Tuesday, 31 July 2012

Low Growth + Lower Rates = High Stocks + The Japanese Trap

I often hear the question "Given the low growth forecasts and all the economic worries, why is the US stock market valued so highly?"

I have explained previously how Stocks and Bonds can rise together in an environment where the Fed is artificially suppressing the yield curve.

"A democratic country equipped with a printing press won’t default. Austerity will fail when faced with seniors dying of poverty. However, it can and will engineer a huge monetary debasement via monetization of government debts (QE continued). US corporations will hoover up this money and cause a secular rise in profits & dividends. In real terms the Dow may not go up much, but in nominal terms this will translate into a huge rally, which began at SPX 666." - 11 AUGUST 2011

"US treasury bears will have to be very patient. There is plenty of drama to sit through before the final act - demonetization of US credit - is played out." - 30 OCTOBER 2011

"It is easy to see how a lower yield curve translates into higher stock prices. The "risk-free" yield curve is key to pricing of most financial assets. Its central role is in the discounting mechanism for future cash-flows. A lower yield curve means a higher Present Value for the future earnings and thus higher share prices. Note that the yield on stocks was in a secular decline, dropping WITH bond yields during the great bull market from the early 1980s to 2000. Another period when stock and bond markets rose together" 23 JANUARY 2012

To demonstrate this mathematically, I have modelled 3 situations using a very simplistic model for a yield curve and a fixed rate for Earnings growth. 

To obtain a valuation for stocks in each case, I discount the next 10 years earnings to their PV and sum them up. The Initial Earnings are normalised to 100, just to illustrate the principle.

Case 1: "Normal" growth and interest rates - e.g. mid 2007
Earnings Model

Initial Earnings

Growth Rate

Yield Curve Model




  US Yield
 Earnings PV


Case 2: Deflation + Credit Crunch, inverted yield curve, falling earnings - e.g. late 2008

Earnings Model

Initial Earnings

Growth Rate

Yield Curve Model




  US Yield
 Earnings PV


Case 3: Low growth, with Fed manipulated low rates - e.g. mid 2012
Earnings Model

Initial Earnings

Growth Rate

Yield Curve Model




 US Yield
 Earnings PV


  • This simple model demonstrates that in a "normal" growth and interest rate environment (Case 1), the valuation for stocks is actually lower compared with an environment where the rate of growth is low, but interest rates are artificially suppressed (Case 3). Only in a deflationary environment with funding stresses (Case 2) do stock valuations fall significantly.
  • This explains why BOTH stocks and bonds have risen over the past few years. In the process of suppressing the yield curve using QE & Twist, the Fed has driven bond prices up.
  • Instead of the normal inverse relationship between stocks and bonds, the low yield curve has increased Stock prices by increasing the Present Valuation of future earnings. The Fed does not like falling Stock markets due to the "wealth effect" acting in reverse. Falling stocks will reduce consumer spending (and therefore growth) even further in a negative feedback loop
  • Therefore, until the Earnings Growth Rate increases, the Fed is stuck with keeping the yield curve suppressed - any RISE in rates will now cause stocks to FALLAlso, thUS government is forced to continue its huge deficits indefinitely, otherwise the present anaemic Earnings Growth Rate will turn negative due to the ongoing consumer de-leveraging, and cause Stock markets to fall.
  • This Fed is forced to absorb new Treasury issuance indefinitely, until the de-leveraging process is complete and consumer purchasing power is freed up from debt-servicing and diverted back to spending
  • Ultimately, absent a financial or austerity shock (which there could be plenty of) - the market will stay buoyant, as long as the Fed keeps buying and the government keeps spending. The US debt situation is destined to become the same as Japan, with large deficits as far as the eye can see, and many years of wasteful government spending projects. 

    Sunday, 15 July 2012

    Why Austrian Economists are mistaken about 100% Reserve Banking

    (Mis)diagnosis of the Debt Bubble

    It is clear that the US and other western economies are not growing fast enough to close their "Output Gaps" - a term that loosely describes the difference between the maximum potential output of an economy and its present output. A symptom of the Output Gap is chronic high unemployment. 

    As Eric Janzen, Koo, Steve Keen, Mish Shedlock and everyone has correctly diagnosed (other than Profs. Ben Bernanke, Paul Krugman & their intellectual bedfellows), the main reason for this Output Gap is the huge PRIVATE debt overhang from the ponzi property bubble. The bubble was caused by Alan Greenspan's policy of holding the Fed's discount rate too low for too long, and this policy was encouraged by Prof. Krugman & friends. The "feel-good factor" created by rising asset prices has now evaporated, and the suckers left holding the bag and will be stuck paying down large debts for a generation. 

    Despite the Fed's numerous attempts to reduce the interest burden on private and public debt, a heavy burden of debt-service hangs over the lives of western consumers. The hangover caused by the past 10 years' borrowing-binge is to be met with self-imposed austerity as consumers increase savings where they can to pay off debts. As long as this condition persists, we can not expect consumers to be the engine of GDP growth in the US and world economies.

    The Fed can not acknowledge that private debt was the root cause of the problem for two reasons:
    1. Ideology - Profs. Krugman & Bernanke; and Alan Greenspan have repeatedly asserted that the level of private debt does not matter. They have never seriously considered the work of Hyman Minsky and Prof. Frederich von Hayek. Instead they have adopted some some of the worst ideas of John Maynard Keynes and taken them to grotesque extremes. 
    2. Complicity - The Fed deliberately turned a blind eye towards the huge growth in private debt under Greenspan's watch. Prof. Krugman continues to insist that the entire financial crisis was caused by a few NINJA loans, and not excessive debt. 
    Since the monetary authorities failed to correctly diagnose the problem, one can hardly be surprised by their continued failure to design an effective solution to the current economic problems. Their wilful and arrogant ideological blindness exposes an inability to fulfil their mandate to regulate the economy; and it highlights the sad neglect of their responsibilities towards those who have lost their livelihoods and homes due to the continuing economic malaise. You can watch an Austrian criticism of the ideas proposed in Prof. Krugman's book "End This Depression Now" by Prof. Pedro Swartz, OBE. Prof. Bernanke's policies are self-evidently failing to revive growth and close the Output Gap.

    Solving the crisis - Prof. Steve Keen proposes a Modern Debt Jubilee

    In this context there is a lively ongoing debate between Prof Steve Keen and Mish Shedlock over how to solve the debt crisis. I have been an avid reader of both Mish Shedlock (Austrian) and Prof. Steve Keen (post-Keynesian) for several years. I have enjoyed watching their respective messages gain a worldwide audience and both of them rise to prominence in internet media. 

    This debate was sparked by Prof. Steve Keen's proposal for a Modern-day Debt Jubilee (video).  He proposes "Quantitative Easing for the Public" wherein the Fed writes each tax-payer a (regular series of) cheque(s), with the proviso that the recipient MUST use the funds distributed to pay any outstanding debts. The idea is to provide relief  to those who participated in the ponzi housing bubble, while offering a cash award to the sensible borrowers who did not.

    This scheme would free many consumers from debt-servitude, while putting enough cash into consumers' pockets to revive demand in the economy. Although this is bound to cause inflation at some point, that would provide central banks with the perfect excuse to re-normalise interest rates. The reduction in debt-principal will allow consumers to continue servicing their debts at higher rates without escalating defaults.  

    I think this proposal is better than the current solution of "Quantitative Easing for the Banks", wherein central banks buy up Treasury debt, while banks front-run Fed-purchases and drive bond prices to stratospheric levels. The resulting distortion of the yield curve makes the price of all risky assets dependent on future actions of the Fed (Risk-on/Risk-Off). 

    The Austrian non-Solution - 100% Reserve Banking

    Mish Shedlock has criticised the idea of a debt-jubilee (see here, here and here). He comes from the view that all lending must be 100% backed by Gold deposits, and that this is the only way to constrain the unlimited growth of credit and prevent asset-bubbles. He holds the view that Fractional Reserve Banking is inherently fraudulent because it creates "credit out of thin air". He asserts that this fraudulent behaviour is the root cause of the business cycle. This view is very popular with several Austrian economists (especially in the U.S.) including Joseph T. Salerno, Gary North and others. It is often repeated on Austrian and Libertarian sites such as www.lewrockwell.com and www.mises.org.

    I believe 100% Reserve Banking is a non-solution to the current crisis. Although it does prevent debt-crises, it does not provide a roadmap to get out of the current debt crisis. Besides it has the dangerous side-effect of hampering efficient production of industrial goods as I explain below.

    Real Bills - a blind-spot in the 100% Reserve Banking argument

    For many years I supported the Austrian 100% Reserve Banking position. My opinion changed after I became aware of the work of Prof. Antal Fekete. He describes the free-market phenomenon of  Real Bills. These are unbacked credit notes that spontaneously circulate in a free-market economy in order to facilitate the production and distribution of goods. I came to the conclusion that Austrian economists have a blind spot towards the role of Real Bills due to their insistence on 100% Reserve Banking.

    The New Austrian School of Economics argues that Fractional Reserve Banking is not only legitimate, but also vital for the proper functioning of modern industrial economies. It arises naturally in a free-market economy - i.e with market-selected money (presumably Gold) and free-banking (i.e. the absence of non-economically constrained Central Banks). In fact, lending without reserves or deposits can spontaneously arise out of a free market, even in the absence of banks.

    Here is an example that illustrates the spontaneous circulation of Real Bills. Consider a producer of consumer goods, such as a flour mill. The mill may not have the money to purchase grain from a farmer to supply flour (a consumer good in high demand). The mill has two options. It can either borrow the money from a saver and pay cash for the grain; OR it can write an IOU to the farmer (payable in say, 90 days) for grain delivered today. In the latter case the farmer will negotiate a premium on the cash price for his produce by discounting the face value of the IOU. This discount rate has two components (1) the opportunity cost of an alternative (safe) investment, and (2) the risk-premium associated with the flour mill's credit-worthiness.

    Typical wording on the bill may be familiar to anyone who has seen a modern currency note - "I promise to pay the bearer of this note the sum of $10 after 90 days from issuance - (signed and dated by an officer of the business)," or words to that effect.

    If farmer is confident that the mill is financially sound (due to ongoing profitability, or a long-standing business relationship), and the discount rate adequately compensates him for the opportunity costs and risks, he will accept the IOU and start to accrue the discount premium while the IOU matures. 

    As a further incentive he can use the IOU to buy items for his own use - if the local store where he makes his purchases also finds the flour mill's IOU acceptable. In this manner the unbacked IOUs issued by the flour mill circulate in the local economy. Their acceptability is ultimately due to the the high consumer demand for flour, which guarantees that a well-run mill will be able to repay the IOU on maturity. Indeed, the quantity of flour demanded by consumers automatically regulates the quantity of IOUs that enter circulation. 

    One can see how the IOUs (which are short-term promissory notes) have gained currency in this manner. In this manner a crucial distinction may be established between currency (that which is commonly used for payments) and money (that item which is demanded to ultimate extinguish a debt).

    Such short-term IOUs (called Real Bills) have historically gained currency in modern industrial economies. Evidently, they do not require any backing in monetary specie by their issuer.  Instead, they represent "forgone consumption" by the holder of the Real Bill. As the bill matures, the initial discount accrues to its holder as compensation for foregoing consumption. Real bills are "self-liquidating" - i.e. when the mill sells flour, the bill-holder demand its fulfilment in real money, and the Real Bill is redeemed. 

    Thus we see that Real-Bills are a consequence of consumer demand in a free-market economy. They exist solely to facilitate the production and sale of products that satisfy this demand. When the demand is satisfied, they "self-liquidate" and cease to exist. Until maturity they gain currency due to the credit-worthiness of the issuer, underpinned by the expected revenue from sale of consumer goods in high demand

    Importantly, any business that uses Real Bills to finance production enjoys a significant competitive advantage over its rivals. It need not raise money for a long duration from capital markets at a high rate to pay for its inputs. It "borrows" from its suppliers at a lower discount rate, and only for the duration required to finance production

    In effect, this creates  "credit out of thin air" due to deferred consumption by prior stages in the production chain. When the end-consumer pays for the product with money, the credit is liquidated all the way down the production chain and the Real Bills vanish-back into thin air.

    Real Bills - Intermediation by Banks

    Banks specialise in Credit Analysis. They are best-placed to evaluate the credit-worthiness of producers such as the flour mill. They profit from this analysis by earning a spread between the discount rate they apply to the business's IOUs; and the market discount rate applied to the bank's IOUs (typically in inter-bank funding markets).

    A bank offers the businesses a credit line. Interest on this is charged only when Bank Notes are borrowed against confirmed orders. In effect, banks facilitate replacing the circulation of the business's Real Bills with Bank Notes of the same duration. For this service a well-capitalised bank can earn a spread between the rate charged on the business's credit line and the Bank's borrowing rate. For this income to accrue to the bank, it must be more creditworthy than the business whose notes it is discounting in the eyes of the market. 

    It is important to re-emphasise that in a free-market: 

    1. Bank Notes circulate as currency, but are discounted at a rate determined by the credit-worthiness of the bankA bank's discount rate is a much better gauge of its health than the CDS price as the Real Bills market is deeper and more liquid than the CDS market.
    2. Bank Notes remain 100% convertible into the market's choice of money
    3. Banks need not to accept any deposits to intermediate the issuance of Real Bills. They need only to maintain a (relatively small) capital buffer to cover infrequent losses caused by the occasional failure of a flour mill. 
    There must be never be a question about a bank's capital buffer being overwhelmed by loan-losses. Otherwise the market discount applied to the Bank's Notes may become higher than the discount rival banks offer on the business's bills. This would eliminate the profit margin enjoyed by the bank and hamper its ability to profit from its Credit Analysis expertise. Poorly run banks will see their balance sheets shrink over time, as borrowers leave to rivals, and if they do collapse due to loan losses they would not be "Too Big To Fail". 

    Thus, a 100% reserve banking is unnecessary, and Real Bills offer a "clearing" mechanism for financing the production and distribution of goods. 

    Real Bills are Vital for Modern Industrial Economies

    In addition to being unnecessary, 100% Reserve Banking is counterproductive, because it would kill off a vital artefact of the free market -  Real Bills. A functional Real Bill market is absolutely vital because without Real Bills financing long production chains that characterise modern specialised, industrial economies could not be affordable. 

    Consider that in a 100% Reserve Banking system, each stage in the production chain needs to borrow working capital equal to the purchase price of its raw material and operating costs (salaries, bills, etc) for the duration of the entire production cycle. In a multi-stage production chain, this working capital requirement in various stages adds up to a impractically large amount.

    For example, assume a production chain for shirts with 10 steps before the shirt is purchased by the end-consumer for $20. Assume that each step in the chain makes a $1 profit. In a 100% reserve system the participants in the production chain will need combined financing to the tune of $19+$18+.....+$10 = $100. In such a system, someone somewhere in the economy needs to save $100 of money, and lend it to the production chain participants before the $20 shirt can be produced. 

    In a above example the economy needs surplus savings of 5 times the "net" production. This becomes increasingly unnecessary and uncompetitive as production chains lengthen due to further specialisation and increased productivity. It is more efficient for each link in production chain to pay for inputs with Bank Notes (exchanged for discounted IOUs at a bank credit facility). When end-consumers pay, each link in the chain repays their bank line of credit. This process is best intermediated through the banking system (which specialises in Credit Analysis) without any need for reserves, or even deposit taking. 

    Preventing Debt Bubbles

    I have described Fractional Reserve Banking using the safest of credit instruments - Real Bills. 
    1. Real Bills are "safe" because they are issued against confirmed orders for goods in high-demand. It is highly unlikely that a well-capitalised bank will suffer large losses on these bills that overwhelm its capital buffer. 
    2. As a manifestation of Fractional Reserve Banking credit is created in proportion to the quantity of goods produced in the economy and only for the duration that the goods are in the production cycle. 
    3. In addition, extension of such credit represents "deferred consumption" by the holder of the Real Bill, and therefore it does not create spurious demand that would confuse the crucial price signal in the market.
    4. There is no duration mismatch if the Bank Notes maturity on the same date as business IOUs against which they were issued.

    The key question is this - how does one prevent the extension of bank credit to activities that are somewhat more speculative than the production and distribution of consumer goods in high demand? What about bank finance for uninsured long-distance trade? Or sub-prime mortgages? Or the purchase of peripheral European government bonds?  

    Well, the simple answer is that you can not prevent these activities in the modern fiat-money system. No market discount is applied to Bank Notes because they have been replaced from circulation by irredeemable Central Bank Notes given the status of "money" (by law). Instead, the free market is prevented (by law) from choosing its own unit of account. It can not discover the discount rate on central bank money relative to its preferred unit of account.  Central Banks blatantly manipulate the discount rate up and down in the name of regulating the business cycle. All they do is cause excessive credit creation and sow the seeds for bigger and bigger financial crises in the future. 

    Such a mis-regulated environment encourages very bad behaviour by banks. While a lender of last resort exists to back-stop cash-strapped banks, they will ALWAYS try to lend as much as they can. Bank Management is incentivised to grab maximum market share for short-term profits and bonuses. Bank management will ALWAYS try to minimise their capital ratios in order to increase the return-on-capital. Banks will ALWAYS push the envelope in borrowing short to lend long (duration mismatch kills banks ) in order to earn maximum carry and rolldown. 

    And when a lending binge falls apart, the Financial industry demands suppression of the inter-bank discount rate by the central bank, re-capitalisation from the tax-payer, etc. Otherwise, they argue, the entire system may collapse and cause a Depression. 

    Therefore, the correct solution to the debt crisis is the restoration of the Real Bills market, and a monetary unit selected by the free-market. This will require a repeal of legal-tender laws that confer a legal status of "money" on Central Bank Notes. This single step will automatically restore convertibility for all Bank Notes into the free market's choice of money. Real Bills will once again signal the credit-worthiness of banks and businesses through the natural Discount Rate, thus providing banks with a financial incentive to behave responsibly.

    Forcing 100% Reserve Banking (by law) is the wrong solution. It will collapse the long, specialised production chains of the modern, industrial economy and (literally) send us back in time beyond the Industrial Revolution into the dark ages.

    Endogeous Credit Money in a Free Market

    Prof. Steve Keen has demonstrated how an endogenous (purely credit-based) monetary system can function properly without the need for 100% reserve backing, or Gold convertibility. In a series of Lectures on Behavioural Economics he used an innovative computer simulation tool to model the dynamic behaviour of stocks and flows of money and credit in an economy. His simulations use double-entry book-keeping to keep accounts and differential equations to represent financial transactions. The key difference between his model and the conventional DSGE (Dynamic Stochastic General Equilibrium) models used by Bernanke, Krugman, & co. - is the lack of any assumption of "equilibrium" in financial flows.

    I think Austrian economists need to take this demonstration by Prof. Keen very seriously. Although Austrians unabashedly support free-markets and libertarian ideas, they demand application of the full force of the law in preventing Fractional Reserve Banking;  which they consider fraud. Some of them go as far as asking the State to force the use of Gold as money. There is a lot of distance between this position and the laissez-faire ethos that guides the free market philosophy they claim to represent. Their approach places an enormous amount of power in the hands of the State instead of relying on private mechanisms to "create money and regulate the value thereof".

    I whole-heartedly endorse the idea that free-markets must be allowed to make their own choice of money; and that today's government-mandated "fiat" paper-money systems exacerbate the business cycle that they claim to regulate. 

    I whole-heartedly endorse the view that that central bank intervention in activities such as Open Market Operations  & Quantitative Easing constitute blatant "price-fixing" of the interest rate - i.e. market price of money. 

    As Keith Wiener correctly pointed out, the LIBOR scandal (wherein a few large banks quoted a low number for the inter-bank lending rate) is small potatoes compared to the massive daily manipulation of the interest-rate markets by people such as Mervyn King, the very central banker who claimed to be outraged by LIBOR manipulation! This appearance of hypocrisy is further reinforced by new reports that key central bankers at the BoE and NY Fed know about LIBOR-manipulation all-along, and did nothing.

    Monday, 23 January 2012

    Falling yields support US Dollar

    Surely, everyone knows by now that money printing causes inflation and that the Federal Reserve is risking hyperinflation by printing money. If you increase the supply of dollars, their price should go down. Even if the money multiplication mechanism is impaired and most of the new supply of base money parks itself in the excess reserves at the Fed, how can anyone claim that money printing causes deflation?

    The deflation mechanism inherent in quantitative easing isn't obvious, so please bear with me as I explain. 

    Pushing down the yield curve 

    When the Fed prints money it mostly buys the so-called "risk-free" bonds guaranteed by the full faith of the US Federal Government - US treasuries, Agency debt, and the like. Yes, it has also taken on a fair amount of toxic debt in the past few years but that is not directly relevant for this explanation. 

    The key thing to remember is that market participants always seek the lowest-risk profits. If they know that someone is in the market to purchase certain instruments they will try and get ahead of the demand in order to sell it to the eventual buyer at a higher price. This type of trading is also known pejoratively as "front-running" when brokers - anticipating the price moves due to their clients' order flows - and placing their orders in front of client orders to reap quick and easy profits. 

    Front-running Fed purchases of risk-free bonds is a relatively painless trade for primary dealers during periods of quantitative easing. They would much rather utilise scarce capital front-running Fed purchases than use it for dangerous and risky speculation - in volatile commodity markets, for instance. The newly created electronic money by the Fed, combined with the primary dealer front-running creates a relentless demand for "risk-free" bonds, pushing their price up in a secular uptrend. 

    Traditionally the Fed's Open Market Operations are centred at the short-end of the yield curve. With short-end rates at practically zero, Fed purchases have been increasingly at longer and longer maturities. Higher prices for the long term bonds have meant lower yields across the entire yield curve, DESPITE all the money printing.

    The Fed as a Man with a Hammer

    As the saying goes "To a man with a hammer, everything looks like a nail". Whenever the Fed tries to fight free-market forces (either inflation accompanied by rising risk-free yields, or deflation accompanied by falling asset prices) it is the metaphorical a man with a hammer. It has only one response in both situations, that is to purchase government debt.

    When the central bank wants to control rising interest rates, then it goes into the open market to be a net buyer of Treasury bonds. Inevitably, speculators want to preempt the central bank. They strive to buy the bonds first, dumping them into the lap of the central bank at a higher price afterwards. Speculators are making risk free profits. The central bank is helpless. It has to pay the speculators' price.
    Likewise, when the central bank wants to control falling prices, it goes into the open market to be a net buyer of Treasury bonds. Speculators will gratefully take the new money so created. Of course, the central bank wants them to buy commodities to prevent prices from falling. However, speculators have a better idea. They go to the bond market where the fun is. Commodities are too risky for their taste, especially when they can make risk free profits in bonds. The risk free profits speculators make are made possible by Keynesian monetary policy.

    Bond and Stock Markets rise together

    It is easy to see how a lower yield curve translates into higher stock prices. The "risk-free" yield curve is key to pricing of most financial assets. Its central role is in the discounting mechanism for future cash-flows. A lower yield curve means a higher Present Value for the future earnings and thus higher share prices. 

    Note that the yield on stocks was in a secular decline, dropping WITH bond yields during the great bull market from the early 1980s to 2000. Another period when stock and bond markets rose together. 

    The author of the chart below wonders when the US bond bubble will burst. It won't happen as long as dealers believe that the Federal Reserve stands ready to buy bonds.

    The Fed as Dealer of Last Resort

    The financial system committed hari-kiri during the securitisation binge by loading itself up to the gills with toxic debt. Highly levered banks and dealers had effectively become securitisation machines.  As Chuck Prince (ex-CEO of Citigroup) said - as long as the music was playing, they had to get up and dance. The inevitable collapse came when the music stopped. 

    Collateral value of the new-fangled securitised assets collapsed when the realisation dawned that underlying credits were not-performing as expected. Credit money created by pledging these securities to banks vanished as margin lending was withdrawn. Dealers saw their earnings collapse as securitisation came to a grinding halt. Their capital was wiped out by losses taken on their inventory and buybacks. The resulting liquidity crunch caused the epic crash of 2008 as all assets were sold to raise cash - stocks, commodities, even gold. Not knowing where the bodies were buried, capital panicked into the safety of US treasuries.

    The Federal Reserve stepped in as a "Dealer of Last Resort" to provide a bid for all sorts of assets where none existed in the markets. The government first arm-twisted lawmakers to provide a bailout package, and then arm-twisted banks to accept the loans. They also permitted accounting changes to hide capital losses at banks, in order to stave off further collapse. 

    Yet, despite a tax-payer funded rescue of the banks and multiple rounds Quantitative Easing consumer demand remains depressed - due to high private debt-levels and persistent unemployment. At the same time the stock market remains buoyant despite the poor economic environment. Many commentators remain confused about this, as they do not understand that stock are pushed up by a falling yield curve.

    Depressing the Real Economy through Capital Erosion

    The risk of lending to businesses does not interest banks as long as they  can enjoy risk-less profits by front-running the Fed. Businesses are also not interested in borrowing towards new capital investments due to stagnant consumer demand.  A falling interest rate environment is a further disincentive  - why borrow and invest today when you could borrow at lower rates in the future?

    When the recession struck, long-term debt on the balance sheet became a destroyer of capital. Capital-heavy industries like airlines and car manufacturers collapsed one after another. In a recessionary environment falling interest rates increase the present value of long-term debt. As capital = PV(Future earnings) - PV(Future Debt Payments), decreasing future earnings coupled with increasing PV of the future debt payments meant companies increasingly became worthless as their capital is destroyed.

    Dollar Strength through Capital Concentration

    Most people assume that the Fed and the U.S. Treasury are fighting tooth and nail to keep the value of government debt high lest it collapse in want of support from Japan, China, and other countries. In actual fact, what they desperately want to beat down the value of the dollar. The stubbornly high and still increasing value of U.S. Treasuries is the greatest obstacle frustrating their effortsThe dollar's strength since 2008 prevails in spite of the withdrawal of Chinese and Japanese support of the U.S. bond market. 

    The destructive monetary policies of the Fed and Treasury are, in fact, self-defeating. The Dollar has become the antithesis of the funding currency. The opportunity for relatively low-risk speculation in the Treasury Bond market invites capital concentration in the US Dollar. What other safe haven exists in these turbulent times (bar Gold)? Would you hide in emerging markets? In commodities? I didn't think so.

    Lessons from Japan

    Finally I invite the reader to consider the Japanese experience. In my view the US is firmly on the Japanese path. As with the Yen and JGBs, this will not necessarily lead to a weaker dollar. As long as Mr. Market believes that the Fed will continue to ensure a falling yield curve, the dollar will remain supportedAs long as the economy limps along without falling into a recession, this will be a tailwind for stock prices. However, some industries with long-term debt contracted at higher rates are at risk of capital erosion in the process. As US investors continue to discover, investing in stocks and commodities is much riskier than buying uncle Sam's promises.

    Up to 1989 Japan's credit bubble caused the Yen to strengthen as capital concentration in Japan with the promise of great returns in Japanese stocks and real-estate. As a result the Japanese Yen strengthened strongly into 1989. The end of the Japanese bubble should have caused capital flight and a weak Yen. Round after round of monetary stimulus was launched to pull the NIKKEI out of the bear market and Japanese property out of its slump. Even then, the Yen did not decline as fast as it has risen. In fact it remained range-bound for two decades. 

    JGBs have been the "bubble" that is "about to pop" for over two decades. As long as BoJ is a buyer, it will keep going strong. Over time it became the comfort blanket for Japanese investors hurt by speculation in the NIKKEI and property markets. They eventually saw the relative benefits of front-running the BoJ, rather than attempting risky speculation in domestic and foreign markets. Since 2007 the Yen has resumed its rise, as capital "returns home" to the JGB. Similarly the USD will not collapse as long as Bernanke and friends keep buying.