In recent blogpost I tried to lay out a general map of monetary/financial politics on which to locate the familiar stereotypes of monetary history – Weimar hyperinflation, bond vigilantes, Glorious Revolution “virtuous circle” etc – and on which to position them in relation to the grey zone of managed money that we currently inhabit.
Since when we have inhabited this “grey zone” is an interesting question, which I postpone to a future blog. But my short answer would be the 1930s and the end of the gold standard.
In the world of managed money the balance sheet of the central bank is the basic organizing matrix of the monetary and financial system. It is the basic indicator of the “state’s” monetary policy stance. But this can be “interpreted” only in relation to the wider ecology of “private money” and credit i.e. everything from overnight interbank lending to long-term capital markets.
Two conversations yesterday with Madeline Woker and Perry Mehrling brought home to me the significance of stressing this interactive, ecological setting of the central bank’s balance sheet. In particular, they brought to mind a fascinating blogpost by the excellent Brad DeLong from May 2013.
The date is significant. This was the period of the “taper tantrum”, when Bernanke was indicating that the Fed’s QE policy might be nearing its end and markets began to react. It was something of a trial of strength between the markets and the Fed. By comparing the notorious London Whale incident of 2012 with the 2013 taper tantrum, DeLong highlighted what distinguishes the Fed from even the largest and most potent private sector actor e.g. JP Morgan Chase. In a tug of war with the markets the Fed is a daunting opponent.
What does this tug of war consist of?
In markets facing a discontinuity, a tug of war can develop between those betting that the change is necessary and “inevitable” and those who have invested in the current state of affairs and are likely to suffer losses in the event of the “inevitable” change. They may dig in their heels hoping that those betting against them will lose confidence and run out of funding, the pressure will ease and they can minimize their losses or even walk away with a profit.
This is nicely illustrated in the Big Short, where those who have recognized that house prices will fall, MBS will fail and CDS will trigger, struggle to sustain their correct and profitable positions whilst, for months on end, the market fails to fall. They rail against the continued idiocy of the backers of MBS, the momentum that sustains the false prices. They even allege that there is a conspiracy, to keep the crucial indices up. It makes for great drama. Will those who are shorting have the courage of their convictions? Will their financial backers hold up? Or will they be forced to liquidate their profitable and historically correct bets, before time?
In 2007-2008 some of those shorting mortgage bonds and taking CDS on them held out long enough to make huge profits. But they were betting against banks and businesses on the other side. They had limited risk tolerance and budget constraints. The same was true for the hedge funds who discovered an arbitrage opportunity at the expense of a rogue JP Morgan trader. The crucial point is that because the rogue trade was using the huge resources of a global bank to support an unsustainable position, its unsustainability was not immediately apparent and those betting against him, though correct, could not make the profit that would vindicate their trade. After months of holding their positions, they were beginning to lose the argument inside their own firms. As DeLong tells the story, the crucial next step is that those betting against JP Morgan policitized the situation. They began to spread rumors about the “London Whale” so as to destabilize his position within JP Morgan. His senior managers were forced to enquire into the situation. They discovered that they faced a choice. They could take the risk of holding his position to maturity. If it went bad, it would jeopardize the bank. To close it out, which is what they chose to do, cost JP Morgan $ 6 bn. Finally, the hedge fund arbitragers were able to take their profits. Their version of reality was vindicated.
The hundred billion dollar question, is what happens if the whale you are up against is not JP Morgan but the Fed? And what if you are in a world in which things like bonds no longer have “natural” prices? What if you are in a managed money world?
Since the crisis hit in 2008 it has been clear that US Treasury yields are unnaturally low. This means that their price is too high and will likely return to a lower level in future. So a rational speculative strategy would be to short them. Promise to deliver them at a future date at the kind of good prices you can get now. Bet that their price will fall by the date at which you have to deliver. The result when you snap them up cheap and deliver at the older higher price, is a big profit.
This made sense and hedge funds made this play, at least according to DeLong. And then, as DeLong puts it, they ran into the super whale, the “widowmaker”. As they shorted Treasuries there was one buyer who kept on buying them and purchased them in historically unprecedented quantities. This perverse behaviour kept their prices up and prevented the speculators from realizing their profits. Unfortunately for them this wasn’t a bank constrained by the need to attract funding. It didn’t have an anxious overseer responsive to market rumors. It was the Fed and for as long as the economy was depressed, Bernanke was committed to holding interest rates down and bond prices up. The speculators found themselves in a painful limbo, holding out for the moment at which their version of reality would kick in.
It was this tension, DeLong argues, that explains the politicization of QE, QE2 and QE3. The frustration of the speculators generated the hostility towards Ben Bernanke. The hedge funds were betting on a version of reality that he seemed determined to defy. And unlike JP Morgan he had the resources to uphold his version against theirs.
Surely, the hedge funders reasoned, the Fed’s policy was risky. It was building up a huge portfolio of bonds. If its policy worked and the economy recovered, and inflation began to pick up and interest rates began to go up, the Fed, on behalf of the US taxpayer, would suffer a huge loss on its giant portfolio of bonds. As measured by mark to market accounting that loss could run to hundreds of billions of dollars. If the Fed were JP Morgan, that would be the end of it. But it is not. During the QE period the Fed made large profits on its portfolio. Now, DeLong insisted, it could make a loss without disaster.
But the more general point from DeLong’s analysis is that in the world of managed money, there is a tendency for market positions and investment strategies to become politicized. This is not a radical indeterminist position. The stance the Fed takes, depends on the state of the macroeconomy. But the transition from one state to the other is a period of acute tension and spiraling dynamics of investment and politicization.
It will be interesting to see how this scenario plays out four years later in 2017, with the wild men of the Tea Party running riot, with inflation and interest rates picking up and the Fed still holding a huge bond portfolio.
But to see the force of the point back in 2013, check out the reaction to DeLong’s post that defends the honor of hedge fund investors as critics of the Fed, which was distributed by way of the combative zerohedge blog.
A choice moment from the reply is the following:
“Getting back to DeLong’s article, his “Bernanke-haters” really don’t have to share their fiscal and monetary policy concerns with the general public. They certainly haven’t done this out of frustration with losing trades. At least two of the three managers whom he cites (in the separate post that refers to Druckenmiller, Bass and Singer) have been on the record with accurate predictions that Fed-fueled market rallies were likely to continue for some time. DeLong’s claim that these managers have probably “spent years shorting Treasuries” is preposterous.
The real reason that we hear from these hedge fund managers is their exceptional track records. The media realizes that they’ve shown a remarkable understanding of economic risks, and therefore, their opinions are widely reported. They haven’t necessarily sought an audience, but they’ve certainly earned one.
DeLong, on the other hand, epitomizes an academic community that regularly gets blindsided by real life events. It’s a shame that they claim authority on economic issues, because we all suffer when their abstract theories blow up in their faces as happens time and again. This is yet another reason that we should call foul when we see an irresponsible piece of fantasy like DeLong’s article.”
As this excerpt makes clear, in a world of managed money, economic interpretation and even meta-interpretation, the development and dissemination of narratives and narratives about narratives, involves a deep intertwining of commercial and political motives.