. Monetary liquidity provision destroys savings with no regard for international borders. Defaults will similarly not pay homage to international borders. Governments will be forced to protect their national savings base against predatory monetary policies of other governments.

Hyper inflated equity prices are yet another manifestation of the digital liquidity hyperinflation wrapped in palatable form, if not extremely attractive marketable form.

The liquidity provisions from digital money must be removed from the global economy for structural harmony to be restored. Either through a long term return to a culture of savings without any further increases in liquidity provision via digital money, debt default or a combination of both. Most of such renewed saving will probably be expropriated through taxes by governments to the extent that they need to reduce their predatory debt levels.

Furthermore, substantial new savings formation cannot happen at zero interest rates. It follows that the division between default and savings formation will be decided at interest rate level. If zero interest rates are a given, then await the default process. Higher taxes and increased interest rates will see a gradual return to harmony. Point out those politicians who will be able to sell higher interest rates and higher taxes and survive at the polls then calculate the odds for systemic default. Voters won’t vote for order and will harvest chaos.

We have already entered the final phase of this process. Look around and know that you are prey even if only for the pension savings flesh that you can provide. Know that governments will hunt your savings like hungry lions in their quest to preserve the pride. Know that your savings cannot prevail against the hungry lions unless you have nimbly removed it from the hunting grounds and placed it into assets far removed from prying eyes of hungry lions. Know also that banks cannot survive without deposits. When most deposits are driven into hyper inflated traded debt or equity in search of alpha, know that a banking system built upon monetary liquidity rather than savings is a system that cannot survive in that form. Know thus that banking systemic risk will untimely rear its ugly head once more when government defaults consume the last available true savings in the system.


Sarel Oberholster
BCom (Cum Laude), CAIB (SA).
1 July 2010

Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .


© Sarel Oberholster

Rouletteconomics

“In December of 1639, Pascal's father had moved the family to Rouen where he took a job as tax collector for the region. Pascal's invention of the mechanical calculator in 1641 was borne out of a desire to help his father in collecting taxes. … Pascal worked on many versions of the devices, leading to his attempt to create a perpetual motion machine. He has been credited with introducing the roulette machine, which was a by-product of these experiments.” - Inventor of the Week Archive, Lemelson-MIT Program, May 2003

The simple economics of supply, demand and price are probably the widest known and most used part of economic life for the majority of all participants. We know the basics, too much supply and the market is flooded with a product, the price drops and the producers are encouraged to produce less of that product and look for another opportunity. Simple, or not? On the other side, rules of demand state that a lower price would actually encourage demand to absorb at least some of the over supply. Huge demand and insufficient supply and the opposite happen.

The truth is that there is an endless interaction between price, supply and demand in a dynamic process of price discovery which, like infinity, can be conceptualised in the abstract but one can never quite get your hands on it. Nobody tries to interfere with infinity or to manage infinity but managing price is always fair game.

Now add the tendency of humans to manipulate their environments to their advantage and we see that economics is studied mostly for insights to manipulate for a gain. Nobody pays more for these insights than government for it has unbridled power to manipulate at a macro level. A myriad of other manipulators are much less ambitious and will stick to “niche” markets where they will often attempt to access government power to manipulate their chosen niche market.

Free market economists are seldom as much in demand as economists specialising in market manipulation so why do these unwanted economists refuse to die out and where do they get gainful employment? These economists have learned to look beyond the manipulation and know that, in time, someone will be needed to attend to the repairs to the economic fabric torn by a multitude of manipulations.

Taking our cue from Pascal, where government economic manipulators are looking to maximise taxes in an economic model of perpetually increased tax flows, a peek into market manipulation can be demonstrated by looking at a roulette table. The rules of the table are devised and the roulette table market is set into operation. All participants to the market event (the betting, the spin of the wheel and the roll of the ball) know the rules and the odds.

Two very important preconditions exist. The wheel and the ball must spin and roll without interference and the fall of the ball be left in the unbiased hands of chance. All the punters must be treated equally.

What happens at the table? A redistribution of the pool of bets at the hands of chance and the “House” as operator of the “roulette market” gets a “house percentage”. That is it, and it repeats endlessly for as long as money enters the table. Pool established, turn of the wheel and roll of the ball, the house cut and redistribution according to the placing of the bets and the outcome of the roll. The house cut in roulette is its statistical edge generally calculated to be 5.26%. The House has to manage its income as it would realise the house edge only once it has a statistically large enough number of events.

The game of manipulation immediately gets under way. Certain punters want to find a system to improve their odds. The House wants to find a way to improve its odds and the “marks” just trust in blind luck.

The House has a vested interest in maintaining a status quo and will go as far as prosecuting punters who “game” the system for the roulette market will collapse should the redistribution be taken from the hands of chance. The House will lose its cut or the punter will walk away from a rigged market. Perpetual motion in the roulette market cannot have a single or a few winners and everybody else a loser, or can it?

Say Mr Well Connected arranges with the House special rules that would ensure that he gets a guaranteed winning percentage of the pool. What would happen? Would the punters simply stop punting?

Say Mr Government wants to do the same but it wants an upfront guaranteed cut irrespective of how the redistribution is done thereafter. What needs to be done? Engage the power of governance.

Say Mr Well Connected wants punters to be forced to continue to punt so he can get his slice. What would need to be done? Engage the power of governance.

Governance is a crude intervention and breeds rebellion so alternatives are always sought. The best solution would be to ensure that there is always a lot of money in the pool for punters, the House and Mr Government to take cuts.

The solution is to flood the betting with counterfeit money of such good quality that nobody can see the difference. Who better to do that than the original source of money, the Central Bank? Central Bank money creation will express as debt and too much of it as reckless private or sovereign debt. No matter, Mr Well Connected and Mr Government enters into a Public Private Partnership whereby Mr Well Connected arranges for the orderly distribution of the counterfeit money on behalf of Mr Government in exchange for a percentage of the cash at the table.

Mr Big Spender at the table soon gets into trouble with too much punting while having too little money and far too much debt. He begs Mr Government for a bailout. Mr Government arranges special “F” chips for Mr Big Spender backed by special counterfeit money because Mr Big Spender must be kept at the table else the whole game collapses.

The House has since also made a deal with Miss Lightning Fast Punt who now has a special arrangement, for a fee. She gets to bet first and can withdraw bets one nanosecond before the ball falls. She manages her bets to time the ball and make sure she hardly ever gets a loosing punt. Mr Government does not like the deal very much but Miss Lightning Fast Punt can sure fill a table fast with bets and makes the game look very good so Mr Government just makes unhappy noises but does not interfere with the arrangement.

Round and round the betting would go, the House makes money, Mr Well Connected makes money, Mr Government makes money, Miss Lightning Fast Punt makes money and even lots of lucky punters on the right side of the wheel make money. Mr Big Spender keeps loosing money but with an unlimited credit line to counterfeit money plays like never before. The money pool at the table is saturated with counterfeit money, gambling on debt, a deadly game that always ends in disaster.

The pool money must remain at the table. It can never be withdrawn from the table to enter the economy of goods and services, of real things. It must remain at the table where the game of illusionary wealth is the reward while Mr Well Connected, the House, Miss Lightning Fast Punt and Mr Government spends their cuts in the real economy. The betting pool, however, must remain at the table or else Mr Government will be called upon to pay its debt, a debt that will have to be taken as taxes while using the power of governance. A debt that may be reneged upon in the interest of "the people".

The roulette market is no longer the willing participants market but a market controlled and managed to maintain the money pool at the table at all costs. It now also needs tinkering with the bets and payouts. For instance, the black and red simple bets may now only be played with “I” chips and Mr Government will decide the payout.

What aught to be and what will be are seldom the same so in the end the pool money will escape or a punter will find that the “chips” simply cannot be cashed in and then the game is up. The game is always up when the “mark” is cleaned out. In the game of economics that is when the savers have been cleaned out.

Until then, Mr Government drains the real money form the roulette pool, spends it and runs up a debt that is impossible to repay. Mr Well Connected and Miss Lightning Fast Punt bets at the table and always win, the House is happy with activity, Mr Big Spender can play at will while the punters enjoy their illusion for as long as it lasts.

In time the rouletteconomy becomes unstable and collapse. Then for a short period there will be strong demand for free market economists to repair what is broken before the counterfeiting of money returns as a pacemaker for economic activity. Benign at first, menacing at the end.

The game at rouletteconomy is a dangerous game but fortunately it is just a figment of my imagination, or is it not?

When the chips are down make sure that your payback will not be all illusion for the “real” economic calculator will apply when more Mr Governments are caught at running up bills they cannot hope to ever repay. If you are a saver, know that you are the mark and convert your savings in good time into a reliable store of value far away from the hands of manipulators.

Sarel Oberholster
BCom (Cum Laude), CAIB(SA).
28 May 2010

Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .


© Sarel Oberholster

The Independence of the FED

There is a thesis that the banks are in control of the Fed and as a result had gained control over the issuance of the currency of the US. This thesis is based on the fact that the shares of the Federal Reserve Bank are held by these private banks. Does that mean that the private banks own the Fed? The short answer is yes but it is a hollow ownership with very restricted rights, basically to provide a smokescreen for the claim that the fed is independent. It is appropriately described as follows in the publication by the Fed available on its website, “Federal Reserve System Purposes & Functions” (1):

“The holding of this stock, however, does not carry with it the control and financial interest conveyed to holders of common stock in for-profit organizations. It is merely a legal obligation of Federal Reserve membership, and the stock may not be sold or pledged as collateral for loans. Member banks receive a 6 percent dividend annually on their stock…” (p12)

This is exactly the manner in which Special Purpose Vehicles (or Special Purpose Entities) are created in the corporate world. There is usually a promoter who does not wish to be seen to own an entity but who wishes to derive some benefit from the existence of such an entity without the burdens of ownership, which more often than not, would adversely impact on the presentation of its financial reporting.

The authorities and regulators including the Fed are very aware of these structures as are the accounting profession and rules have been devised and implemented to assess any such arrangement to establish its true nature. It is therefore appropriate to assess the Fed independence or alternatively interdependence according to the very rules that it uses to assess Special Purpose Entities. First let’s draw the simple ownership structure.






Anyone with a rudimentary knowledge of accounting principles would know that ownership of an entity without control over that entity requires further investigation. Consolidation of a group of companies can become complex when ownership and control are split. Ownership will be ignored and focus will be shifted to control according to GAAP (Generally Accepted Accounting Principles).

For example, a right to appoint the majority of the Board of Directors even in the absence of ownership would trigger a consolidation of that entity. Thus the controller and the entity would be seen as part of a group and collectively as a single interdependent consolidated entity. It follows that the above simple structure of the Federal Reserve Banks is a split structure where “ownership” is of limited significance and “control” must be established. Control will tell us whether the entities are independent or interdependent.

All regulation targets “control” and not just the legal form of ownership.

Accounting principles of consolidation have evolved from Special Purpose Vehicles, to Special Purpose Entities and very lately with the revision in June 2009 for implementation in January 2010 of Financial Accounting Standard 46(R) (“FIN 46(R)”) to the concept of a “Variable Interest Entity”. One can simplify the concept to question whether they are a family and the DNA test is to check for a “variable interest”. FIN 46 (R) defines a “variable interest” as follows:

“Paragraph 1A:

The enterprise with a variable interest or interests that provide the enterprise with a controlling financial interest in a variable interest entity will have both of the following characteristics:

a. The power to direct the activities of a variable interest entity that most significantly impact the entity’s economic performance

b. The obligation to absorb losses of the entity that could potentially be significant to the variable interest entity or the right to receive benefits from the entity that could potentially be significant to the variable interest entity.”(2)

The first test is to check for “the power to direct the activities…” Who exactly holds that power?

Here we turn to the Federal Reserve Act which instructs the Regional Federal Reserve Banks to elect each their own Board of Directors of which the Chairman and Vice Chairman of the Regional Board will be appointed by the Board of Governors of the Federal Reserve System. The Regional Boards must have nine directors in 3 classes of 3 each (A, B and C directors). Three A directors chosen by the stockholders; three B directors to represent the “public”; and three C directors to be appointed by the Board of Governors of the Federal Reserve System. The Board of Governors of the Federal Reserve System will appoint the Chairman and Vice Chairman from the ranks of the three C directors.

Two important concepts now present. The Board of Governors of the Federal Reserve System seems to have powers which could indicate “control” including the appointment of the power positions of Chairman and Vice Chairmen. The second is the question, “do the Regional Boards have independent powers normally associated with ownership and control or are their powers restricted and controlled in any manner?”

The answer again lies in the Federal Reserve Act, Section 4, par 8:

“8. Administration of Affairs; Extension of Credit
Said board of directors shall administer the affairs of said bank fairly and impartially and without discrimination in favor of or against any member bank or banks and may, subject to the provisions of law and the orders of the Board of Governors of the Federal Reserve System, extend to each member bank such discounts, advancements, and accommodations as may be safely and reasonably made with due regard for the claims and demands of other member banks, the maintenance of sound credit conditions, and the accommodation of commerce, industry, and agriculture. The Board of Governors of the Federal Reserve System may prescribe regulations further defining within the limitations of this Act the conditions under which discounts, advancements, and the accommodations may be extended to member banks. Each…”

The Regional Boards are limited in their abilities to perform the primary functions of the Regional Federal Reserve Bank in terms of the act and under the control of the Board of Governors of the Federal Reserve System. It is clear from the Federal Reserve Act that control does not vest in the Regional Federal Reserve Boards, nor are they independent but they take instruction and are controlled by the Board of Governors of the Federal Reserve System.

It is now appropriate to update the simplified structure above to add these two steps of control.






The question of “who has control?” is not yet resolved as the nature of the Board of Governors of the Federal Reserve System must be investigated next. Is the Board of Governors of the Federal Reserve System an independent body or beholden to another entity?

Federal Reserve System Purposes & Functions on page 4 describes the nature of the Board of Governors of the Federal Reserve System:

“The Board of Governors of the Federal Reserve System is a federal government agency. The Board is composed of seven members, who are appointed by the President of the United States and confirmed by the U.S. Senate.”

“The Chairman and the Vice Chairman of the Board are also appointed by the President and confirmed by the Senate. The nominees to these posts must already be members of the Board or must be simultaneously appointed to the Board.”

The Board of Governors of the Federal Reserve System is a federal government agency and power to appoint all its members, Chairman and Vice Chairman is vested in the President of the USA, with a veto power over any appointment for the Senate.

The first requirement for a “variable interest”, “the power to direct the activities…” is answered in the affirmative.

Federal government at Presidential level holds “the power to direct activities”.

The final version of the structure of control is as follows:






The next requirement which must be met for a “variable interest” is any one of (i) an “obligation to absorb losses” or (ii) a “right to receive benefits”.

I would argue that the right to create currency granted to the Fed together with the vested interests of Federal Government are more than sufficient to infer an “obligation to absorb losses”. The Federal Reserve Act adds a complication to this argument by holding the shareholders responsible to the extent of their stockholding for the liabilities of the Regional Federal Reserve Banks. The “obligation to absorb losses” is not a requirement that needs to be met, provided that the alternative “right to receive benefits” requirement is met and since it is not clear cut, it is better to concentrate on the latter right. Note that the obligation or the right need not be an absolute.

Again we can turn to the two sources, the Federal Reserve Act and the Fed publication Federal Reserve System Purposes & Functions for guidance.

Federal Reserve Act:

“Section 7. Division of Earnings

Dividends and Surplus Fund of Reserve Banks(a)

1.

A. After all necessary expenses of a Federal reserve bank have been paid or provided for, the stockholders of the bank shall be entitled to receive an annual dividend of 6 percent on paid-in capital stock.

B. The entitlement to dividends under subparagraph (A) shall be cumulative.

2. That portion of net earnings of each Federal reserve bank which remains after dividend claims under subparagraph (1)(A) have been fully met shall be deposited in the surplus fund of the bank.

(b) Transfer for fiscal year 2000.

1. The Federal reserve banks shall transfer from the surplus funds of such banks to the Board of Governors of the Federal Reserve System for transfer to the Secretary of the Treasury for deposit in the general fund of the Treasury, a total amount of $3,752,000,000 in fiscal year 2000.

2. Of the total amount required to be paid by the Federal reserve banks under paragraph (1) for fiscal year 2000, the Board shall determine the amount each such bank shall pay in such fiscal year.
During fiscal year 2000, no Federal reserve bank may replenish such bank's surplus fund by the amount of any transfer by such bank under paragraph (1).”

Federal Reserve System Purposes & Functions, page 11:

“The income of the Federal Reserve System is derived primarily from the interest on U.S. government securities that it has acquired through open market operations. Other major sources of income are the interest on foreign currency investments held by the System; interest on loans to depository institutions; and fees received for services provided to depository institutions, such as check clearing, funds transfers, and automated clearinghouse operations.

After it pays its expenses, the Federal Reserve turns the rest of its earnings over to the U.S. Treasury. About 95 percent of the Reserve Banks’ net earnings have been paid into the Treasury since the Federal Reserve System began operations in 1914. (Income and expenses of the Federal Reserve Banks from 1914 to the present are included in the Annual Report of the Board of Governors.) In 2003, the Federal Reserve paid approxi¬mately $22 billion to the Treasury.”

The statement “about 95% of the Reserve Banks’ net earnings have been paid into the Treasury since the Federal Reserve System began operations in 1914” says it well enough. It is an irrefutable fact that the Federal Government is the overwhelming recipient of the “right to receive benefits”.

The outright undisputable conclusion is that the Fed, when tested against GAAP as is used by it in it’s assessment of those it regulates, is a Special Purpose Entity of Federal Government or according to the latest definition is a Variable Interest Entity of Federal Government. The rules of consolidation therefore apply and the Fed must be seen as controlled by Federal Government, indivisiably part of Federal Government. The pretence of independence is no more that that, a pretence.

There is, however, no denying that the banks have tremendous vested interest in influencing the policies of the Fed and that the power so narrowly vested in the President makes the President a special target for influence. Still, the power to control the Fed is not in the hands of the “owners” but firmly in the hands of Federal Government and the President of the USA.

Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
7 March 2010


© Sarel Oberholster

1. Board of Governors of the Federal Reserve System Washington, D.C., Ninth Edition June 2005, Federal Reserve System Purposes & Functions.
2. Financial Accounting Standards Board of the Financial Accounting Foundation; Connecticut, No 311; June 2009, Statement of Financial Accounting Standards No 167.


Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .

Zero Cost Carries

Interest rates as a pricing mechanism in the economy go much deeper than the superficial assessments of mortgage loan rates or what one earns on deposit. Arguably one of the most significant jobs of interest rates as a pricing mechanism is the “cost of carry”.

This in plain language means how much it would cost to buy any item for resale at a future date. A simplified example may help. Say a store buys a product for resale at $100 with the aim of selling it within one month. Now let us state that interests rates at that time was 12%. That would translate into an interest rate of 1% for one month. So the store owner would have a cost of carry of $1.

The store owner paid $1 to carry the stock for one month. Say in this example that the store owner would have expected to make a net profit of $10 on the sale before paying for the cost of carry. That would imply that the store owner’s cost of carry would have calculated as 10% of the net profit. The importance of cost of carry is yet but partially explained.

What happens should the product not sell as expected in one month and the store owner is only able to achieve the sale after 12 months? Cost of carry now amounts to $12 and has wiped out the entire expected net profit and some. Accountants developed a measure to manage cost of carry in a stock turnover ratio. The manager would ensure that the total stock turns over as fast as possible to keep cost of carry as low as possible. The store owner would be encouraged to purge slow moving unwanted stocks from inventory through the cost of carry mechanism. A desirable and economically efficient behaviour trait operating on autopilot without outside intervention.

The principles of cost of carry translate directly into financial markets and financial speculation. Interest rates are not the only component in cost of carry but have always been an important component, that is before the advent of the zero bound interest rate policies of central banks.

Say you want to speculate on a rising oil price. Calculating the cost of carry on your position follows this economic and accounting logic. You borrow the cash required to make the purchase. Buy the oil and store it. Cost of carry will be the interest paid on the loan and the cost of storage for the period from when you entered into the transaction until you chose to exit. That’s the basics. Why should it be significant?

Cost of carry cascades through the economic fabric in millions of ways. A real estate owner for profit would purchase a commercial or industrial property and the expected profit would be the rental incomes, less cost of carry, less operating expenses. A speculator in shares would expect a profit equal to the difference between the buying and selling prices, plus dividends, less cost of carry. Interfere with this mechanism and it impacts as wide as supply and demand variables of property. Too low interest rate and access to easy credit would drive up demand and prices in no time for example. That is the birthplace of property bubbles (and all other asset inflations also known as asset bubbles).

The whole economic cosmos of derivatives is priced on a cost of carry basis. Forward cover on foreign exchange (say $/Yen) is based on the perfect hedge of borrowing the dollars and purchasing yen at inception. Invest the yen for the period. Cost of carry for the period would be the dollar loan cost less the yen income, both interest rate denominated. Thus the forward price of Yen would be the spot (today’s price) plus the cost of carry, which may be positive or negative. A neat little cross border trick performed by interest rates in this pricing mechanism. Mess with the interest rates in one or both sovereign economies and the exchange rate pricing mechanism get similarly messed up.

Interest rates are an invisible spider’s web influencing every price of every type of good or service produced in the economy. No matter where you touch it, it reverberates throughout the whole structure. Interest rates would regulate the allocation of scarce savings, and yes savings are always scarce without huge quantities of debt facilitating liquidity provision from the central banks. This job of allocation by interest rates when interest rates are free form manipulation or outright control is performed as a delicate harmonious melody throughout the economy in that invisible spider’s web. The dynamic takes cognisance of economic merit right down to the smallest individual transaction maintaining an intricate economic balance which in turn contributes to the harmony of all other pricing mechanisms.

Just try and imagine the corps of central bankers required to perform the same functions previously performed by interest rates without the interfering central bankers. It is not only probable but guaranteed that these delicate operations will no longer take place. At first the interest rates just gets distorted. The distortion in interest rates distorts all other pricing mechanisms and influences the choices and behaviour of economic participants. The previous dynamic harmony is lost.

Sadly it does not stop there. Every intervention breeds another intervention to sustain the distortion of the previous intervention. All interventions breed like germs on rotting flesh left outside in the sun and spread like a virus on a university open website. The interventions accumulate and compound and monetary policy interventions reach the pinnacle of absurdity when it attains that final resting place of the zero bound.

The central bank has effectively discontinued the base interest rate from the economic landscape. Of the spider’s web which were tattered and torn by interventions now only remains a few malfunctioning strands. Interconnecting harmony and relative rebalancing is but an abstract memory.

Then again why would it matter? Unfortunately it matters very much. Visualise an economic pickup truck with no intricate wiring. Nothing works and it is simply being pushed around by government and central bank officials. Having destroyed the fabric of pricing mechanisms are not without consequences. Those consequences are as varied and as complex to pin down as were the contribution of interest rates to the pricing mechanisms.

Cost of carry is but one component where consequences will manifest. Staying with the examples given we can see that inventory management has been compromised and dead stocks can be carried without cost, which will certainly diminish efficient management of stock levels; the oil speculator can double or triple his position and carry it for longer with an immediate consequence that the price of oil may rise for everyone else though the general tendency would be for oil prices to become unstable and subject to violent unpredictable adjustments; the most obvious consequence for real estate is similarly boom bust pricing cycles but a menacing economic rot in the encouragement to banks to roll and refinance bad debs while in reality becoming owners of the properties on a zero interest cost of carry is a less obvious outcome; perhaps the most devastation to pricing mechanisms are the consequences of a zero cost of carry on derivative markets distorting macro pricing of exchange rates between currencies, hedging and arbitrage in all commodities and financial securities across all forms of derivatives from the plain futures and options to the exotics. No pricing mechanism is spared the taint.

A very real example which carries influences from cost of carry on inventory, to finance, to derivatives and even sovereign currency pricing is copper. Thus we can observe the absurdity of huge stockpiling and rising prices concurrently in real time.








The global economy is now cursed with the affliction of the zero bound interest rate policy in all the major economies. Thus all micro and macro pricing mechanisms must function with the heavy hand of central bank bureaucrats allocating with bias, subject to vested interests and central government direction. They only allocate where they can see and how they desire in the absence of the delicate spider’s web of dynamic interest rate allocation on economic merit.

Adam Smith’s invisible hand of the market has been chopped off at the elbow.


Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
31 January 2010


© Sarel Oberholster



Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .

Twin Peaks – Jumping in Mud

In this edition of Twin Peaks we continue to monitor the unfolding developments in the Global Financial Crises (yes it is still with us) and the developments of the post Dec 1989 crises in Japan as expressed in the Dow and the Nikkei. The thesis as has been discussed at length in previous Twin Peaks series, is that the USA and Japan are following similar monetary policies of excessive monetary stimulation which achieved an artificial market condition described as “the zero bound” where short term interest rates are stuck at zero or near zero for extended periods. The 1989 economic collapse in Japan initiated its drive towards the zero bound and the USA started its march towards the zero bound after the 2007 economic crises. Both economies have achieved the condition of being stuck in the zero bound but the USA is about 18 years behind Japan. The zero bound monetary policy combines with Quantitative Easing and fiscal policies of budget deficits to generate an explosion of public debt.

The present tale of the charts is one of divergence. The USA chose aggressive monetary and fiscal interventions while the Japanese took a more measured approach. It is the Bernanke theory that this difference is what will distinguish the USA from Japan, where the USA will recover to rapid economic growth as opposed to the Japanese experience of a low level deflationary depression stretching over two decades and entering its 3rd.

The aggressive policies of the USA are showing up in the charts. That does not mean that the Bernanke theory is proven, it simply means that the markets reacted in predictable fashion to the very aggressive government policies. Government and central bank interventions are not self sustaining and must be repeated in ever growing tranches to simply maintain a stimulation effect. The next stimulation will need to be even greater than the previous two but it may not be as visible due to the adverse political consequences attached to the previous spectacles.

Stimulation decay sets in after a while unless, and this is what is hoped for, the spark provided by the government is sufficient to get the economy going. The jury is out on whether stimulation will be a gasoline and newspaper bonfire burning fast and bright for a while to sputter and die or not. Everything rides on that outcome.




(Click chart to enlarge.)

The peaks of the Nikkei and the Dow are matched in this chart and not rebalanced thereafter to allow for significant deviances. The peak of the 1929 Dow has been added just to spice up the test against depressionary conditions. The aggressive US intervention has now carried the Dow upwards beyond the levels of the Nikkei, for a similar period as unfolded. The positive divergence in itself is not compelling as the initial equally aggressive reactions to the 2007 crash caused a similar positive divergence then, which was resolved with a dramatic convergence and negative divergence between October 2007 and April 09. This chart does not show it but the long term bottom of the Nikkei since Dec 1989 is as recent as 10 March 2009 at 7054.98.

The decay in the stimulations is already showing up in the momentum inherent to the move from April 2009.

The Momentum chart hereunder needs some explanation in interpretation. It measures the relative change in the gap between the 50 day moving average and the 200 day moving average, counting backwards. A 180 degree flip-over (negative to positive) in data occurs when the 50 dma crosses over the 200 dma.

Here’s what the chart tells us. The momentum in the bear move down was failing for weeks before late March, early April 2009. The bear market momentum gave way to a negative momentum bear, i.e. a bull market momentum since early April 2009. The flip-over/crossover occurred just before the end of June 2009. Momentum still spiked unto mid July but since then bull momentum has been in decline. The “jumping in mud” period started in late October 2009 where the market is still in bullish trend but just can’t get going.

Presently we are still in the “jumping in mud” phase but the beginning of a downward trend is showing up in the negative momentum bull, i.e. the bull marked momentum is failing. We have not yet reached a point where we can make a call to say that the bull marked has failed. The historic indications are that a -1.5% to a -2% recording is required to indicate a high probability that a bear market move is underway. The highest recording was -0.7% on Dec 31st 2009. So for now it is simply “jumping in mud” time until momentum picks up in either direction.




(Click chart to enlarge.)

The here and now is where the bulls will believe in the Bernanke thesis that this time it will be different for we acted faster and with more aggression in our stimulations. The bears will continue to claim that the speed and extent of intervention will not alter the outcome of a deflationary depression only how we get there. They would further insist that the likely outcome of a too fast and too furious monetary response will harvest an even worse outcome of a hyperinflationary depression in an effort to escape the deflationary depression. Already gold, silver, copper and every other commodity are being stuffed in custody and warehouses discounting such excess. Another vote of no confidence in official policies and not a sign of economic recovery.

The Japanese economy in this phase was typified by warehousing growing bad and delinquent debt with central bank and central government support. Mortgage debt for instance was warehoused in the Jusen structures, with similarities to the Freddie Mac and Fannie Mae structures in the USA. Every stimulation, regulation and intervention was aimed at reviving the asset inflation pre 1989 and denying the accumulation of decay in the economy. The economic events forced Japan to disprove the Keynesian theories of sticky downwards salaries and wages when after endemic unemployment, salaries and wages stated falling. Asset inflations never revived and in fact continued to deflate as each stimulation and intervention to prevent that outcome failed. Minuscule rises in interest rates or in direct or indirect taxes dumped the economy right back into crash mode, stumbling through two decades of economic decline until government debt equalled national savings in this previously high net savings nation.

Perhaps this time the outcome of Zero Bound and Quantitative Easing monetary policies combined with budget deficits and excessive government debt will be different, but probably not.

May you trade with wisdom and reward in 2010.


Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
6 January 2010

Ps. I will post a news flash update should the Momentum chart post a negative 1.5%.


© Sarel Oberholster


Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .