Having just read the article in the latest Economist magazine on Emerging Market economies creating a welfare state I started thinking about how economies mature.

I used to think that the sign of an economy maturing was the establishing of social welfare, a safety net. I think it is still true.

With the death of communism, capitalism has been left to grow uncontested and unquestioned. Unfortunately our best available system of economics seems to increase income and wealth inequality. Under capitalism there is no attempt to reduce it at all. So the Gini coefficient rises monotonically and social problems arise. At some stage in the development of a country, unfettered capitalism increases inequality to the extent that the masses, the underclasses, revolt. Governments are eventually faced with either providing a safety net, or establishing some form of redistributive policy. It is in the interests of the rich to support such policies that keep the poor at least marginally satisfied. Even exploitation has to face questions of sustainability and repeatability.

With safety nets and social welfare come a slowing of productivity simply because people become less adaptable, less driven, less hungry. Short term gains derive from the stability that social welfare provides in the form of the ability to plan further and to invest in skills and other labour empowering policies. Eventually, safety and security are the enemies of invention, adaptability and progress.

Even in the absence of social welfare an economy evolves and matures and slows. As an economy grows, the distribution of wealth and income grows. Societies can address this in two ways, social welfare, being the collective solution, or private saving. Where social welfare is absent, uncertainty and risk encourages private saving. Safety nets whether public and collective or private and individual lead to the same loss of adaptability and flexibility, loss of drive and a growing intransigence. Eventually economies face a suboptimal labour force.

A proper model of employment takes into account the unpleasantness of the job (including such considerations as physical risk, mental stress, prestige or lack thereof), and not just the wage or marginal factor price, but the wage in relation to the stock of wealth of the individual. This may explain why some jobs are undersupplied despite reasonable wages, and others are oversupplied despite relatively low wages.

The rescue efforts from 2008 – 2012 to bail out the global economy have resulted in a massive inflation of sovereign balance sheets almost everywhere from the US Fed, to the Bank of England, the Bank of Japan, the Peoples Bank of China, and even the ECB.

Central banks have become some of the largest buyers of their own countries’ debt issues. Holdings of US treasuries have surged not only at the US fed but by the US private commercial banks as well. Regulations such as Basel 3 encourage banks to purchase assets which do not consume capital (as assets risk weighted zero under Basel 3 are treated.) High grade sovereign bonds are risk weighted zero and even dodgy sovereign bonds face a lower risk weight than better quality SME loans. The result is a buying frenzy of government bonds.

There are two reasons a country would seek to buy its own bonds, whether directly through its central bank, or indirectly through its state pensions or private commercial banks. One is to increase the money supply in the hope of boosting nominal output growth, in the further hope of generating real output growth. Two is to compensate for any shortfall in demand for the country’s bonds, that is to act as lender of last resort to oneself.

Chart: Fed System Balance Sheet:

M.dV + dM.V = P.dQ+dP.Q is the relationship between money supply, velocity of money, inflation and real output.

Since 2008, the efforts of central banks to increase the right hand side of this equation, that is nominal output, has seen a drastic increase in the money base and the assets of the banking system. Central banks have levered their banking systems between 3 to 5 times over. Unfortunately for both real and nominal output, the velocity of money has simply compensated for the increase in the money base so that nominal output growth has been tepid. A proxy for the velocity of money is the money multiplier.

Chart: Money Multiplier:

For an economy not at full employment, the hope is that real output rises instead of prices. Apparently the global economy is not at full employment. The risk of inflation is thus low. This analysis does not take into account some psychology.

Given how widespread money printing is globally, and given the scale of the monetary expansion, consumers and investors would be reasonably expected to be concerned about how this policy can be retracted once full employment is restored. Further, given that money printing debases its value in real terms purely as a store of value, one may reasonably be concerned about the inflationary impact of protracted and continued debt monetization. In addition, at least thus far, quantitative easing has been seen as a part of expansionary monetary policy and not as debt monetization from an excess supply of debt perspective. Any loss of confidence may lead inflation expectations to rise. Even a real recovery might boost inflation expectations. In itself, inflation expectations can be benign but in the context of the scale of leverage in the banking and sovereign debt system, inflation expectations demand answers to difficult questions: how will financial system wide balance sheet leverage be reduced when full employment or inflation threatens?

The world’s economies and markets are all acutel
y dependent on low interest rates. If central banks were forced to withdraw liquidity, a way would have to be found which would keep rates suppressed, an almost contradictory condition. Selling bonds would be highly risky given the impact on interest rates. The borrowing requirements also suggest that the treasury will need to refinance itself well into the future.

The 30 year bull market in bonds, the agency issues with central bank ‘puts’, have brought us deep into a game of chicken played on a suspension bridge. Its not clear how long we can carry on, but neither can we flinch.

Given the fragile state of the global economy the resilience of risky assets is remarkable.

Year to date, the MSCI World index is up 8.0%, bonds are up 11.7%, high yield has gained 8.3%, emerging markets bonds 12.3% , emerging markets equities a paltry 3.2% and crude 7.9%.

Volatility and risk in developed markets has risen relative to emerging markets. A rational strategy therefore is to buy straddles on developed markets’ businesses while selling straddles on emerging markets’ businesses. Here we refer not to equities but to the underlying assets and cash flows of the businesses. Thus, buying a straddle would involve buying both a call and a put option on a company’s assets. This is equivalent to buying the equity stock and selling short its corresponding bond. Put together the whole trade broadly looks like: long (or overweight) developed market equities and short (or underweight) emerging market equity; long (or overweight) emerging market bonds and short (or underweight) developed market bonds.

Apart from the real options theory basis for the trade there is a more intuitive justification. Emerging markets growth rates continue to outpace develop markets (despite the current synchronized slowdown). Yet corporate governance and rule of law remain underdeveloped in emerging markets, at a protectionist and mercantilist time in global economics. It is safer to access emerging market growth through developed market companies deriving revenues from emerging markets, or through foreign listings. As Europe slumps and the US remains under very muted growth, the export heavy listed markets of the developing world are more likely to suffer. If one feels compelled to buy emerging market companies for whatever reason, the seniority of claim of bonds is a safer trade expression.

The co opting of banks in debt monetization, the fear of investors, the shackles of Basel 3, place significant constraints on the banking industry. 

Fractional reserve banking has always carried liquidity mismatches, but has managed to mitigate this by relying on some degree of inertia and asymmetrical information. Bank’s historically high ROEs were a function of leverage and the carry trade.

Today, government bond yields are low on a historical basis (even in Italy and Spain), and term structures are still flattening.

For the investor, the actions of central banks and regulators have created an acutely high liquidity risk premium. Normally, this would imply a steep term structure. Today it manifests in a flat term structure. How can this be? The liquidity in sovereign bond markets is responsible for their flat structures and low yields. Because the longer maturity bonds are tradable, they are liquid; and because they are liquid, they are sought after, hence their yield compression. Mark to market volatility remains a risk, however.

Investors seeking liquidity are now forced to take much higher risk than before since liquid assets either produce a low yield, or exhibit high volatility, or both.

Dogged demand for both liquidity and yield will drive some investors to seek equity dividends (discounting capital gains or losses), high yield bonds (discounting mark to market volatility and default), selling options (sometimes unknowingly in structured products), and whatever new products the financial industry will almost surely invent to meet this demand.

Spread between 2 and 10 year US treasuries:

What’s all this talk of QE3? The private commercial banks have been big buyers of US treasuries to the extent that they are operating QE3 on behalf of the Fed. Buying has accelerated from 63 billion usd in 2011 to 136 billion usd YTD 2012. The Fed is already the largest lender to the US treasury, ahead of the PBOC.

The BoE and BoJ are explicitly monetizing sovereign debt hand over fist. The only mega scale central bank to not engage in direct debt monetization is the only central bank without a country, the ECB. Constitutional issues impede the ECB from direct debt monetization, however, Mario Draghi has already found proxies in the private commercial banks using the LRTO. The current negotiations will likely lead to capitulation and a direct flow of capital from the ECB to sovereigns.

So every single central bank will be in easing mode with most of them monetizing local domestic debt.

The question of local or external funding of sovereign debt is only relevant at the micro level. At the global level, all debt is internally funded. Economists who point out that Japan need not worry since its debt is internally funded should not worry any further.

One question that arises is whether with excess liquidity at an extreme, inflation might become a problem. Debt monetization increases the money in circulation per unit output potentially leading to inflation. Depending on sentiment and confidence, inflation can occur even before the economy achieves full potential.