Draghi; Hi Tom. I’m going shopping next Thursday.

Jordan: How nice Mario. What are you buying?

Draghi: Nothing special. Just some high grade bonds.

Jordan: Really. How interesting. How much are you buying?

Draghi: Well, that’s the thing Tom. It sort of depends.

Jordan: Oh. On what Mario?

Draghi: Well, on how much YOU will be buying.

Jordan: I’m sorry? What was that?

Draghi: The exchange rate cap… Tom. Tom, are you there… Hello?

Could the ECB embark on a large scale bond buying program without consulting the SNB, which has been a large buyer of Euro sovereign investment grade bonds in order to maintain its currency cap? Of course not. The ECB would have to consult the SNB as to its intentions if it was to calibrate its own bond buying program size.

The fact that the SNB has abandoned its cap means that on Jan 22, the ECB will act with high probability and the program size is likely to be large, compensating for the fact the SNB will not be party to the purchase efforts.

Can you bail out a country by extending it more credit? Can a distressed entity borrow itself into solvency? The answer to both questions is, yes, but its hard. Greece seems to be expected to do so. In 2014 Greece has managed a primary surplus and is expected to repeat this performance in 2015.

1. 1. Greece stays in the currency union but defaults on its debt.

This Greece has done before in March 2012 when creditors exchanged existing bonds for longer dated ones with a 53.5% write-down of face value. Absent a better business model or an internal adjustment to domestic factor prices, expect more defaults.

2. 2. Greece stays in the currency union but has its debt restructured subject to austerity conditions.

This is what was the situation in 1 above was sold to creditors and the market. The restructuring above involved an exchange and a write-down. Absent a better business model or an internal adjustment to domestic factor prices, expect more debt restructurings.

3. 3. Greece leaves the currency union.

It would be irrational for Greece to leave the union without also defaulting on its Euro denominated debt. This would be the main perk for leaving the union. A new Drachma would re-price rapidly to adjust domestic factor prices so as to reflect productivity. It is likely that inflation would surge as the Drachma fell and Greece would be pushed into stagflation. Then it would recover. Without the crutch or shackles of the Euro, a flexible Drachma would adjust where domestic prices were sticky and factor and goods markets would clear. Absent a better business model… well, you get the idea. A country that defaults in Euros will default in Drachmas.

4. 4. Greece is ejected from the currency union.

The only reason Greece might be ejected from the currency union, apart from economic enlightenment, would be debt default. Actually, there is another reason but it is highly unlikely. The ejection of Greece would certainly encourage the rest of the union to take fiscal viability seriously. It is in Germany’s interest therefore to eject Greece before any default or bailout is negotiated. Such brinksmanship is highly improbable.

What does Greece want? Scenario 1 is most preferable for Greece. A debt write-down would be ideal for the debtor nation but this would leave Greece locked out of debt markets for some time. If the ECB had intended to buy sovereign debt in its recent plans for QE, a Greek default would certainly delay if not destroy such plans as questions would be raised as to the treatment of Greek bonds already on the ECB’s balance sheet. These bonds were not impaired in the first Greek debt exchange in 2012 and it is improbable that they would escape a write-down this time. Hold them at par and the recovery on the rest of the claims will be reduced. It would debase the entire “whatever it takes” pledge of the ECB.

What does Germany want? Fiscal rectitude and austerity on the part of Greece. Already it has leaked to the media its preparations for a Greek exit from the union, a leak which it subsequently quickly denied.

QE in the US seems to have worked whereas elsewhere it has either failed to take hold or has not been started. Yet even the US, QE has had less than stellar results requiring three rounds, with a twist and the last one was unlimited as well. Why is QE not very effective? To understand why, we need to clear what QE is. In the US context, it is specifically the purchase of US treasuries and agency mortgaged backed securities.

QE appears to be useful in two ways. One, it makes cost of debt lower for sovereign issuers and by association, private issuers, thus boosting investment. Lower interest rates it is hoped also drives consumer credit and consumption. Government debt issuance has indeed accelerated and so has private debt issuance, yet proceeds have not been recycled as much as hoped. Investment has been muted, and consumption has also been slow to respond. Two, to the extent that it monetizes debt, it allows governments to finance expenditure through borrowing. From 2008 to the present, the US, UK, Germany and France expanded government expenditure even if at a decreasing rate. Notably, Italy and Spain shrank government expenditure under austerity programs. The main impact of QE appears to be in funding expansionary fiscal policy. Where countries have practiced fiscal rectitude the economic results have disappointed. Where QE is not used to finance fiscal expansion, that is where government expenditure is not expanded or maintained, the impact on output is probably negligible. The US of QE therefore appears to be solely in keeping borrowing costs down as the government borrows and spends.

A number of factors have blunted the intended impact of QE. Proceeds of asset sales (purchases by the central bank) have been one time and not recirculated, thus the velocity of money has fallen to fully compensate for the injection. The marginal propensity to consume has been low and thus the multiplier low. Weak consumer and business confidence have led households and firms to hoard capital and not consume or invest. Buying of seasoned debt issues do not encourage new lending only provide relief to stressed balance sheets. Private commercial banks having repaired their balance sheets have been slow to releverage. Buying of new debt, particularly loan securitizations on a blind pool to be announced basis would have worked much better in encouraging new loans. QE together with austerity or neutral to contractionary fiscal management is self defeating. While government balance sheets may improve the impact on consumption and output is neutralized. Austerity neutralizes QE. When we turn our eye to Europe, ECB QE will be relevant only if Europe abandons austerity and balanced budgets.

For QE to be effective, central banks cannot purchase legacy debt or bonds in issue; central banks have to underwrite new issue. The use of proceeds for such a targeted QE has to be pre-specified to directly boost output and consumption. Accepting as collateral for cheap repo blind pool, conforming, new issue, is a valid way of operating QE.

We have seen how long it has taken US QE to be effective and we have seen how blunt a tool it has been. As the ECB and BoJ and potentially the PBOC embark or continue their QE efforts, we can now build expectations about the efficacy of policy based on the above observations, namely that underwriting of new issue is fast acting and purchase of legacy assets is slow acting and ineffective. There are trading implications for this. Investment strategies are not one dimensional. Time is as important as potential returns. If policy is expected to be slow, derivative or option strategies such as calendar spreads can be used to maximize efficacy.

Put simply, if QE doesn’t involve buying new issue securities but seasoned issues, the impact will be small and late. The trade is to bet that the policy will work using long dated calls financed by selling short dated calls. If QE involves buying new issue blind pools, buy outright underlyings, futures, or short dated calls.

If governments are really serious about reviving moribund economies they might want to try more controversial (fruitcake) remedies such as:

Credit all retail bank accounts with money. Get the money down to the people who need it most. This can be quite inflationary.

Distribute to the public amortizing cash vouchers which decay when not used. This is deliberately inflationary.

All of the above will rubbish the balance sheet but desperate times call for desperate measures and you don’t want to waste desperation in half measures.

Central Bank Large Scale Asset Purchases, by which is meant the buying of government or agency debt, is intended to ensure demand for such bonds and to keep borrowing costs low for the government and any other debt issuer whose cost of debt is correlated or benchmarked to government bond yields. Large Scale Asset Purchases, or QE, as they are popularly called, are meant to be a boost to the economy. The experiment has worked in the US, to  a certain extent. Lower borrowing costs have certain allowed corporate bond issuers to liquefy their balance sheets. Lower mortgage rates have spurred a rebound in housing prices which have led to healthier household balance sheets. The follow on impact from businesses to labour and employment has been slow.

QE directly funds government whereby a central bank buys bonds issued by the government. The central bank’s assets rise by the value of the bonds it has bought, and the liabilities rise by the same amount as it issues liabilities to fund the purchases. These can take the form of cash in the government’s reserve or cash accounts. It is convenient if the bonds are sufficiently highly rated that they consume no capital. It is hoped that central banks are thus able to help governments refinance themselves and buy enough time to return to fiscal balance and thus more attractive to private lenders. A growing economy is necessary, but not sufficient, for a government to improve its fiscal position through improving tax receipts. Fiscal profligacy can confound even a growing economy and rising tax receipts. It would appear that debt monetization cannot go on indefinitely if the government’s financial position is steadily deteriorating. Note that a constant budget deficit or a constantly rising level of debt has been demonstrated to be sustainable whenever there was sufficient domestic savings to fund this debt. It helps if the savers have no option but to fund this debt. In the absence of a such private funding there is debt monetization by central banks. The result, however, is an ever inflating balance sheet as more debt is issued to central banks in return for more printed money. This type of creative accounting can be quite persistent.

If rates rise and the bond prices fall, the central bank can either not mark them to market arguing that they will be held to maturity, or, they can mark them as available for sale and mark them to market. At that stage, any loss incurred by the bank will impact its equity. If the issuer, that is the government, buys back these bonds at below par, they will have made a profit equal to the loss incurred by the bank. The government could then recapitalize the bank by precisely the loss it had incurred in the first place. The value of the bonds, therefore, once in the hands of the central bank, are immaterial. This is pure money printing.

The government’s reserves with the central bank do not count as the money base. A government that is printing money is, however, likely not to leave too much money in its reserve account but to spend it quickly. The money thus finds its way to the commercial banks and becomes part of the money base. The money base is the multiplicand to which the velocity of money is multiplier in the identity that equates to nominal output. A sufficiently large money base makes an economy vulnerable to inflation or hyperinflation. Hyperinflation is usually a consequence of loss of confidence rather than a continuous process and will require more than an over inflated money base to trigger. But, persistent inflation can lead to a loss of confidence at some point.

Inflation aggregates domestic and external purchasing power. The measure of the external purchasing power of a currency is its exchange rate. Where debt monetization results in acute currency weakness, external inflation is already underway. This can impact headline inflation through imported goods and inputs.

In many ways, inflation is a signal rather than a lever. Targeting inflation religiously can distract policy from underlying causes. Disinflation can either be a result of productivity gains or deficient demand, or both. Persistent QE and low inflation can be a sign of an acutely weak economy as efforts at supporting sagging demand only just compensate for natural weakness. If the currency is also weak at the same time, it could signal that price support from rising costs were being compensated by substitution in a flexible economy with high productive efficiency which was also operating below capacity.

Where a country has financed itself in a foreign currency and or with foreign capital, as many emerging markets do, the ability to borrow is limited. Countries can default on debt not denominated in their own currency. The risk of default limits the demand for ever increasing issuance. Countries are not compelled to, but may choose to default on debt denominated in their own currency. Venezuela (1998), Russia (1998), Ukraine (1998), Ecuador (1999), Argentina (2001) are some examples. The ability to choose not to default, come hell or high water, on local currency debt, comes at a price, being the external value of that debt, thus the currency bears the brunt, and a de facto default occurs with a recovery rate equal to 100% less the depreciation of the currency relative to the bond holders base currency. Where the bond holders are hapless domestic investors, forced to lend to the government, no default de facto or technical occurs. Such investors would behave rationally if they save more to make up for the debasement of their forced saving and invest abroad as far as possible to compensate for the de facto expropriation. This can result in lower demand and deflation. Governments of such countries have to spend more to compensate for this demand deficiency, worsening their balance sheet and necessitating further debt monetization or de facto expropriation.

Gold.

To determine the value of an object one has to determine its usefulness. To determine the price of an object one has to understand the convolutions of the collective human mind.

More than half of gold production per annum is used to make jewellery. The jewellery industry’s margins are so diverse that it makes an analysis of the value of gold as a factor of production difficult.Gold is also used as a type of currency. Since all currencies are denominated in one another, the act of backing a currency by gold is to make gold a currency. The value of having gold as a currency against which to peg was that the supply of gold was limited (but not fixed) and making it a useful standard of measure. The problem with using gold as a standard was that monetary policy lost a degree of freedom, namely the potential for central banks to print money freely without encumbrance. Every action has consequences, however, and not backing a currency with gold and thus being able to print unlimited amounts of money has other consequences, some of which will undoubtedly surface in the coming years.

Gold also has some industrial uses where an analysis of marginal productivity and cost are possible but the impact on the gold market is negligible.

The period following any sufficiently acute financial crisis tends to rekindle the idea of going back on the gold standard. Fear and doubt surrounding the validity and value of fiat currency spurred a massive rally in gold from 2008 – 2011. Since then the stabilization of the financial system has seen a steady decline in the price of gold. As the price of gold languishes, and the price of other assets begin to lose momentum, attention occasionally returns to gold. For gold to rally sustainably, faith must falter or fail in all other credible alternative stores of value. That means there must be sufficient volatility in the currency majors, notably the USD, there must be widening credit spreads in investment grade, there must be volatility in US treasuries and other major sovereign bonds. Volatility in equities and high yield bonds don’t count so much since they are speculative and not seen as stores of value but as generators of value. When the volatility in the US treasury market fell off in late 2011, gold began its decline. So, the question one should ask in contemplating the prospects for gold are, will there be a wholesale existential threat to the major sovereign and investment grade credit markets in the world and at the same time will currency volatility pick up between the currency majors.