The Next Bubble

Liquidity is a problem.

It's not solvency, although, with market contractions, solvency may soon, again, be an important short-term concern. Increased reserve/liquidity rules on banks mean that the next shock is survivable in the near term. If, in fact, the markets decide that the bubble hasn't burst.

The bubble will burst. Treasury, under Geitner, has decided that liquidity is more important than growth of the money supply. The Bernanke has abdicated the Fed's authority to political considerations. Volcker, while admired by some, was known to indulge in politics. While I admired his cigar consumption, there have always been problems with Volcker. Greenspan, and his focus on the money supply has always been, in my humble opinion, one of the best friends of markets since the establishment of the Federal Banking System.

QE1 and QE2 have been busts. Just as has been the Democrats "Shovel Ready" approach to the current recession. Keynesians simply aren't equipped with enough statistical evidence to support their advocacy of government expenditures creating wealth. You cannot, over the long-run, steal from your neighbor and call it wealth creation. At a certain point, you run out of people to rob.

QE3, which is being proposed as the next fix is, ante doomed to failure. Q1 and Q2 were bad enough, a program designed to increase liquidity, in order to force investment in "big board" exchanges. With too much money, the desire to seek returns led to investments that offered higher rates of return than those of other markets. It is obvious that the private businesses of America are fearful of the future; taxation, regulation, and the big one, Obamacare.

So, QE1 and QE2 created an economic environment where there was excess liquidity and reduced demand. Basically, if you ever studied Macroeconomics, what has occurred has been a shift to the right of the GDP curve. Whether you are a fan of Expectations, Monetary, or even, Keynesian economics (and you could add other view, like the Wealth Effect or Rational Expectations) all of these schools of thought relate to its practitioners that it is possible that all of the precepts of their individual schools are reliant upon tastes and preferences remaining constant.

What happens when tastes and preferences shift? What happens when uncertainty rises to a level never seen within a generation? The macroeconomic GDP curve shifts. To the right.

Keynesians treat the GDP curve as a constant. Spend more on transfers, increase demand. Increased demand leads to increases in income, as sales from the various sellers of goods and services increases. Remember Nancy Pelosi telling us that unemployment payments are the best thing for our economic growth.

How could anyone believe such a thing? Marginal propensity to consume.

It is true, that when people get more money, they tend to consume more. This is especially true for people on the lowest levels of income. You get a buck, you spend a buck.

The disconnect comes from the mpc becoming subsumed by the income effect. At a certain level, you can buy all you want to buy, and the marginal propensity to consume drops to zero, and then negative. Rather than spending every dollar you receive, you start to save money, invest money. The more income you make, the more likely you are to save, to invest, and this capital formation, either through the banking system or investments in equities or the bond market, allow companies and individuals to borrow money in order to invest in land, buildings, capital and employees.

There is a half-baked conviction that the marginal propensity to consume results in a "multiplier effect." (This isn't necessarily the best example of how the multiplier effect works, but it's close enough.0

The key to the discussion of the multiplier effect is, that preferences of consumption remain constant. Our current recession evidences that preferences have changed. That is, the GDP curve has shifted to the left. As we continue to follow the policies of the Democrats--increase taxes, increased regulation and increased uncertainty--the preferences of those with wealth that exceeds their marginal propensity to consume, will continue to withhold funding for investment, job creation and innovation. We simply do not know what level of taxation will be in the next year, let alone ten years, what levels of regulation, from such things as energy, land-use, emissions, labour laws, etc., might be in the next year, let alone the next ten years. And finally, the law passed to "improve health care access" is having a truly chilling effect on business. Not only do I not want to increase my workforce, I'm not even sure if my current provider will be in business in the next five years. Not that the insurance company will be out of business. Just unwilling to do business in the United States.

So, QE1, QE2. Possibly QE3. States and the Federal government spending more than revenue. Excess liquidity.

Lets take a look at bonds.

Let's assume Federal bonds sell for one-hundred dollars.

A Federal bond pays a dividend twice yearly. It is guaranteed to return to you the face value of the bond on the expiration of the bond. Guaranteed.

Assume you buy a bond at 7 percent. The value of the bond after five years is $100.00. If the market interest rates at the time of redemption is still 7 percent. What happens if bond prices drop? Bond prices are an indicator of interest rates. If a 7 percent bond for one-hundred dollars drops to $90.00, what is the effective rate on the bond? In the short-run, a bond worth $100.00 sells for $90.00, upon redemption you receive $100.00 plus the payments of interest--semi-annually--during the term of the bond. If bond prices rebound, he gets a premium for the short-term, and the advantages of a bond that retains value against time.

What if a bond, of an hundred dollars, at eight percent is held when a long-term increase in interest rates happens? A five year note will have a Net Present Value of $95.94. That is, a nearly five percent loss occurs.

If a bond's price drops enough, to an effective yield of 8 percent, that five-year bond will have a redemption rate of ten percent, the Net Present Value of that bond lowers to $88.42. The bondholder has a nearly twelve percent loss in his holdings. You think equities have suffered (now that we're back to levels seen in 2006), imagine interest rates at 8 percent. If you have any memory of the 1980's, you know that bonds can increase well into the upper teens. At a fourteen percent interest rate, that one-hundred dollar bond will be worth $75.42. A loss of one-quarter of the value of your investment.

Your President was a lawyer, not a mathematician. Timmy and the Bernanke are aware of these possible changes. Which must make both of them as nervous as a cat on a tin roof. As equities crash, as QE1 and QE2 announce their failures, take a look at your portfolio and ask, "am I inoculated from a crash in the bond market?" Chances are, you're not.

Our President has no idea of what this post is referring to. He is a lawyer. And, possibly, not that good of an attorney. Math was not a requirement. Liberals and Leftists don't really care that much about mathematical certainties. Math is hard. Doing good, or social justice, is more important than patriarchal considerations that simply support the ruling, white, capitalist system.

Take a minute and ask yourself why borrowing for new projects--without government subsidy--is so low. I would offer risk, regulation and tax policy uncertainty. But that makes me a terrorist, no?