The end of QE2

Recently, more and more Federal Reserve officials have been going on record to say that they believe there is no need to extend the second round of quantitative easing (or QE2) beyond its planned June deadline.

Some of them, such as St. Louis Fed President James Bullard, have even publicly stated that the Fed should stop short of buying the entire amount of securities ($600 billion) anticipated when QE2 was first announced. In a statement this morning, Mr. Bullard said: "We have to get started on the process of getting back to normal on the balance sheet. We are fueling the fire right now, and it needs to be turned around."

"Quantitative easing" describes a Fed method of increasing bank reserves by purchasing securities, which enables banks to lend more money, in effect creating more money in the system without lowering interest rates (hence, "easing" the monetary policy through the "quantity" of assets on the Fed balance sheet). We described the mechanics of this process in this recent blog post.

Chicago Fed President Charles Evans said it would be a "high hurdle" to end QE2 early, but that he did not anticipate needing to go beyond the June end-date or the $600 billion target, as he had previously thought they would. Atlanta Fed President Dennis Lockhart also said there would be a "high bar" to clear to go beyond the target, and Minneapolis Fed President Narayana Kocherlakota said the economy would have to worsen "materially" in order for the Fed to go beyond the target.

Philadelphia Fed President Charles Plosser stated that the Fed would need to normalize its balance sheet and even begin raising rates in the "not-too-distant future."

We have been on record for a long time saying that the Fed is "oversteering" by staying this easy for this long (see here and here), and agree with both Mr. Plosser and Mr. Bullard that the Fed should begin to unwind QE2 and begin to tighten Fed funds rates, which have been at 0% for over two years.

At the same time, we realize that unwinding QE2 and later raising rates will both inevitably rattle the markets. There are a huge number of investors and pundits who believe that the Fed's easy rates and quantitative easing are the primary reason that the stock market recovered, and that "removing the punch bowl" will remove the only thing that has supported asset prices since the bear market bottom of 2009.

Harvard economist Martin Feldstein published a widely-read article in February entitled "Quantitative Easing and America's Economic Rebound" in which he argued that the Fed's bond purchases induced bondholders to shift their wealth into equities, propping up the stock market and increasing consumer confidence and consumer spending. When this "artificial support for the bond market and equities" comes to an end, he wonders if "we are looking at asset-price bubbles that may come to an end before the year is over."

We disagree that the stock market recovery has been driven primarily by the Fed's "punchbowl." We believe the 2008-2009 recession was induced by a financial panic and that once the accounting rule (mark to market accounting) that helped fuel the panic was removed, the real economy began to recover almost immediately (see "How your view of the crisis of 2008-2009 impacts your understanding of today's big issues"). As the chart above shows, corporate profits have been on a steady rise since then, and have now reached new highs, but not ridiculous new highs. In fact, they are roughly in line with the growth that was rudely interrupted by the crisis on Wall Street.

We have also demonstrated that, although QE2 massively expanded the Fed's balance sheet, the new money available to the banks did not go anywhere, but rather appears to have stayed on the balance sheets of banks as excess reserves held at the Federal Reserve itself (see "Understanding where the banking system is right now").

Therefore, while the stock market may be rattled by the end of QE2 and the eventual tightening of the excessively-easy rates, we believe any negative reaction will be short-lived and that most businesses will be just fine when it happens. These are issues that investors should consider carefully, and which may create opportunities for those who understand the big picture.

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Information and meaning

Hat-tip to Bret Swanson, who recently linked to three thought-provoking book reviews of the new book by James Gleick entitled "The Information: A History, A Theory, A Flood."

The three articles -- by Nicholas Carr, John Horgan, and Freeman Dyson -- hint at the deep issues explored by Gleick concerning information and meaning, centered around the seminal life and work of Claude Shannon, founding father of information theory, and inventer of the concept of the "bit" (or "binary digit" -- the theoretical smallest unit of information, encoded as a choice between two opposites, such as "yes" vs. "no," or "up" vs. "down," or "0" vs. "1").

Shannon noted the distinction between signal and noise -- information is best transmitted by disrupting a regular background, such as a blank sheet of paper rather than a page full of other scribbles, or a regular sine wave within the electromagnetic spectrum in which the disruptions to the regular pattern or the wave constitute information.

He also authored the radical proposition, as Dyson's article discusses, that "meaning is irrelevant" -- that information can be transmitted, stored and manipulated more efficiently when divorced from meaning, turned into a mathematical formula.

This concept has ushered in the incredible flood of information -- an "Information Age" -- an "Exaflood" as Bret Swanson calls it, with reference to the sheer volume of information being shared, a reference to "exabytes," each of them equal to 50,000 "Libraries of Congress" of information or about a trillion 400-page books (each byte is equal to eight bits, and an "exabyte" is equal to one times ten to the eighteenth bytes). As the book reviews above indicate, it has also led to new ways of understanding the universe itself, as an expression of coded information (think, for instance, of DNA).

The epistemological questions raised by this topic are endless, but for investors there are some clear and important areas to consider. We have already written extensively about the important investment opportunities related to the new ability to transmit more information more rapidly and cheaply than ever before, in our series of posts on the concept of "the unstoppable wave" (see here and here).

A different angle on this same issue for investors to consider carefully is the distinction between information and meaning. At the end of Nicholas Carr's review of The Information is the warning that: "The danger in taking a mathematical view of information, with its stress on maximizing the speed of communication, is that it encourages us to value efficiency over expressiveness, quantity over quality." This subject is extremely pertinent to the management of investment portfolios, where the sorting through of massive amounts of information is a daily necessity, and the ability to find the meaning in the information is critical.

We have written before about those who wish to reduce investing to mathematical formulas or capture "risk" in a series of graphs and reduce it away with esoteric vehicles of structured finance (see here, here and here). It strikes us that those who fall for this error have fallen into what Carr calls "the danger in taking a mathematical view of information."

Nicholas Carr warns in his final sentence that what can be lost in such a reduction is "the stuff of poetry." It might not seem like "poetry" has much to do with portfolio investing, unless you understand that poetry is actually about seeing connections, and that great poets can see and articulate connections that nobody has seen before.

The challenge in negotiating the flood of information that we are faced with in the modern world and in investing today is to find the right connections between the bits. We would argue that this requires more than a computer model can deliver. This is not to say that the incredible growth of information available is a bad thing -- far from it. However, it is certainly true that this exponential increase creates challenges, and that it makes the ability to analyze critically and see connections all the more necessary for the modern investor.

We are looking forward to reading Mr. Gleick's book, and believe that all investors should think carefully about its implications.

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Understanding where the banking system is right now

Economist Scott Grannis has a noteworthy discussion of the current state of the monetary policy in the US over at his Calafia Beach Pundit blog.

In it, he observes that "the Fed has dumped a ton of reserves into the banking system, but banks have been either unwilling to make new loans, or the economy has no desire to take on more debt, or both." He draws this conclusion based on his examination of the Fed's balance sheet, which has ballooned to unprecedented proportions, versus the M2 measure of the monetary supply, which has not expanded at any unusual rate.

To understand this discussion, it is important to understand how balance sheets work throughout the banking system, which is illustrated in the diagram above (click on diagram to see larger image). The primary concept being illustrated is that deposits made into a bank are an asset for the depositor (in this illustration, the couple at the lower right) and a liability for the bank (in the center of the diagram). The couple has earned some income, which they deposit in their bank account, creating an asset on their balance sheet and a liability on the bank's balance sheet. The couple's savings or checking account is a liability to the bank, because the couple can demand those funds back at any time from the bank.

The bank, of course, also receives an asset to correspond to the liability on their balance sheet. They can hold the cash from the couple in their vault, they can purchase some securities with it (most likely US government bonds), they can turn around and loan it out to someone else, or they can put it in a bank account themselves.

If the bank selects this last option, the balance sheet activity will be very similar to the balance sheet activity we discussed when the couple took their deposit to the bank: the bank will send its deposit to a Federal Reserve Bank (the Federal Reserve acts as the "banker's bank") and will have an account there, which will be a liability to the Federal Reserve Bank (known as "bank deposits") and an asset to the bank (known as "reserves"). This is illustrated in the diagram below:

In the illustration above, the bank is shown doing two things: banking some deposits at the Federal Reserve (green arrow and green circled lines on the balance sheets, which creates the corresponding asset on the bank's balance sheet under their "reserves," and also creates a liability for the Fed under "bank deposits") and making a loan to some other members of the public (in this case, some businessmen who are starting some kind of business). The loan (red arrow and red circled lines on the balance sheets) creates a liability for the businessmen on their balance sheet, but it is an asset for the bank and it is the primary way that the bank makes money, because it is going to pay them interest.

The reason the diagram above shows the bank putting some of the deposits into reserves (green arrow) and lending some of it out (red arrow) is that this is the typical activity of a bank. It is required to hold some percentage of deposits in reserves, and it will usually lend some or all of the rest out (since lending is the way that banks make money).

As an aside, this lending activity by banks creates more money in circulation. When the two businessmen receive their loan in the diagram above, they may put it into their bank (which can then put some into reserves and then loan the rest out again) or they may use it to buy capital goods or other items for their business (in which case the vendors of those goods will put the money into their own bank accounts, and their banks will then save some in reserves and loan the rest out). The measure of money M2 mentioned in the Calafia Beach Pundit article looks at the sum of all currency, checking deposits, savings deposits, time deposits (such as CDs) and money market funds.

As Scott Grannis explains, QE2 has "dumped a ton of reserves into the banking system." The way this has taken place is that the Federal Reserve has decided to purchase massive amounts of US Treasury bills and bonds. Where does the Federal Reserve go to purchase these US government securities? The answer is: banks and other depository institutions (such as savings banks and credit unions). Banks have US government securities on their balance sheets, as we discussed above when we noted that banks can hold deposits as cash, send them as deposits to the Fed to become reserves, loan them out, or invest them in securities -- if they invest them in securities, those are usually US government debt instruments.

When the Fed decides to purchase US Treasury securities, the balance sheet repercussions are shown in the diagram below:

In the diagram, the Fed has decided to buy some US government bonds from the bank. These will leave the asset side of the bank's balance sheet and show up on the asset side of the Fed's balance sheet. The Fed will pay for these by increasing that bank's reserves, which increases the asset side of the bank's balance sheet by the value of the bonds that it sold to the Fed.

On the Fed's balance sheet, the newly-purchased government bonds will increase the asset side of its balance sheet. To counter-balance this entry, the Fed will gain a corresponding liability in the "bank deposits" line on the liability side of its balance sheet. This liability also corresponds to the "reserves" asset on the bank's balance sheet, as discussed previously. This explains why the purchase of US Treasury securities by the Fed increases the bank reserves available to banks.

Because banks are required to have a certain amount of reserves to support a certain amount of lending (the reserve requirement), an increase in their reserves creates the potential for banks to increase their lending as well.

Scott Grannis is observing that although bank reserves have grown tremendously due to the Fed's purchase of treasury securities, the M2 measure of the money supply has not grown any faster than its rate for the past fifteen years, which indicates that banks are not lending out what their larger reserves enable them to lend out.

Thus, he concludes that the Fed's actions have so far not been extremely inflationary. Had banks been lending to the degree that their larger reserves would allow them to lend, inflation could have become a huge problem already (remember that bank lending actually creates more money in the money supply, and boosts the size of M2, as discussed above; inflation is a function of "too much money chasing too few goods").

The reason bank lending has been lower than it could have been (or, seen from the other side, borrowing demand has been lower than it could have been) primarily has to do with fear and uncertainty, some of it on the part of lenders and some of it on the part of borrowers. Some of it also has to do with the fact that the private sector is awash in cash, with businesses holding huge reserves of cash on their balance sheets, and households generally paying down debts and shoring up their own balance sheets during the past four years.

There are indications, however, that business profits are picking up in many parts of the economy, which will tend to increase the appetite for borrowing to pursue business opportunities. And, as Scott Grannis points out, there are plenty of inflationary indicators that have been ticking up strongly over the past several months. Both of these observations indicate that both lending activity and inflation may be on the verge of increasing very sharply very soon.

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Creative destruction continues

Kris Tuttle at Research 2.0 has an excellent article today entitled "Who Pays?" which discusses the latest New York Times attempts to get people to pay for their content*. He examines the many issues surrounding free versus paid content, and the problems that arise from "existing companies trying to apply old models to the new online medium."

Kris notes the connections to other forms of content, such as music. On that subject, we would also recommend Steve Waite's Research 2.0 article from earlier this month covering the Digital Music Forum in New York City. Here again, the discussion highlights the plight of businesses hoping somehow to apply old models in a world that has dramatically changed.

One of the positive aspects of capitalism, according to economist Joseph Schumpeter, was that it not only allows innovation and radical new advances, but it actually makes them inevitable when free enterprise and competition are not blocked by the government. Using examples from one industry after another, he wrote that free-market capitalism "incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism."

Ironically, the published content of the New York Times typically takes positions that belittle the positive effects of free-market capitalism: we have highlighted several examples in the past, such as this one, this one, and this one.

It's not surprising that those who reject the economic insights of pro-free-enterprise economists such as Schumpeter also have a difficult time perceiving the revolutionary aspect of certain technological advances, such as the ones that now pose a lethal threat to the Times' entire business model. Over three years ago, we criticized the shortsighted thinking in a New York Times article that declared that not enough Americans had high-speed internet connections to make web-delivered movies a good business, and contrasting that with the insights of George Gilder, who published a book all the way back in 1990 entitled The Death of Television predicting exactly the sort of revolutionary changes that the web is now wreaking on the delivery of content.

There are plenty of companies -- perhaps even the New York Times -- that will continue to have a business in providing content of value to those who are willing to purchase such content, as Kris Tuttle and Steve Waite discuss in their articles. But it will certainly help their own cause if those companies avoid trying to apply old business models in a radically different landscape, and if they accept the truths about business available from far-sighted authors such as Joseph Schumpeter and George Gilder.

* At the time of publication, the principals of Taylor Frigon Capital Management do not own securities issued by the New York Times Company (NYT).

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Be centered, be still -- 2011

We, along with the rest of the civilized world, are of course horrified at the awful developments in Japan as a result of the massive earthquake and tsunami.

From an investment perspective, in times of great catastrophe or calamity, our professional experience suggests that the best response for investors is to pursue a philosophy which we describe in the phrase, "be centered, be still."

We have written about this concept before, most notably here and here, and we explained that our definition of being "centered" (in terms of investment) can best be defined as "remaining within a consistent discipline; not making rash changes that represent a departure from the discipline."

Similarly, we argued that being "still" does not mean "doing nothing" but that it means "continuing to act in line with the principles of an investment process." We have observed that during times of great turbulence, many are tempted to either abandon their process (if they ever had one) or alter it in the face of events that cannot help but arouse strong emotional responses.

The most recent catastrophe has inspired a host of irresponsible predictions, some of which we believe are causing investors to overreact. Misinformation spurred by dubious claims of "imminent" catastrophe almost always prove to be hyperbole and can cause investors to make poor decisions regarding their long term investment and finances.

Yesterday, for example, an official from the European Union Energy Commission, Guenther Oettinger, stated that the Japanese nuclear accident was effectively "out of control". This comment came a day after this same official stated Japan was facing an "apocalypse". Apparently, this official's statement was at least partially based on the same sensational media reports the rest of us are getting. Hardly a responsible manner of conduct from someone in a perceived position of authority!

In his recent television show, popular host Glenn Beck engaged in what professional investors call technical analysis (the interpretation of charts and chart patterns) and issued dire pronouncements declaring "a collapse of the financial system as we know it [. . .] I'm gonna show you some stuff -- don't kid yourself -- it's coming."

Many watchers may think that such statements carry authority, especially when they are backed up by four charts and someone with a pointer explaining about "trend lines," particularly in the wake of the tragic images from the disaster in Japan. We disagree with his specific line of argument in this example and do not believe that his simplistic explanation of broken trend lines presages the collapse of the entire financial system at all.

The bigger lesson, however, is that in times of crisis, authoritative-sounding voices can get people who probably should know better to panic in ways that they otherwise would not, and that can lead to consequences that they will later regret. We believe strongly that this is one of those times.

The events in Japan are horrible, and we are not in any way making light of them and the human suffering that they have caused and continue to cause. However, that does not argue that investors should throw away their investment discipline; on the contrary, we believe that in such times investors should be more careful to stay within that discipline than ever.

This is what we mean by the phrase, "be centered, be still."
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The question of our time, continued

Here is a recent interview with economist Veronique de Rugy, discussing the tremendous increase in unfunded pension liabilities that state governments in the US have racked up in recent decades.

Dr. de Rugy presents evidence that the problem is much larger than many states are willing to admit, in part because state accountants are projecting that the asset pools they have set aside to pay those benefits will gain average investment returns of 8% per year every year, which may be an overly optimistic assumption.

She also presents evidence that underfunding of these asset pools (which occurs when state governments do not invest in their pension savings at a level that will support the amounts that they have promised to give out in future years to their retired government employees) is largely due to the fact that states were spending the revenues that they were supposed to be saving, rather than being due to major bear markets in 2000-2002 or 2008-2009.

Many who defend the unaffordable government pension system like to claim that everything would have been fine if it hadn't been for these market corrections, but the facts simply do not support that argument. Also, it is contradictory for defenders of these pensions to use assumptions of steady 8% annual returns when calculating the size of the unfunded liability problem, and then to turn around and blame market corrections for creating the enormous unfunded liabilities that they now face.

We have called this issue "The question of our time" in previous blog posts. The good news is that the world seems to be waking up to the problem. Many of the most egregious increases to state-employee retirement benefits were enacted in the late 1990s, such as California's 1999 legislation that allowed many public workers to retire at 50 and draw 90% of their salary for the rest of their lives, along with cost-of-living adjustments (which were made retroactive for those already retired as well, as described in this article).

We have also argued that the most important concept to understand in this whole discussion is the role of economic growth in solving government budget problems (see here and here). This is why it is so important that government does not create obstacles to economic growth, through high taxes, intrusive regulation, or capricious monetary policy.

Investors are well-advised to monitor such obstacles and be alert when they are on the rise (we have written about how to do that, and thoughts about how to invest when they are on the rise, in previous posts such as this one and this one). For this reason, we applaud Dr. de Rugy's efforts to provide good analysis on this important subject.

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For later posts on this same subject, see also:
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Inflation is a monetary phenomenon

We've written before that inflation is everywhere and always a monetary phenomenon. This morning during a brief televised interview, Gerry Frigon made that point and countered the notion that economic growth creates inflation.

The idea that economic growth creates inflation, and that economic stagnation or contraction counteracts inflation, is associated with the Phillips curve, and history has proven the Phillips curve to be wrong.

We have written about this discredited concept in the past, and would recommend investors revisit those posts, since many in the news media continue to base their comments on the idea that growth and inflation are linked together (see for example here and here). We have also noted troubling signs which indicate that high-ranking economists still subscribe to outdated Phillips-curve thinking.

With the renewed focus on inflation, this is an important principle which investors should understand.

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Blocking out the benefits of free enterprise

Economist Scott Grannis recently published an excellent discussion of the problem with healthcare in the United States entitled "The big problem with healthcare? It's not a market."

He provides a graph showing that consumers now pay only 12% of total healthcare costs theselves -- the rest is paid for by insurance companies or the government. As his graph shows, this percentage has declined dramatically and consistently since the 1960s, when consumers paid for over 45% themselves.

Mr. Grannis concludes: "It stands to reason that when people don't pay the bill for the services they receive, they are very unlikely to take price into consideration when making a healthcare decision. Why shop around if everything is paid for by someone else?" We agree with him, and his ultimate point that the problem with healthcare in the United States is the steady removal of the beneficial forces of free enterprise and individual choice.

We have made this point in the past, and pointed out that if this is indeed the problem with healthcare, the solution is more freedom, not less. We would advise interested readers to go back to our 2009 article entitled "The healthcare black hole," where we linked to an article written by the late Milt Friedman published in 2001 entitled "How to cure health care."

In that article, Dr. Friedman goes through the history of how we got to the system we have today (which Scott Grannis also explains in his piece), and provides excellent support for his conclusion that "the high cost and inequitable character of our medical system are the direct result of our steady movement towards reliance on third-party payment."

Americans are the beneficiaries of the tremendous positive power of free enterprise in so many areas of their lives. It is unfortunate that they have been increasingly denied access to those beneficial forces in the critically important field of medical care.

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