Hayman Capital's Kyle Bass Writes About The Cognitive Dissonance Of It All

Hayman Capital's Kyle Bass writes about "The Cognitive Dissonance of it All" - the fact that an increase in the unsustainable policies and economic structure of the past forty years that led to the recent financial crisis is being offered as the cure to the ills the very same policies caused. Sovereign defaults, debt accumulation, the Keynesian endpoint, Japan's coming X-Day, the future of the euro/EMU, fiat money, gold and other topics are all discussed.

Enjoy.

48881153 Kyle Bass Hayman Investor Letter February 2011[1]

Yen:Dollar In Freefall

Wow - the yen's strength is remarkable (or is it the dollar's weakness - pick your poison). Say Sayonara to the Japanese government's budget. Say Ohaiyo Gozaimasu to QE52 in Japan and the ultimate destruction of their currency. As we've discussed several times in the past, this is a "when, not if" scenario.

SCHWARZIES!!!!

Ah, it feels so good. Long time TILB readers know that last year we had something of an obsession with California's 2009 vintage scrip, which we named Schwarzies.

Well, today we read an article (linked here) from Bloomberg which says California is not close to passing a budget and it will run out of cash by end of August. The article goes on to discuss how state legislators will (yet again) violate the state constitution and not provide a proposed budget to the Governator by midnight tonight (June 15th). This is perhaps our favorite quote of the year:

“We’re working on it,” said Alicia Trost, a spokeswoman for Senate President Darrell Steinberg, a Democrat from Sacramento. “The most important thing is that we have a fair and balanced budget instead of getting it done by a constitutional deadline.”

I know, right? I mean, like, who needs, like, to follow the constitution thingy?

In any case, in honor of hints of renewed Schwarzie issuance, the author of Directive 10-289 and friend of TILB sent along this song to celebrate the moment. Enjoy.

You are now about to witness the strength of Wall Street knowledge

Verse One: Arnie

Straight outta Sactown, crazy governator with his lats blown
From the gang called IOU
When I'm called out I get politically put out
Flex the pecs and raise the Tax no doubt
You too boy if don’t pay me
The police are gonna hafta come and get ya out of Cali
Off yo ass that's how I'm goin out
For the punk Kalifornians that's showin out
SoCal start to mumble, NoCal wanna rumble
Mix em and cook em in a pot like gumbo
Goin off on a governator like that
with a gat that's pointed at yo cash
So give it up smooth
Ain't no tellin when I'm down for a jack move
Here's a financial rap to keep you dancin'
with a debt record like Greece Athens
Schwarzie is the tool
Don't make me act the no payin' fool
Me you can go toe to toe, no maybe
I'm knockin' playas out tha box, daily
yo weekly, monthly and yearly
until them dumb democrats see clearly
that I'm down with the capital I.R.S.
Boy you can't play with me
So when I'm in your neighborhood, you better duck
Coz Arnie is pumped up like a buck
As I leave, believe I'm issuin, something missin'
but when I come back, boy, I'm comin straight outta Sactown.

Genius.

In case anyone wants the original, it's Ice Cube's opening verse to Straight Outta Compton.

David Einhorn OpEd: NY Times - Easy Money, Hard Truths

TILB friends know that we have followed Greenlight Capital's David Einhorn for years. A year and a half ago, when he first began to publicly disclose his position in gold, we took note.

As we reported from yesterday's Ira Sohn Conference, Einhorn gave a presentation called "Good News for the Grandchildren" (implying that the debt crisis will manifest itself in our generation, not theirs). In today's NY Times, he basically provided them with a slightly modified version of the speech as an OpEd.

Here is the OpEd from the NY Times. Because it's basically the transcript of a speech he gave yesterday, we provide it below in its entirety. Please support the NY Times, one of TILB's favorite newspaper.

Op-Ed Contributor
NY times
Easy Money, Hard Truths
By DAVID EINHORN
Published: May 26, 2010

Before this recession it appeared that absent action, the government’s long-term commitments would become a problem in a few decades. I believe the government response to the recession has created budgetary stress sufficient to bring about the crisis much sooner. Our generation — not our grandchildren’s — will have to deal with the consequences.

According to the Bank for International Settlements, the United States’ structural deficit — the amount of our deficit adjusted for the economic cycle — has increased from 3.1 percent of gross domestic product in 2007 to 9.2 percent in 2010. This does not take into account the very large liabilities the government has taken on by socializing losses in the housing market. We have not seen the bills for bailing out Fannie Mae and Freddie Mac and even more so the Federal Housing Administration, which is issuing government-guaranteed loans to non-creditworthy borrowers on terms easier than anything offered during the housing bubble. Government accounting is done on a cash basis, so promises to pay in the future — whether Social Security benefits or loan guarantees — do not count in the budget until the money goes out the door.

A good percentage of the structural increase in the deficit is because last year’s “stimulus” was not stimulus in the traditional sense. Rather than a one-time injection of spending to replace a cyclical reduction in private demand, the vast majority of the stimulus has been a permanent increase in the base level of government spending — including spending on federal jobs. How different is the government today from what General Motors was a decade ago? Government employees are expensive and difficult to fire. Bloomberg News reported that from the last peak businesses have let go 8.5 million people, or 7.4 percent of the work force, while local governments have cut only 141,000 workers, or less than 1 percent.

Public sector jobs used to offer greater job security but lower pay. Not anymore. In 2008, according to the Cato Institute, the average federal civilian salary with benefits was $119,982, compared with $59,909 for the average private sector worker; the disparity has grown enormously over the last decade.

The question we need to ask is this: If we don’t change direction, how long can we travel down this path without having a crisis? The answer lies in two critical issues. First, how long will the capital markets continue to finance government borrowings that may be refinanced but never repaid on reasonable terms? And second, to what extent can obligations that are not financed through traditional fiscal means be satisfied through central bank monetization of debts — that is, by the printing of money?

The recent United States credit crisis was attributable in large measure to capital requirements and risk models that incorrectly assumed AAA-rated securities were exempt from default risk. We learned the hard way that when the market ignores credit risk, the behavior of borrowers and lenders becomes distorted.

It was once unthinkable that “risk-free” institutions could fail — so unthinkable that the chief executives of the companies that recently did fail probably didn’t realize when they crossed the line from highly creditworthy to eventually insolvent. Surely, had they seen the line, they would, to a man, have stopped on the solvent side.

Our government leaders are faced with the same risk today. At what level of government debt and future commitments does government default go from being unthinkable to inevitable, and how does our government think about that risk?

I recently posed this question to one of the president’s senior economic advisers. He answered that the government is different from financial institutions because it can print money, and statistically the United States is not as bad off as some other countries. For an investor, these responses do not inspire confidence.

He went on to say that the government needs to focus on jobs now, because without an economic recovery, the rest does not matter. It’s a valid point, but an insufficient excuse for holding off on addressing the long-term structural deficit. If we are going to spend more now, it is imperative that we lay out a credible plan to avoid falling into a debt trap. Even using the administration’s optimistic 10-year forecast, it is clear that we will have problematic deficits for the next decade, which ends just as our commitments to baby boomers accelerate.

Modern Keynesianism works great until it doesn’t. No one really knows where the line is. One obvious lesson from the economic crisis is that we should get rid of the official credit ratings that inspire false confidence and, worse, are pro-cyclical, aggravating slowdowns and inflating booms. Congress has a rare opportunity in the current regulatory reform effort to eliminate the rating system. For now, it does not appear interested in taking sufficiently aggressive action. The big banks and bond buyers have told Congress they want to continue the current system.

As William Gross, the managing director of the bond management company Pimco, put it in his last newsletter, “Firms such as Pimco with large credit staffs of their own can bypass, anticipate and front run all three [rating agencies], benefiting from their timidity and lack of common sense.”

Given how sophisticated bond buyers use the credit rating system to take advantage of more passive market participants, it is no wonder they stress the continued need to preserve the status quo.

It would be better to have each investor individually assess credit-seeking entities. Certainly, the creditworthiness of governments should not be determined by a couple of rating agency committees.

Consider this: When Treasury Secretary Timothy Geithner promises that the United States will never lose its AAA rating, he chooses to become dependent on the whims of the Standard & Poor’s ratings committee rather than the diverse views of the many participants in the capital markets. It is not hard to imagine a crisis where just as the Treasury secretary seeks buyers of government debt in the face of deteriorating market confidence, a rating agency issues an untimely downgrade, setting off a rush of sales by existing bondholders. This has been the experience of many troubled corporations, where downgrades served as the coup de grâce.

The current upset in the European sovereign debt market is a prequel to what might happen here. Banks can hold government debt with a so-called zero-risk weighting, which means zero capital requirements. As a result, European banks stocked up on Greek debt, and sold sovereign credit default swaps, and now need to be bailed out to avoid another banking crisis.

As we saw first in Dubai and now in Greece, it appears that governments’ response to the failure of Lehman Brothers is to use any means necessary to avoid another Lehman-like event. This policy transfers risk from the weak to the strong — or at least the less weak — setting up the possibility of the crisis ultimately spreading from the “too small to fails,” like Greece, to “too big to bails,” like members of the Group of 7 industrialized nations.

We should have learned by now that each credit — no matter how unthinkable its failure would be — has risk and requires capital. Just as trivial capital charges encouraged lenders and borrowers to overdo it with AAA-rated collateral debt obligations, the same flawed structure in the government debt market encourages and therefore practically ensures a repeat of this behavior — leading to an even larger crisis.

I don’t believe a United States debt default is inevitable. On the other hand, I don’t see the political will to steer the country away from crisis. If we wait until the markets force action, as they have in Greece, we might find ourselves negotiating austerity programs with foreign creditors.

Some believe this could be avoided by printing money. Despite the promises by the Federal Reserve chairman, Ben Bernanke, not to print money or “monetize” the debt, when push comes to shove, there is a good chance the Fed will do so, at least to the point where significant inflation shows up even in government statistics.

That the recent round of money printing has not led to headline inflation may give central bankers the confidence that they can pursue this course without inflationary consequences. However, printing money can go only so far without creating inflation.

Government statistics are about the last place one should look to find inflation, as they are designed to not show much. Over the last 35 years the government has changed the way it calculates inflation several times. According to the Web site Shadow Government Statistics, using the pre-1980 method, the Consumer Price Index would be over 9 percent, compared with about 2 percent in the official statistics today.

While the truth probably lies somewhere in the middle, this doesn’t even take into account inflation we ignore by using a basket of goods that don’t match the real-world cost of living. (For example, health care costs are one-sixth of G.D.P. but only one-sixteenth of the price index, and rising income and payroll taxes do not count as inflation at all.)

Why does the government understate rising costs? Low official inflation benefits the government by reducing inflation-indexed payments, including Social Security. Lower official inflation means higher reported real G.D.P., higher reported real income and higher reported productivity.

Subdued reported inflation also enables the Fed to rationalize easy money. The Fed wants to have low interest rates to fight unemployment, which, in a new version of the trickle-down theory, it believes can be addressed through higher stock prices. The Fed hopes that by denying savers an adequate return in risk-free assets like savings deposits, it will force them to speculate in stocks and other “risky assets.” This speculation drives stock prices higher, which creates a “wealth effect” when the lucky speculators spend some of their gains on goods and services. The purchases increase aggregate demand and lead to job creation.

Easy money also aids the banks, helping them earn back their still unacknowledged losses. This has the perverse effect of discouraging banks from making new loans. If banks can lend to the government, with no capital charge and no perceived risk and earn an adequate spread, then they have little incentive to lend to small businesses or consumers. (For this reason, higher short-term rates could very well stimulate additional lending to the private sector.)

Easy money also helps the fiscal position of the government. Lower borrowing costs mean lower deficits. In effect, negative real interest rates are indirect debt monetization. Allowing borrowers, including the government, to get addicted to unsustainably low rates creates enormous solvency risks when rates eventually rise.

While one can debate where we are in the recovery, one thing is clear — the worst of the last crisis has passed. Nominal G.D.P. growth is running in the mid-single digits. The emergency has passed and yet the Fed continues with an emergency zero-interest rate policy. Perhaps easy money is still appropriate — but a zero-rate policy creates enormous distortions in incentives and increases the likelihood of a significant crisis later. It was not lost on the market that during this month’s sell-off, with rates around zero, there is no room for further cuts should the economy roll over.

EASY money has negative consequences in addition to the risk of inflation and devaluing the dollar. It can also feed asset bubbles. In recent years, we have gone from one bubble and bailout to the next. Each bailout has rewarded those who acted imprudently. This has encouraged additional risky behavior, feeding the creation of new, larger bubbles.

The Fed bailed out the equity markets after the crash of 1987, which fed a boom ending with the Mexican crisis and bailout. That Treasury-financed bailout started a bubble in emerging market debt, which ended with the Asian currency crisis and Russian default. The resulting organized rescue of Long-Term Capital Management’s counterparties spurred the Internet bubble. After that popped, the rescue led to the housing and credit bubble. The deflationary aspects of that bubble popping created a bubble in sovereign debt, despite the fiscal strains created by the bailouts. The Greek crisis may be the first sign of the sovereign debt bubble bursting.

Though we don’t know what’s going to happen next, the good news for our grandchildren is that we will have to face our own debts. If we realize that our own future is at risk, we might be more serious about changing course. If we don’t, Mr. Geithner and others might regret having never said never about America’s rating.

David Einhorn is the president of Greenlight Capital, a hedge fund, and the author of “Fooling Some of the People All of the Time.” Investment accounts managed by Greenlight may have a position (long or short) in the securities discussed in this article.

A version of this op-ed appeared in print on May 27, 2010, on page A35 of the New York edition

Keynesianism Is So Nuanced

[This will be a multi-part series that discusses inflation, what money is and why it has value. We begin with some basics through the lens of Keynesianism's "attractiveness".]

I was on an email string recently about The Carnegie Endowment for International Peace's Uri Dadush. I made the statement that Dadush is simply a Keynesian, albeit one that is well connected and understands there are many difficult challenges that need to be addressed. In response to my email, a long-time friend of TILB and fellow liberty loving free marketer - though he is still finding his legs with regards to understanding the implications of his beliefs - responded to me that he has spoken at length with Dadush and that he's more nuanced and "complex" than being simply called a Keynsian. Here's a quote from Dadush's recent FT OpEd:

There are ways to mitigate the pain. For example, Germany and other countries could adopt more expansionary fiscal policies for a while. Or, more powerfully, the wider euro area could adopt more expansionary monetary policies for several years. Today, this second option is anathema as the “inflation fundamentalists” will have none of it.

Nuanced? I guess.

Here's what my friend said (mind you, he's an avowed libertarian - though he's still figuring himself out so to speak) - light editing for privacy reasons or clarification:

I met with the guy for 2 hours, and I would not classify him as such [a "strong Keynesian with fairly mainstream opinions"]. If anything, he is complex – and clearly what he says on CNBC and in NY Times oped is not what he can say behind closed doors. While Keynesian, he is not a classically academic Keynesian, sitting in a library dealing with only theory. He counsels governments facing massive social unrest and high unemployment, and he approaches his work with a much deeper appreciation for the human situation than we can. So while espousing money creation below, he was also very pragmatic with me about the moral hazard of this choice, the continued low interest rates, our over-reliance on debt, etc.

I am sympathetic with his situation. We often throw around our ideas without considering the reality of what will inevitably happen – at least in the short term – if our ideas were implemented. I know you will vehemently disagree with me on this, but the fact is that – again, in the short term – what you and I want ideally is economically wishful thinking and politically impossible. Yes, the opposite will bankrupt the world, and we are largely already insolvent. There’s no argument there. Should we suddenly balance our budget, shrink government dramatically, stop stimulus, war, and over-regulation, the result could be 50-60-70% unemployment rates – in the short run. I do believe the LT benefits of Austrian economics are obviously far superior to the Keynsian ponzi scheme.

However, no one talks about the transition, and what it would really mean for us. If you take a heroin addict, and suddenly “reform” him with complete withdrawal and going cold turkey, he will often die from this. His body cannot handle the shock.

Uri had just met with the Italian Finance Minister prior to seeing me – I can imagine that conversation. How do you convince someone like that that what he really needs is to leave the EU, get on the gold standard, balance his budget, cut taxes – and face assassination b/c 100 million are thrown into convulsions?

My point is that Uri deals with the reality of our current situation, while we do not. We read letters and books, then pontificate and rant without a good understanding of what it really means. It will kills us eventually, yes. But it will be a long, slow death probably instead of a quick one.

Lastly, I’ve read Ron Paul, Murry [sic] Rothbard, etc. They all talk about how wrong things are – and I agree with them. I have yet to see a transition plan, so if you know of anything they have written on how to get off the system we are currently addicted to, I’d love to read it.

I decided not to send him a reply by email. Instead, I decided to bring the discussion to TILB, as it's a more productive forum for this sort of thing. To be direct, I disagree with a number of his assertions.

In my opinion, what you described is in fact classic Keynesianism. No self respecting Keynesian would claim that running large deficits and printing money is a long-term viable solution or economically healthy approach. That is simply the tag line non-Keynsians use to belittle the Keynsian approach. It's the politicization the word "Keynesian" but not the reality. Dadush is a classic, behind-the-desk academic Keynesian. He provides advice based in theory as does every other economist, Austrian or otherwise.

The Keynesian argument is always more nuanced or "complex". The argument is generally that goverment needs to implement aggressive and targeted public spending policies during difficult economic periods because taking the hard medicine in the middle of a recession would (they believe) be too painful and counterproductive. By putting it into human terms it becomes very powerful (for obvious reasons) even if - in my opinion - the Keynsian trade is to attempt to avoid some human pain today in exchange for accepting much more human pain in the future.

What's here is tangible and it matters more to voters than tomorrow's pain.

So if we can just take a few easy money bong hits and confuse our body into thinking it's healthy, we can take the hard medicine then. We'll do what needs to be done, but just not yet. Tomorrow. Always some day in the future.

As you know, the issue is that the recession is not the problem, the recession is the cure. It's the cure to profligacy; a recession is simply a period of excess savings that offsets periods of excess spending and consumption.

Switching from a societal bias toward spending to one of savings is painful because society was confused by the profligacy into setting up a structure that serves society's apparent "needs" as if the profligate period is normal. The profligacy is full of false/unsustainable demand signals that trick people into creating/investing in the wrong kinds of businesses or in the wrong amount. The longer the cure is postponed by inflicting more easy money and socialist disease (e.g., Dadush's prescription), the more painful the necessary recession will be because the imbalances are greater and become more depended on.

It's not just imbalances as defined as switching from spending/borrowing to saving/investing. It's that entire industries were created to serve an unsustainable consumptive demand rather than productive advancement. It requires more than just saving new capital, but shifting existing capital from entire industries and possibly geographies to others. A human toll is left in the wreckage of these corrections. It is, however, unavoidable.

What is avoidable is compounding the problem through continued interference with the needed correction.

Bernanke/Bush/Obama's current postponement means the next recession (assuming we are - in fact - past "this one") will feel worse than this one. Their fight of postponement is really an attempt to induce even more capital to become malinvested toward less productive industries and to have us become even more dependant on unsustainable behaviors. So there will never be a period in which the hard medicine can be comfortably consumed because the hard medicine IS the recession and the imbalances it wants and needs to address continue to grow in the meantime. So avoiding taking the hard medicine means avoiding curing the disease; allowing it to metasticize, take root, grow and spread.

You know me well and you are correct: I do vehemently disagree with your statement. Short of a major North American landwar, there is virtually no scenario in which a society as productive as ours would experience anything like "50-60-70%" unemployment rates, even if one mistakenly changes the whole system in one yank.

Ron Paul and others have addressed transition plans. They logically begin with the easiest part: balancing the budget while cutting taxes. By taxing less and borrowing less, capital remains in private (productive) hands and out of public (unproductive) hands. Sounds hard, but if you are of the opinion that most of government is value-destructive, it's actually easy. First, bring the troops home and end the American military empire abroad (foreign military bases). Those two actions are somewhere in the $500 billion to $750 billion annually of savings (1/3 to half of our expected deficit this year and 100% of our deficit from three years ago). Other than for providing a platform for safe living and investment, military is a non-productive expense, by definition. Then end most of the "Department ofs", as I call them. Dept of Education, Dept of Interior, Dept of Energy, Dept of Homeland Security, etc. and slash the size of those you keep, emphasizing of course a strong defense (not offense - defense). This is key, bringing home the military does not mean having a weaker defense. It means changing the nature of it and allowing us to invest in true defense rather than wasting investment on overseas bases.

These cuts are - importantly - phased in but transparent and forecast so that the change is digestible.

That's the easy part. The harder part (though made much, much easier by having already shifted to a smaller government that runs a balanced budget) is moving to a harder currency. This involves ending the Fed and installing free banking, which means a banking system that doesn't "create" money with customer deposits. My personal view is the only way to do that is a slow, planned, well understood phase-in. It might take two decades to let happen so that the adjustment is manageable. I believe the huge benefits reaped from freeing capital from government hands would unleash such a lollapalooza of positives on society that shrinking the banking system would actually shift from an economic headwind to a tailwind by the latter years of the process.

As a final aside, in contrast to your assertion, I am not actually a government-installed-gold-standard man, because it relies on government to be well behaved. I am for market-based money, but that's a discussion for another day.

The Revolution Marches Forward

I have nothing to add.

Our Peter Schiff Man Crush Grows

Watch Connecticut's refreshing senate candidate Peter Schiff just absolutely embarass this poor Columbia professor David Epstein that espouses mainstream "Keynesian" economics in this excellent debate. Epstein plays a perfect foil to Schiff in this long, thoughtful debate. I think the main lack of understanding of mainstream economists is a fundamental lack of understanding of what "money", productivity, and the pricing system really are and what they serve. This leads to all sorts of decisions to promote government deficit spending as "cures" for economic ills without the understanding that the government does not have a capital base to invest from without first taking it from the private market. This perpetuates and compounds the problem, preventing healing.

Enjoy.

Hayman Capital's Kyle Bass Waxes Philosophical On The Debacle That Is U.S. Macro

Kyle made his name for crushing it hard on the subprime short trade. If you're a fiat currency fan and you don't like dissent, do not read below.

Bass Provides Sleep Demons

Hat Tip: Wild West