RISK - Consider the VIX Inversion

CONSIDER THE VIX INVERSION

US equity markets are showing signs of investor panic and capitulation.

BofAML points out the inversion of the VIX to levels that have coincided with market lows for much of this year, the significant underperformance of recent outperformers (the NASDAQ Comp fell 2% and the Russell 2000 fell 1.72% vs an S&P500 decline of 1.23%), and pop in the ARMS Index all point to signs of capitulation. While this is encouraging from a technical perspective, as it says we are one step closer to completing the multi-week correction, they warn - it does not mean the correction is finished.

Click Image to Enlarge

Price action according to BoAML indicates that we should see another push lower towards the Aug 27 low at 1627 (1618.25 in ESZ3), Potentially, the 200d (1599), before a more material base develops. This next leg lower should be a less dramatic and result in bullish momentum divergences that often accompany a base and turn higher. Back above 1662.75 in ESZ3 turns them from bearish neutral, while bulls need to overcome 1679.50/1687.15 (ESZ3 and CASH, respectively) to gain control.

RISK - US Treasury Default Risk Hits 2011 Highs

US Treasury Default Risk Hits 2011 Highs 10-09-13 Zero Hedge

Not much comment necessary on a topic we have beaten to horse pulp in the past 2 weeks aside to note that this time is ironically different from 2011 as the inversion in the CDS curve is considerably more biased to a piling up of short-term default risk than in 2011.

[Sure enough as we warned last night, we are seeing the longest-dated "Cheapest to deliver" Treasuries well bid as tradesr prepare for a potential CDS trigger in sovereigns - watch the 2.75s of Aug 2042 and the 2.75s of Nov 2042]

T-Bill rates exponentially rising (10/17 +20bps at 48bps!!) - no worries... Fidelity selling all its short-term Treasuries - not a problem... Repo markets starting to panic - have no fear... CDS markets signaling extreme short-term default concerns - baah humbug.... We have a solution for that - Janet Yellen's "buyback" plan.

RISK - A Collateral Crunch in The Repo Market the Short Term Exposure

Collateral Crunch Feared as T-Bill Yields Leap 10-09-13 FT

Halloween has taken on a new meaning for US Treasury bills: the threat of a debt default now looms as the ultimate “trick” for financial markets. The humble short-term Treasury bill occupies a pivotal place in the infrastructure of financial markets. But its “risk free” status is at risk as politicians in Washington squabble over raising the $16.7tn debt ceiling. The fight in Congress could leak to the US Treasury delaying a payment on its debt, which would constitute a technical default.

Investors such as Fidelity and other money funds are already voting with their feet. Yields for bills that mature in October and November have risen above 30 basis points – a level not seen since late 2008, when the Federal Reserve adopted a zero interest rate policy during the depths of the financial crisis.

Risk aversion was certainly the mantra on Tuesday, when the Treasury sold new one-month bills at a yield of 35 basis points, a threefold jump from the prior week and just shy of the two-year Treasury yield of 0.38 per cent. Normally investors demand a smaller return for holding shorter-term debt, since they are usually viewed as less risky.

The flight from near-term bills could have major repercussions for key financing markets as Treasury collateral is widely used by central banks, sovereign wealth managers, banks, custodians and other investors for borrowing short-term cash and supporting derivatives positions and other types of trading.

The longer the stand-off in Washington continues, so the risk grows that certain Treasury securities start to be seen as too risky to take as collateral for the short-term loans that underpin this financing, via the vast “repo market”.

“The twists and turns in the debt ceiling stand-off are now finally beginning to make its presence more forcefully felt in the markets,” says Eric Green, global head of rates strategy at TD Securities. “The bills market was the first red flag and that has now extended into a broader repo market as a cash hoarding theme begins to take shape with some transactions even steering clear of using Treasury as collateral.”

The head of rates trading at a major bank told the FT: “There are certain types of collateral [bills maturing in the next month] we do not want.” In the event of an actual missed payment by the Treasury, all bets are off.

Steven Major, strategist at HSBC, says: “In a payment delay situation, the financial system would be tested and the biggest impacts would be on the repo market and clearing systems that take Treasuries as collateral.” Chris Probyn, chief economist at State Street Global Advisers, says all kinds of investments could go into free fall, as they did when funding markets dried up in 2008.

“The repo market could then become absolutely inoperable, there would be all kinds of sellers and no kind of buyers. It is a sobering thought,” says Mr Probyn.

While some investors exit bills, others are taking advantage of owning them at sharply higher yields as they expect the debt ceiling will be raised before the US Treasury runs out of cash after October 17.

In the event the debt ceiling is not raised, others contend that the Treasury is likely to prioritise payments or simply extend maturities in order to make sure a technical default does not occur.

“If the US does hit its debt limit and goes into technical default this shouldn’t need to cause financial chaos as long as there continues to be an expectation that missed coupon payments will eventually be repaid within days or, at worst, weeks,” says Jim Reid, strategist at Deutsche Bank.

“The problem comes as the longer we go past the debt limit date and the deeper in arrears the US government gets, the greater the chance of a sudden break in the system.”

Burgeoning disruptions are already evident in a variety of technical financial markets. The yield on one-month T-bills has overtaken the one-month interbank lending rate, known as Libor, for the first time in a dozen years.

The curve in credit default swaps (CDS) on US debt has also inverted – indicating that purchasers of the derivatives are, in theory, pricing in a higher risk of default in the short term than in the longer term.

CDS on US government debt has doubled in the past month and trading volumes have jumped as a growing number of investors have bought the instruments, seeking protection against a potential default or making bets on subtle movements in the derivatives.

Meanwhile, some fear bill yields could rise further as the gridlock continues.

“For now, people will keep selling Treasury bills,” says Robbert van Batenburg, director of market strategy for Newedge. “The US Congress is not going to look at what’s been going on with Treasury bills and take it as a sign that now they have to get really serious. That will only happen once stocks start to collapse.”

But bill yields are already sending an important signal that this year’s Halloween may be remembered in more ways than one.

Mr Probyn says: “If you play with matches in an ammo dump for long enough, something is going to go boom.”

JAPAN - How Japan's National Debt Grew

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GLOBAL GROWTH - Clearly Slowing

Goldman's Global Leading Indicator Plunges Back To "Slowdown" 10-01-13 Zero Hedge

• Everything looked so good in August. Goldman's global leading indicator (GLI) "swirlogram" had recovered quickly from a 'growth scare' in Q1 and was holding firmly in "expansion" territory.
• Then reality hit as new-orders-less-inventories worsened, various manufacturing surveys rolled over, industrial metals gave up gains, and Korean exports provided no help.
• Among the few factors holding up the index from already plunging levels was the Baltic Dry Index (which has collapsed recently) and Consumer Confidence (which appears to also be rolling over).
• September's plunge into "slowdown" for the GLI is the biggest drop in 8 months.

US FINANCIAL POWER - The FAC is to the FED as the TBAC is to the TREASURY (Same Banks)

Here Is What The Fed's Advisors Really Think About The US Economy 10-11-13 Zero Hedge

Five months ago, in May, in a release that stunned markets, the Federal Advisory Council (FAC) which is composed of twelve representatives of the banking industry (including the CEOs of Morgan Stanley, TD Bank, State Street, PNC, BB&T, First Horizon, Commerce Bank and Discover), and which "consults with and advises the Board on all matters within the Board's jurisdiction" said something very disturbing: the truth.

To wit: "There is also concern about the possibility of a breakout of inflation, although current inflation risk is not considered unmanageable, and of an unsustainable bubble in equity and fixed-income markets given current prices."

This took place just as the Fed launched its PR campaign to "taper" or rather see what the market's response would be to concerns that the Fed may be, slowly, pulling out of the monthly monetization business. The outcome as we all know, was not good, and it certainly punctured the equity and fixed-income bubbles, if only for the time being. A few days ago, the same Fed Advisory Counsil met again, and once again shared its views on current banking conditions, the economy and markets, with the FOMC Board.

Contrary to the all "rose-colored glasses" reports by the Fed released in the past year, which constantly talked up the "economic recovery" only to punk everyone - economists and market participants alike - when it stunned markets with its no taper announcement in September, over fears what this would do to the economy, the Federal Advisory Council's view on things is decidedly less "rosy."

This is a the summary of how the various bank CEOs that tell the Fed what it "should" do, see the US economy and financial system currently:

• Loan demand is tepid due to uncertainty around the economic outlook, regulatory burdens, health care and tax reforms, geopolitical risk, and sovereign deficit spending.
• Senior bank leaders at the recent Barclay’s investor conference consistently noted that loan demand is softening and mortgage banking revenue is evaporating faster than expected. This consensus has led some analysts to lower quarterly earnings forecasts for several regional banks.
• Both consumers and businesses have deleveraged over the past few years and remain more selective about new borrowing and capital expansion.
• Loan volumes are dominated by refinance activity. New loan volumes are concentrated in mergers and acquisitions, capital distributions, and share repurchases.
• Excess capacity remains in the banking sector and in the institutional markets. Loan tenor, structure, and pricing continue to drift negatively. With large inflows of funds seeking yield and variable pricing, there is greater structuring weakness in the institutional markets.
• The outlook for the loan markets is uncertain and no near-term changes are expected.
• The financial markets appear to be dominated by decreasing liquidity as some dealers are no longer making a market in certain asset classes. It is clear that dealers are less willing to hold sizable inventories of bonds.
• The financial markets have been adversely impacted by ever-changing regulatory metrics, such as leverage capital requirements, Basel III’s Liquidity Coverage Ratio (“LCR”), and the liquid asset buffer. The response to these ratios may cause downstream implications for other financial institutions and municipalities, with SIFIs less willing to use their balance sheets to provide secured funding (repurchase agreements) or to book municipal deposits.
• While many analysts have argued that a small reduction in monthly asset purchases still represents an extremely accommodative monetary posture, the markets’ recent price movements suggest otherwise. Thus far, even the threat of lower Federal Reserve purchases paired with an increase in selling has had a major negative impact on the bond market.
• Increases in longer-term rates have caused a flip from unrealized gains to unrealized losses in longer-duration investment portfolios, which could ultimately impact consolidation in the industry.

Still think anything is recovering, and that stocks reflect anything more than the unprecedented liquidity tsunami the same ill-advised Fed has created (and which by implication means that said liquidity is likely never going to me removed voluntarily)?

Didn't think so.

US BANK RISK CAPITAL- $2.3 Trillion of Leveraged Derivative Collateral

The Biggest Banking Disconnect Since Lehman Hits A New Record 10-10-13 Zero Hedge

As regular readers know, the biggest (and most important) disconnect in the US banking system is the divergence between commercial bank loans, which most recently amounted to $7.32 trillion, a decrease of $9 billion for the week, and are at the same the same level when Lehman filed for bankruptcy having not grown at all in all of 2013 (blue line below), and their conventionally matched liability: deposits, which increased by $60 billion in the past week to $9.63 trillion, an all time high. The spread between these two key monetary components - at least in a non-centrally planned world - which also happen to determine the velocity of money in circulation (as traditionally it is private banks that create money not the Fed as a result of loan demand) is now at a record $2.3 trillion.

Which, of course, also happens to be the amount of reserves the Fed has injected into the system (i.e., how much the Fed's balance sheet has expanded) since the great experiment to bailout the US financial system started in September 2008, in which Ben Bernanke, and soon Janet Yellen, stepped in as the sole source of credit money. The only difference is that while the Fed is actively pumping bank deposits courtesy of the fungibility of reserves, loan are unchanged.

For those who still don't understand the identity between Fed reserves and bank deposits, here is Manmohan Singh with the simplest explanation on the topic:

When central banks buy securities, one of the immediate effects is to increase bank deposits, which adds to M2 (in the U.S., practically the Fed has bought from nonbanks, not banks). Whether banks maintain those added deposits as deposits, or convert them into other liabilities (or, by calling in loans, reducing or moderating the growth of their balance sheets), is an open question.

Actually it's not. As the JPM London Whale episode taught us, it is the excess deposits on bank balance sheets courtesy of the Fed, that serve as collateral for marginable derivatives (IG9, HY9, ES, etc) which then can and are used by banks to chase risk higher, often with leverage that runs into the orders of magnitude. In other words, as the chart below shows, in the past week, the Fed injected a net $69 billion in risk-ramping power on the commercial bank balance sheets, and, more importantly, since the failure of Lehman, this amount is a record $2.308 trillion.

So for those confused where the money comes from to ramp equities ever higher on a daily basis for the duration of QE, and why the S&P correlates (and "causates") exquisitely with the Fed's balance sheet, now you know. More impotantly: don't expect banks to lend out much if any real new loans as long as they can generate far greater and far less riskier returns simply by chasing risk in the capital markets.

SENTIMENT - Confusion Reigns

Confusion Reigns 10-10-13 Bespokeninvest

If you are having a hard time making sense out of what's going on in Washington regarding the government shutdown and the debt ceiling, trying to make sense out of investor sentiment is not going to be any easier.  The charts below show the weekly readings of bullish and bearish sentiment from the American Association of Individual Investors (AAII).  As shown in the top chart, even as the stock market has been steadily declining this week, bullish sentiment actually increased, rising from 37.84% up to 41.33%.  While bullish sentiment rose this week, so too did bearish sentiment.  As shown in the lower chart, bearish sentiment rose from 30.07% up to 33.58%.  

It is not too often that you see a week where both bearish and bullish sentiment rise by three or more percentage points in the same week.  In fact, the last time it happened was back in May 2009 just as we were coming out of the bear market.  However, when you have a market where prices move on headlines or even rumors of meetings, you can't blame investors for being confused.

SENTIMENT - Economic Confidence Collapses At Fastest Pace Since Lehman

Economic Confidence Collapses At Fastest Pace Since Lehman 10-08-13 Gallup via ZH

Last week we showed the cognitive dissonance, nurtured by a liquidity-providing Fed, that has growth this year between stocks and economic confidence. In the last week, fed by a diet of DC headlines, Gallup's economic confidence index has collapsed. In fact, this is the worst 3-week plunge since Lehman - worse than during the 2011 Debt Ceiling debacle.

Gallup's Economic Confidence is collapsing...

at the fastest pace since Lehman...

Data: Gallup

GLOBAL RISK - Cascading Complexity To Systemic Collapse

From Cascading Complexity To Systemic Collapse: A Walk Thru "Society's Equivalent Of A Heart Attack" 10-05-13 FEASTA's David Korowicz via ZH

Over a year ago, FEASTA's David Korowicz stunned the world with his fascinating analysis titled "Trade-Off: Financial System Supply-Chain Cross-Contagion: a study in global systemic collapse," in which he shone a much needed light on the "weakest link" choke points of modern hyper-complex society: a forensic investigation into a "Minsky Moment" thought experiment gone wrong, one crossing the systemic instability threshold, and culminating with society, economics and the modern world as we know it grinding to a halt and worse.

Since Korowicz' analysis is precisely the terminal outcome that awaits the world caught in a state of relentless denial that even refuses to contemplate "Plan B", what we said then is that "everyone who wishes to know what will happen unless everyone is aware of what may happen" should read said study in global systemic collapse. Before proceeding further, we urge all readers who are fascinated by the topic of crossing thresholds of social, systemic instability to read the original analysis if they have not done so already.

The original paper led to an eruption in opinions and responses both on the pages of Zero Hedge and elsewhere, to an issue that has chronically received virtually no media attention (for obvious confidence preserving reasons in a world in which centrally-planned ignorance confidence is bliss), we are delighted to present Korowicz's follow up, "Catastrophic Shocks through Complex Socio-Economic Systems—A Pandemic Perspective" which "provides an overview of the effect of a major pandemic on the operation of complex socio-economic systems using some simple models. It discusses the links between initial pandemic absenteeism and supply-chain contagion, and the evolution and rate of shock propagation. It discusses systemic collapse and the difficulties of re-booting socio-economic systems."

In a way that only Korowicz can, the author summarizes the increasingly more precarious state of systemic social equilibria, and how a more determined push away from a trendline (or back toward mean reversion as those who can see right through the central banks increasing desperation to preserve the world's legacy status quo "just one more day") could result in the end of modern society.

To wit: "The commonalities of global integration mean that diverse hazards may lead to common shock consequences. The systems that transmit shocks are also the systems we depend upon for our welfare and the operation of businesses, institutions and society, so to borrow Marshal McLuhan’s phrase, the medium is the message. One of the primary consequences of a generic shock is an interruption in the flow of goods and services in the economy. This has diverse and profound implications - including food security crises’, business shut-downs, critical infrastructure risks and social crises. This can in turn quickly destroy forward-looking confidence in an economy with major consequences for financial and monetary stability which depend ultimately on the collateral of real economic production. More generally it can entail multi-network and delocalised cascading failure leading to a collapse in societal complexity."

What follows is a "thought experimental" methodology which is used to look at the socio-economic implications of a major pandemic. In other words, a step by step walk through of how society transitions from its unstable current equilibrium state, one represented by the highest level of socio/economic/monetary entropy, to society's equivalent of a heart attack: a straight line collapse in social entropy once parametric thresholds are breached, leading to failure and halt of any and every process reliant on incremental, evolutionary complexity. It is here that epistemological assumptions about society's future can simply and subjectively be reduced to simple heuristics: "optimism" and "pessimism." The former holds that even in a complete systemic collapse, the system can eventually regroup and eventually return to its most recent, highest level of complexity. The latter.... does not.

This is how Korowicz frames it:

We imagine that after a pandemic wave people are again available for work. But people cannot however become productive immediately because other inputs are also needed. But those inputs are stalled because they rely upon other inputs and so on. More broadly we may define Recursion failure as: “the inability of a complex economy to easily resume production and trade after a significant collapse because in a complex and interdependent economy, production and trade must resume in order for production and trade to resume”.

Further even if a government wanted to rebuild, it may be too complex to orchestrate resumption from the top down. This is firstly because the economy has evolved by self-organization, nobody has ever had, nor could they have put its elements together in the first place. Secondly, even if it could be done, the systems of command, control and supply that might do it would be the very systems that had been undermined.

Over time entropy would become an issue as engines rust, reagents become contaminated, and expected maintenance and repairs are left undone. This would all add to the cost and inputs needed for resumption. In a more complex society the degradation rate may be higher for thermodynamic reasons.

Overall, we are saying the longer a socio-economic system spends in the critical regime, the more likely it is to undergo a complete systemic collapse and loss of basic function. In addition, the longer it spends in this state, the more difficult it may be to ever return to its pre-pandemic state.

This is a complex society’s equivalent of a heart attack. When a person has a heart attack, there is a brief period during which CPR can revive the person. But beyond a certain point when there has been cascading failure in co-dependent life support systems, the person cannot be revived. This means that the socio-economic system could be changed irretrievably and the job of society and government would be to both manage the crisis and plot a fundamentally different path.

The extent of our contemporary complex global system dependencies, and our habituation to a long period of broadly stable economic and complexity growth means a systemic collapse would present profound and existential challenges.

It is precisely this inevitable final denouement, and the fact that its mere contemplation simply acknowledges there is nothing society can do to prepare for a terminal outcome, which is why modern society is replete with pre-ordained distractions that seek to prevent the vast majority to contemplate a narrative in any way resembling the one above, and why nobody is willing to admit the contemplation of a "Plan B" as even merely the fact that "very serious people" - those whose actions have resulted in the current precarious systemic environment- are thinking about the "what if" potentiality, sets off events in motion that culminate with the entire system ultimately crashing under its own complexity.

Which, of course, is precisely why we present the full piece as everyone should be aware of what the absolutely worst case outcome may and will look like in a world in which sticking one's head in the sand has become a religion.

Catastrophic Shocks Through Complex Socio-Economic Systems: A Pandemic Perspective (pdf), source FEASTA

David Korowicz

Summary

The globalised economy has become more complex (connectivity, interdependence, and speed), de-localized, with increasing concentration within critical systems. This has made us all more vulnerable to systemic shocks. This paper provides an overview of the effect of a major pandemic on the operation of complex socio-economic systems using some simple models. It discusses the links between initial pandemic absenteeism and supply-chain contagion, and the evolution and rate of shock propagation. It discusses systemic collapse and the difficulties of re-booting socio-economic systems.

1. A New Age of Risk

Consider the following scenarios:

• A highly contagious pandemic outbreak in South-East Asia (of comparable or greater human impact than the 1918 influenza outbreak).
• A disorderly break-up of the Eurozone and global financial system implosion.
• A ‘perfect storm’- during a time of major global financial instability - there are terrorist attacks on North African oil installations (partially driven by social unrest arising from record food prices) & a category 5 hurricane hits a major population/ industrial/ oil producing regions of the US east coast.

These are all examples of potential global shocks, that is hazards that could drive fast and severe cascading impacts mediated through global systems. Global systems include telecommunications networks; financial and banking networks; trade networks; and critical infrastructure networks. These systems are themselves highly interdependent and together form part of the globalised economy. The interest in global shocks and how they manifest themselves has grown in recent years (WEF 2012, 2013; Helbing 2013,; Buldyrev et. al. 2010).

First it useful to acknowledge that the hazards referred to in the opening scenarios are increasingly likely. Potentially new pandemic strains are being encouraged by increasing human pressure on the biosphere, while mass global air transport could aid rapid global transmission. Ecological constraints, presently pre-eminent amongst them are food and oil flows and increasingly the effects of climate change are growing. Stresses in the credit backing of our financial and monetary systems are arguably increasing, with the additional vulnerability that such systems are the primary vector through which major ecological constraints in energy and food would be expressed (Korowicz 2011).

One of the primary issues for this paper are, given any significant hazard, how does the impact spread through the globalised economy and in what way are we vulnerable to the failure of interconnected systems. To answer this we need to understand how complex societies are connected and how they have changed over time.

The globalised economy is an example of a complex adaptive system that dynamically links people, goods, factories, services, institutions and commodities across the globe. Such systems can be represented by a‘state’ that is not in equilibrium, but defines a set of ordered characteristics that exist within a range of deviations from a mean and persist for a period of time. For example, the state is characterized by exponential growth in Gross World Product of about 3.5% per annum over nearly 200 years within a range of several percentage points. This had correlated with emergent and self-organizing growth in socio-economic complexity which is reflected in the growth of the:

• Number of interacting parts (nodes): This includes exponential population growth; the 50,000+ different items available in Wal-Mart; the 6 billion+ digitally connected devices; the number of cars, factories, power plants, mines an so on.
• Number of linkages (edges): This includes the 3 billion passengers traveling between 4000 airports on over 50 million flights each year; the 60,000 cargo ships moving between 5000 ports with about a million ship movements a year; the average number of media channels (internet sites, TV channels, twitter feeds) per person times the population; and the billions of daily financial transactions.
• Levels of interdependence between nodes: The growing number of inputs necessary to make a good, service, livelihood, infrastructural output or the function of society as a whole.
• The speed of processes (or time compression):This includes the increasing speed of financial transactions; transportation; digital signaling; and Just-In-Time logistics. If we consider the globalised economy as a form of singular organism, we can understand this process as an increasing metabolic rate.
• Efficiency: increasing competition and global trade arbitrage driving down inventories; and globalised economies of scale.
• Concentration: The emergence of ‘hubs’ within the globalised economy- a small number of very highly connected nodes whose function (or loss of function) have a disproportionate role in the operation of the globalised economy . For example, banks are not connected at random to other banks, rather a very small number of large banks are highly connected with lots of other banks, who have few connections to each other. These arrangements are sometimes known as scale-free networks. We can also see concentration in critical infrastructure, and trade networks.
• De-localization: The conditions of personal welfare; business or service output; or country’s economic output is smeared over the whole globalised economy. The corollary is that if there is a major failure of the systems integration in the globalised economy, a localised community may have extreme difficulties meeting its basic needs.

Economic and complexity growth have in many ways reduced risk. Localized agricultural failure once risked famine in isolated subsistence communities, but now such risk is spread globally. It has made critical infrastructure such as sewage treatment and clean water available and affordable. Global financial markets enable an array of risks, from home insurance and pensions to default risk and export credit insurance, to be dispersed and potential volatility reduced. Indeed, what is remarkable is just how reliable our complex society is given the number of time sensitive inter-connections.

Another way of saying all this is that our society is very resilient, within certain bounds, to a huge range interruptions in the flow of goods and services. Within those bounds our society is self-stabilizing. For example supply-chain shocks from the Japanese tsunami in 2011, the eruption of the Icelandic Eyjafjallajokull volcano in 2010 or the UK fuel blockades in 2000 all had severe localised effects in addition to shutting down some factories across the world as supply-chains were interrupted. However the impacts did not spread and amplify, and normal functioning of the local economy quickly resumed.

But we know from many complex systems in nature and society that a system can rapidly shift from onestate to another as a threshold is crossed (Scheffer 2009). One way a state shift can occur is when a shock drives the system out of its stability bounds. The form of those stability bounds can increase or decrease resilience to shocks depending upon whether the system is already stressed prior to the shock.

The commonalities of global integration mean that diverse hazards may lead to common shock consequences. The systems that transmit shocks are also the systems we depend upon for our welfare and the operation of businesses, institutions and society, so to borrow Marshal McLuhan’s phrase, the medium is the message. One of the primary consequences of a generic shock is an interruption in the flow of goods and services in the economy. This has diverse and profound implications - including food security crises’, business shut-downs, critical infrastructure risks and social crises. This can in turn quickly destroy forward-looking confidence in an economy with major consequences for financial and monetary stability which depend ultimately on the collateral of real economic production. More generally it can entail multi-network and de-localised cascading failure leading to a collapse in societal complexity.

Previously the dynamics of such a scenario was studied when the initial shock was caused by a systemic banking collapse and monetary shock. This coupled the exchange of goods and services causing financial system supply-chain cross contagion and a re-enforcing cascade of de-localizing multi-system risk (Korowicz 2012).

In this paper a similar methodology is used to look at the socio-economic implications of a major pandemic. After a very brief review of other researchers work (section 2), some real life examples of partial systems failure are reviewed (section 3). This allows us to make make some estimates of shock spreading rates. In section 4 the links between pandemic absenteeism and supply-chain contagion is discussed and related to societal complexity. In section 5 we look at how contagion spreads, the rate, and the relationship to complexity.

In section 6 we look at some of the multi-system interactions. In 7, we look at why after a major collapse, the pre-shock socio-economic state may not be recoverable. Finally there is a short conclusion. This paper aims to broadly outline how very simple models can shed light on catastrophic shocks in complex socio-economic systems. A significantly more detailed discussion on several issues may be found here,(Korowicz 2012).

2. Socio-economic Impact of a Major Pandemic

We are interested in the socio-economic implications of a major influenza pandemic whose initial impact would be direct absenteeism from illness and death, and absenteeism for family and prophylactic reasons.

The pandemic wave (we will only consider one) lasts 10-15 weeks. We assume this causes an absenteeism rate of 20% or 40% over the peak period of 2-4 weeks, and a rate above 20% for 4-8 weeks when the peak is 40%. This represents our initial impact. Our question is then what happens next.

There are two general perspectives to studying such impacts. The first focuses on the impact on a specific industry or service, often with a view to Business Continuity Planning (BCP). Unsurprisingly, the question of how a health service would manage a pandemic when its own operation is compromised is of recurrent interest (Bartlett and Hayden 2005; Itzwerth et al. 2006). Or for example the effect of worker absenteeism on the movement of freight in a coupled US port-rail system (Jones et al. 2008). This analysis is important for local preparations however it suffers from having to isolate the system under consideration from the environment to avoid the analysis becoming too open and complex.

The alternative track is to use macroeconomic modeling to look at the impact on an economy as a whole. This type of modeling might be useful for low impact pandemics where the economy remains in its historical range of conditions, for example the impact of the 2003 SARS outbreak ( Knapp et al. 2004; Keogh-Brown and Smith 2008).

However when considering major pandemics (McKibbin and Sidorenko 2006; Keogh-Brown et al. 2010) it is highly questionable if such conventional macroeconomic modeling works, or would be very mis-leading. This is firstly because such models are built out of, and parameterized within the context of long run macroeconomic stability. A major pandemic could be highly de-stabilising, causing, as we shall see, cascading systemic disruption and failure.

Secondly, such models are blind to the issue of rising complexity and the speed of processes, which we argue here are essential for understanding major shocks. Finally, they have little to say about the dynamics of the impact, how it spreads through time and cascading failure. This is of most interest to actual risk manageent.

3. Vulnerability Revealed

One way to understand and even parameterize the structure and behavior of complex socio-economic systems is to empirically study occasions when there has been some systemic failure.

In September 2000 truckers in the United Kingdom, angry at rising diesel duties, blockaded refineries anad fuel distribution outlets (Public Safety and Emergency Preparedness Canada 2005; McKinnon 2006; Peck 2006). The petrol stations reliance on Just-In-Time re-supply meant the impact was rapid. Within 2 days of the blockade starting approximately half of the UK’s petrol stations had run out of fuel and supplies to industry and utilities had begun to be severely affected. The initial impact was on transport - people couldn’t get to work and businesses could not be re-supplied. This then began to have a systemic impact.

The protest finished after 5 days at which point: supermarkets had begun to empty of stock, large parts of the manufacturing sector were about to shut down, hospitals had begun to offer ‘emergency only’ care; automatic cash machines could not be re-supplied and the postal service was severely affected. There was panic buying at supermarkets and petrol stations. It was estimated that after the first day an average 10% of national output was lost. Surprisingly, at the height of the disruption, commercial truck traffic on the UK road network was only 10-12% below average values.

There were clear indications that had the fuel blockades gone on just a few days longer large parts of UK manufacturing including the automotive, defense and steel industries would have had to shut down. In the end this was a point hazard with systemic impacts, so once government became aware of the systemic risks they forced the truckers’ hands and they desisted. Still the event concentrated minds. The UK was within days of a severe food security crisis and widespread socio-economic breakdown.

Lest one think this is an issue for only the most complex societies -a week-long truckers strike in September 2012 in South Africa again saw emptying petrol station and ATM machines within a week of the disruption. And hospitals reliant on burning coal for power had to fall back on reserve stocks (Boesler 2012).

While the UK fuel blockade was probably the most dramatic and well-documented example of supply-chain failure, we also got glimpses of what can happen the following Icelandic volcano eruption in 2010, and the tragic events surrounding the Japanese tsunami and Thai flooding in 2011. From these examples we see that failure of production or supply from one area can shut down factories on the other side of the world within days of the initial interruption. A report from the think-tank Chatham House on the impacts of the Icelandic volcano and subsequent interviews with businesses about its impact and their preparedness came to the general conclusion (Lee et. al. 2012) :

“One week seems to be the maximum tolerance of a Just-In-Time economy”…..before major shut-downs in business and industries would occur.

Further, after such a disruption, things would not just return to normal. Again, from the Chatham House study:

“... many [of the businesses surveyed] said that had the disruption continued just a few days longer, it would have taken at least a month for companies to recover”

And a quote from a desk study on the impact of a one week long absence of (just) trucks in the UK economy, things would not just return to normal (McKinnon 2006):

“... After a week, the country would be plunged into a deep social and economic crisis. It would take several weeks for most production and distribution systems to recover”

So the indications for the UK are that over the first week of the disruption, contagion across supply-chains and businesses rises relatively slowly. But very soon after that socio-economic disruption rapidly become very severe. And then even if the primary cause can return to normal, the economy takes weeks to recover. The studies do not consider what would happen if the primary disruption were to continue for many weeks.

4. Interdependence, Liebig’s law, and Cascading

One of the defining features of rising complexity is growing interdependence. That is, the output of a person, a service provider, a factory, a piece of critical infrastructure, or a complex society as a whole depends upon ever more inputs, be they tools, intermediate products, consumables, specialist skills and knowledge or collective societal infrastructures. And those outputs in turn become further inputs through the dispersed networks of the globalised economy.

Some of these inputs may not be necessary to the output of a factory, a service or economy. However, there will also be more critical inputs that the output cannot proceed without. Some of these are easily substitutable through other replacements, suppliers, people or stores that are easily accessed. What we are left with are critical inputs with low substitutability. This is shown in figure:1. We can also see that some of the least substitutable critical inputs are labeled hubs. Hubs are things like electricity, fuel, water, and financial system functionality - things generally referred to as critical infrastructure. They are societal services and functions upon which all society depends. This is represented by the dotted line.

A simple but important principle, Liebig’s Law of the Minimum, says that the production is constrained by the scarcest critical input. So even if you have ample supplies of all but one critical input, your production fails. That is, production fails on the weakest link.

This explains why the most exposed businesses to supply-chain failure are the most complex businesses. Firstly; they have some of the most inputs (making a car can mean assembling up to 15,000 components). Secondly, they have more inputs are very complex and specialized, and so cannot be easily substituted. Alternative production lines might not be available or take months to re-engineer or specialist skills may be in limited supply. Thus, auto and electronic manufacturers were some of the most affected by the Icelandic volcano, the Japanese tsunami and the Thai flooding in 2011.

What Liebig’s law shows is that you do not need to lose everything to stop a business, service or function or society - just the right bit. This helps to explain why a loss of only 10-12% of commercial vehicles had such a big impact during the fuel blockades.

As our economies have become more complex we have been, on average, adding more inputs into our lives, into goods and services, into the functioning of our societies. Secondly more of those are critical with low substitutability.

Let us now apply Liebig’s law to pandemic absenteeism. The people affected by a pandemic are part of the supply of inputs to any system’s function. There may be many people contributing to one output of a business, service or function. We assume that most employees are either unnecessary for the period of the pandemic, can telecommute, or are easily substituted. But there is a smaller number of sub-functional roles occupied most likely by those with specialist skills who are critical with low substitutability. If any one of them is unavailable, the sub-functional role fails and with that, the output of the whole organization/ function. We can then say that the complexity of the output is the number of specialist, low substitutability sub-functions, this we can take as a measure of complexity C.

In figure:2 we see a simple model of absenteeism as might happen in a pandemic situation. It is shown for absenteeism rates of 20% and 40%. It also shows where there is no staff redundancy, and where every specialist has a ‘spare’.

Clearly, higher absenteeism rates and no staff redundancy increase the chance of a system failure. We can imagine a factory or service with hundreds of employees including 6 independent but critical specialist roles, with 100% redundancy, upon which the whole factory depends. But even with a 20% absenteeism rate, there is still a 20% probability that the factory or service goes down because one critical specialist and their spare is absent. Once this happens, all the other hundreds of employees might as well go home. These become the indirect absentees.

Firstly, with the loss of this output good or service (especially if it is critical with low substitutability) other businesses and services may be affected potentially causing cascading affects through complex socio-economic networks as a whole. The dual absenteeism-output cascade is shown in figure:3.

Secondly we can see the effective absenteeism in society is the initial absenteeism due to the pandemic plus the sum of indirect cascading absenteeism. Further the lack of inputs stopping production would add further indirect absenteeism. This positive feedback means the number of economically inactive people in the society is potentially far greater than the absenteeism rate. This tends not to be reflected in macroeconomic modeling which is blind to complexity risk and cascading affects.

5. Time and Cascading Failure

In society there is always a level of absenteeism and a percentage of goods and services that can’t be delivered for whatever reason. You do not get the spread of supply-chain contagion as complex societies are efficient at finding alternative suppliers, and some inventories are carried to help when there is a hiatus. Further most factories don’t produce very critical things or there is lots of substitutability. One wont miss a brand of toothpaste in the supermarket when there are 20 brands available.

To initiate a cascading failure one first needs appropriate scale, from a major hub failure or large enough absenteeism. Secondly, one requires that what is affected has what is sometimes known as centrality, meaning how critically connected it is to other parts of a socio-economic network. Thus the effects of a pandemic or hub failure in a weakly connected country, Mali say, would be unlikely to spread supply-chain failure widely.

Thus we can conclude that there might be point above which supply-chain contagion takes off, and below which the society is still operational and recovery can occur. This point depends upon the initial pandemic absenteeism rate and the society’s complexity at the epicenter of the pandemic. This point, in the languageof complex systems is a critical transition, Ic ,measured as the initial number of ‘infected’ supply-chain nodes, which when crossed, causes a positive feedback of supply-chain contagion.

A simple model of supply-chain failure can be based upon the idea that the more supply-chains are disrupted or infected, the greater the chance that further supply-chains will be infected (Korowicz, 2012). This is limited ultimately by the number of connected parties, L. This has the form of the logistic equation where we can associate the time constant with the average time a society can operate using its stock inventories, Ti. The number of infected nodes is:

Where Io>Ic and is a constant

the dividing line between the sub-critical and critical acceleration. We can see that the longer time inventories are held within a society, the longer the time the operation of society can function before the critical acceleration. Clearly then the rising speed of societal processes, in this case, supply-chain re-charging, reduces temporal resilience to shocks.

Even this very simple model reproduces the main features of real events and studies seen in section 3 - the impact on society does not rise linearly with time but starts to accelerate as more inventories are drawn down. From what we have seen, the sub-critical time is about a week for the UK. In section 2 the scenario for a major pandemic would have had greater than 20% initial absenteeism for 4-8 weeks, clearly this would be very deep into the critical acceleration regime. Of course this assumes the initial absenteeism brought the supply-chain failure above the critical transition. There are good grounds for thinking this would be so by considering that a loss of 12% of trucks was already bringing the UK along the sub-critical acceleration curve.

For pandemics in less complex societies we would expect a higher critical transition point, and a longer period before critical acceleration occurs.

6. External Cross-Network Contagion

We imagine a pandemic outbreak occurs in South-East Asia, say. The main vectors through which a shock could propagate outside the region are pandemic contagion, financial system contagion, and supply-chain contagion. How they transmit that contagion depends upon the network structure and centrality of the effected region with respect to the external world. We might also assume that the spread would require an initial external impact greater than some critical value for external contagion to occur, this is in correspondence with the critical transition level Ic in section 5. Further we would expect the shock to spread at different rates (banking shock could travel faster than supply-chain contagion because the operational speed of the financial system is greater than the inventory turn-over time). We would also expect different periods for each networkbefore critical acceleration occurs, with the fastest system dominating.

The local spread of the infection would in broad terms spread out in geographical space at the speed of human transport. There would also be the spread through airport linkages. Here the global spread of the pan-demic is across a different topological space related to the density of linkages between airports and the shortest paths between any airports (Woolley-Meza et. al. 2011).

Some countries’ role in trade is far more important to the globalised economy than others. The more important the initially impacted region is, the greater is the likelihood of spreading supply-chain contagion globally. Kali & Reyes (2007) measured countries' influence on global trade, not only by trade volumes, but the influence a country has on the global trading system. They used an Importance Index to rank their influence. For example, they find that Thailand, which was at the centre of the 1997-1998 Asian financial crisis ranked 22nd in terms of global trade share, but 11th on their level of importance. In another study, Garas et. al. (2010) used an epidemic model to look at the potential any country had to spread a crisis. One of their data sets is based upon international trade in 2007. It uses a measure of centrality to identify countries with the power to spread a crisis via their level of trade integration. Like the previous paper, the centrality in the network does not necessarily correspond to those countries with the highest trade volumes. There are 12 inner core countries,which are listed in no particular order are: China, Russia, Japan, Spain, UK, Netherlands, Italy, Germany, Belgium-Luxembourg, USA, and France. The data sets used by both groups combine Belgium and Luxembourg data, both sets of authors have classified them together and separately respectively.

Hidalgo & Hausmann (2009) used international trade data to look at two things - the diversity of products a country produces, and the exclusivity of what they produce. An exclusive product is something made by few other countries. Most countries in the world are non- diversified and make standard products. The most complex countries are diversified and make more exclusive products. More exclusive products have less substitutability.

It can also be assumed that even a standard product, bread say, requires many more critical inputs in a complex country than in a less complex one.

Financial system contagion outside the initially impacted region could be through banking networks, the bond market, the shadow banking system, currency volatility and confidence. Again the structure of financial networks and the centrality of the region with respect to financial assets and liabilities would determine the extent of any shock. A additional issue is how vulnerable or resilient the external financial system is at the time of the shock.

If a multi-network failure were to spread globally the ability of the external world to help the initially impacted region would be undermined. In this case there would be global systemic collapse.

7. Recovery & Recursion Failure

We saw indications in the empirical studies of failure in section 3 that once supply-chain failure starts to go critical, the removal of the primary cause does not allow the immediate resumption of socio-economic activity. Why?

The disruption could have pushed companies into bankruptcy, and purchasing power in the economy would be lost as trade collapsed. Failures in critical infrastructure including payment might also occur. More generally there would be an intertwined supply and demand collapse.

More broadly, if an economy was shattered, and its forward looking viability looked both precarious and uncertain one would expect a collapse in the value of a country’s currency. Rather than helping exports (which would be very little because the economy’s productive capacity had collapsed), it would hinder imports of emergency supplies and make debt in external currencies much more difficult to service. The economic damage and reduced economic prospects may then cause tightened credit conditions, spiraling bond yields and systemic bank failure.

There are also issues that are most pertinent for more complex societies. We imagine that after a pandemic wave people are again available for work. But people cannot however become productive immediately because other inputs are also needed. But those inputs are stalled because they rely upon other inputs and so on. More broadly we may define Recursion failure as: “the inability of a complex economy to easily resume production and trade after a significant collapse because in a complex and interdependent economy, production and trade must resume in order for production and trade to resume”.

Further even if a government wanted to rebuild, it may be too complex to orchestrate resumption from the top down. This is firstly because the economy has evolved by self-organization, nobody has ever had, nor could they have put its elements together in the first place. Secondly, even if it could be done, the systems of command, control and supply that might do it would be the very systems that had been undermined.

Over time entropy would become an issue as engines rust, reagents become contaminated, and expected maintenance and repairs are left undone. This would all add to the cost and inputs needed for resumption. In a more complex society the degradation rate may be higher for thermodynamic reasons.

Overall, we are saying the longer a socio-economic system spends in the critical regime, the more likely it is to undergo a complete systemic collapse and loss of basic function. In addition, the longer it spends in this state, the more difficult it may be to ever return to its pre-pandemic state.

This is a complex society’s equivalent of a heart attack. When a person has a heart attack, there is a brief period during which CPR can revive the person. But beyond a certain point when there has been cascading failure in co-dependent life support systems, the person cannot be revived. This means that the socio-economic system could be changed irretrievably and the job of society and government would be to both manage the crisis and plot a fundamentally different path.

The extent of our contemporary complex global system dependencies, and our habituation to a long period of broadly stable economic and complexity growth means a systemic collapse would present profound and existential challenges.

8. Conclusion

To make the systems we depend upon more resilient ideally we would want more redundancy within critical systems and weaker coupling between them. Localization and de-complexification of basic needs (food, water, waste etc) would provide some societal resilience if systems resilience was lost. We would have more buffering at all levels, that is, larger inventories throughout society.

All this is the very opposite of the direction of economic forces. The reason we have such tight inventories, tight coupling, and concentration in critical infrastructure is they bring efficiency and competitive advantage. Further, in a time of global economic stress there is a drive towards further economic efficiency. For example, during super-storm Sandy, fuel shortages were exacerbated by low inventories that were the direct result of cost cutting arising from the financial crisis (Schneyer & Gebrekidan 2012). In general we are locked into socioeconomic processes that are increasing complexity-derived vulnerability.

Increasing vulnerability coupled with increasing hazard mean that the risk of a major socio-economic collapse is rising. The commonalities of catastrophic shock outcomes across a range of hazards suggest common risk and resilience planning is urgently required. Further, because of the possibility that a permanent state shift could occur, planning needs to consider how to deal with non-reversion to pre-shock conditions.

PATTERNS - Post Government Shutdown Resolutions

Chart of the Day 10-11-13

• This chart provides perspective on how the stock market tends to perform after a government shutdown ends. The chart plots the average S&P 500 performance for the 20 trading days (approximately one calendar month) before and 60 trading days (approximately 3 calendar months) after a government shutdown ends.
• The stock market has tended to struggle prior to the end of a government shutdown due to the fact that investors fear the unknown.
• Following this, the stock market has (on average) trended higher over the ensuing three months in what amounts to a relief rally.
• It should be noted that the chart is an average performance chart and that following the last 17 shutdowns, the stock market traded up 60 trading days after a shutdown ended on 12 out of 17 occasions (i.e. 70.5%).

TECHNICALS - US$, EURJPY, Currency Debasement

US DOLLAR

October 8, Reuters -- “Demand for dollar cash outside the United States surged on Tuesday, with market participants paying sharply higher premiums to get their hands on dollars to tide them over a mid-October deadline to raise the U.S. borrowing limit.”

ELLIOTT WAVE INTERNATIONAL: "What does this mean for the USD’s exchange rate against other currencies? Well, on the surface, high dollar demand should be bullish for the buck: Rising demand equals rising prices. But what if the U.S. government shutdown ends tomorrow? Will the dollar immediately reverse as the demand for it falls?

As usual, Elliott wave analysis gives you some much needed objectivity at a highly uncertain time. You see from this chart that for most of October, EUR/USD, the most-traded forex market, has gone sideways. The sideways trading has the look and feel of an Elliott wave correction: an overlapping, choppy move. That’s why we have labeled it ABC.

But notice that the preceding move was much more directional, and with less internal overlap. That looks like an Elliott wave impulse -- and it’s labeled just that: 12345.

What does this all mean? Well, impulses unfold in the direction of the larger trend. Corrections provide pauses within that trend. We have said before on these pages that news and events may add to short-term volatility, but they don't change the broad trend. That trend is set by the bias and mood of the traders. Right now, forex traders are betting on the unknown outcome of the U.S. government shutdown. You can't know how and when it will be resolved. But you can know which way traders' collective biases are leaning. "

EURJPY

EURJPY is in charge of 'carrying' stocks higher.

CURRENCY DEBASEMENT

If all these currencies (see list at bottom of graphic below - enlarge ) debase in a corordinated fashion, then you have not frame of reference to see the debasement unless you measure them together against an instrument that can't be 'printed'! Its pretty clear what is happening to the value of money as a store of value.

Click to Enlarge

EARNINGS - Consensus Continues Down Trend

Visualizing The Triumph Of Hope Over Reality 10-04-13 Zero Hedge

One of these things is not like the other...

Aside from this it looks like the Q2 record for negative pre-announcements is about to be broken for Q3...

Any Quarter now, it will all be fixed and the economy will reach escape velocity and money on the sidelines will emerge and Capex will surge and banks will lend and....

EARNINGS - Still Believe in the Q4 Earnings Hockey Stick Forecast?

36 Years Of Over-Optimistic Earnings Growth 10-07-13 Zero Hedge

The chart below should provide enough evidence of the "value" being added by a consensus of equity analyst extrapolators over the last 36 years.

On average consensus EPS growth rates have slumped from over-optimistic highs of the left to dismal reality check lows on the left. Of course, hope remains that this year will be different... but it doesn't appear to be heading that way.

Since 1976, Morgan Stanley shows the average consensus EPS growth rate trajectory among the consensus... doesn't seem to be so "accurate"...

But it remains assured that this time will be different if we look ahead yet again...

Charts: Morgan Stanley

VALUATIONS - US Equity Market Are The Most Expensive In The World

Is The US Equity Market The Most Expensive In The World? 10-07-13 SocGen via ZH

Over the weekend, we humbly suggested that the dream of ongoing US equity market multiple expansion may be over. It would appear SocGen not only agrees but finds current valuations very stretched.

On the basis of Price-to-Book (valuation) and return-on-equity (profitability), the US equity market is extremely 'expensive'; and "hoping" for further expansion on the RoE to save the day is whimsical given the limits to leverage.

Via SocGen,

The chart below illustrates a strong and rational link between profitability (as measured by Return on Equity) and valuation (price to book value). The more profitable a market, the higher its valuation. Along with Switzerland, the US equity market generates the highest return on equity and profitability. Both markets have been considered a safe haven over the last few years.

Like for the valuation, the gap between the RoE for US financial stocks (9%) and non-financial stocks (17%) is huge. Excluding financials, US RoE is already back to a high level and has stopped rising over the last 2 years.

It was higher in 2007, but with much more corporate leverage.

And as we warned before - that leverage does not come for free as the credit cycle appears to have turned.

PATTERNS - Watching the AUDJPY as a Market Driver$

The AUDYEN has become an excellent short term DRIVER$ tool because it combines the Yen Carry Trade with a Commodities (real assets) based economy. Below is an illustrative example of that.

Pre-Market Activity 10-08-13

Stocks then tracked FX Carry All Day (10-08-13)

After Hours (10-08-13) - YELLEN NOMINATION: Trying their best to spark a rally

Someone wants this Yellen nomination to be a big deal - they just chose a bad time to do it... Someone really really really wants the US equity market higher - 3rd momentum ignition try of the night...

PATTERNS - October 8th Bradley Turn Date & Phi Cluster

October 8th Bradley Turn Date & Phi Cluster

RUSSEL 2000: Back to its 50DMA -with its biggest 2-day drop in almost 4 months.

S&P 500: The 4.3% drop from recent highs in the S&P 13 days ago is the largest drop over that period since mid November 2012. The S&P broke its 11-month uptrend and closed below its 100DMA having fallen 11 of the last 14 days post Un-Taper.

DOW: The Dow is now 5.9% off its highs and testing its 200DMA for the first time this year.

VIX: VIX broke back above 21% briefly (almost its highest level of 2013).

T-BILLS: The 4 Week Treasury Bill auction priced at a stunning 0.35%, blowing through the 0.295% When Issued, the highest yield since October 2009, the lowest Bid to Cover since March 2009, and the largest tail since March 25, 2008. The bond market panic is beginning to be palpable.

VOLATILITY - VIX surged by its most in over 3 months above 19%.

VIX surged by its most in over 3 months above 19%.

The Interactive Brokers announced late Monday afternoon (10-/07/13) that over the next week or so will be increasing maintenance margin to 100% - effectively squeezing leveraged momentum out of the market.

Click to Enlarge

Why the regulators would force or allow margin increases at such a tenuous market timing point raises a lot of questions?

We are very close to that 11-month trendline break above.

October 8th +/- is our Bradley Turn and Phi Cluster Date which we have been signalling for some time.

RESULT:

UNDERSTANDING THE VIX

The IB margin hike appeared to drive FX carry traders crazy and USDJPY collapsed (with JPY surging back below 97 to 7 week highs against the USD) - Japan will not be happy...

Think fundamentals (and not marginal leverage) drives stocks? Think again. The Australian-Yen Cross has the best correlation with leverage trading (i.e. Yen Carry plus a Commodities Economy).

MARGIN DEBT - Divergence Has Preceded Equity Market Peaks

The Reason For The Selloff: Microcap Traders Punk'd With 100% Interactive Brokers Margin Hike 10-07-13 Zero Hedge

Margin Debt still contrarian bearish

Using closing basis monthly data, peaks in NYSE margin debt preceded peaks in the S&P 500 in 2007 and 2000.

• The March 2000 peak in NYSE margin debt of $278.5m preceded the August 2000 monthly closing price peak in the S&P 500 at 1517.68.
• The July 2007 margin debt peak of $381.4m preceded the October 2007 monthly closing price peak of 1549.38 for the S&P 500.
• Margin debt reached a record high of $384.4m in April and the S&P 500 continued to rally into July, August, and September.

This is a similar set up to 2007 and 2000.

Margin Debt: the Long-Term Overlay

Going back to January 1959, margin debt and the S&P 500 have moved together for the most part. But leverage is a double edge sword and can exacerbate sell-offs, leading to deeper than expected market pullbacks.

Still think the "market" is driven by earnings or fundamentals? or just leverage and marginal credit expansion (shadow banking repo... etc.)?

SPECULATION - The Bloomberg IPO Index Indicator

The Bloomberg IPO Index (US) is a capitalization-weighted index which measures the performance of stocks during their first publicly traded year. It includes all companies with a market value of at least $50 million at the initial public offering.

HISTORICAL PERSPECTIVE

What Happened The Last 2 Times IPOs Were Outperforming The Market By This Much? 10-07-13 Zero Hedge

When the momentum chasing public greatly rotates to the IPO-du-jour, it would appear that bad things happen in the market. The last two times Bloomberg's IPO index doubled the market's performance (in 2007 and again in 2011) it seems it marked a euphoric top.

The volume of coverage allotted to this IPO or that IPO (and not just Twitter) is awfully reminiscent of the go-go days of yore (and we all know how that ends) - though you'll never be the bag-holder again right?

Charts: Bloomberg

PRECIOUS METALS - Bottom Still Likely Not In - A Little More in Price and Time

Precious Metals Sentiment 10-11-13 Decision Point by Carl Swenlin

Central Fund of Canada (CEF) is a closed-end mutual fund that owns gold and silver exclusively -- the metals, not stocks -- at a ratio of about 45 oz. of silver to 1 oz. of gold. Closed-end funds trade based upon the bid and ask, without regard to their net asset value (NAV). Because of this, they can trade at a price that is at a premium or discount to their NAV. By tracking the premium or discount we can get an idea of bullish or bearish sentiment regarding precious metals. Very recently CEF has been selling at about a -7.5% discount to the net asset value of the gold and silver it owns. Considering that CEF has experienced a -54% decline from its 2011 top, that is a remarkably small discount when compared historical discounts of -15% to -20%. Even more remarkable it the fact that after the -50% CEF correction in 2008, CEF was still selling at about a +15% premium!

Conclusion:  Obviously precious metals sentiment is somewhat bearish, but not so much so that we can detect a buying opportunity based upon it.

INDICTMENT: US Public, Fiscal & Monetary Policy

Sundown In America - David Stockman Explains The Keynesian State-Wreck Ahead 10-05-13

David Stockman, author of The Great Deformation, summarizes the last quarter century thus: What has been growing is the wealth of the rich, the remit of the state, the girth of Wall Street, the debt burden of the people, the prosperity of the beltway and the sway of the three great branches of government - that is, the warfare state, the welfare state and the central bank... What is flailing is the vast expanse of the Main Street economy where the great majority have experienced stagnant living standards, rising job insecurity, failure to accumulate material savings, rapidly approach old age and the certainty of a Hobbesian future where, inexorably, taxes will rise and social benefits will be cut... He calls this condition "Sundown in America".

  SUNDOWN IN AMERICA: THE KEYNESIAN STATE-WRECK AHEAD

Remarks of David A. Stockman at the Edmond J. Safra Center for Ethics, Harvard University, September  26, 2013

The median U.S. household income in 2012 was $51,000, but that’s nothing to crow about. That same figure was first reached way back in 1989--- meaning that the living standard of Main Street America has gone nowhere for the last quarter century. Since there was no prior span in U.S. history when real household incomes remained dead-in-the-water for 25 years, it cannot be gainsaid that the great American prosperity machine has stalled out.

Even worse, the bottom of the socio-economic ladder has actually slipped lower and, by some measures, significantly so. The current poverty rate of 15 percent was only 12.8 percent back in 1989; there are now 48 million people on food stamps compared to 18 million then; and more than 16 million children lived poverty households last year or one-third more than a quarter century back.

Likewise, last year the bottom quintile of households struggled to make ends meet on $11,500 annually ----a level 20 percent lower than the $14,000 of constant dollar income the bottom 20 million households had available on average twenty-five years ago. 

Then, again, not all of the vectors have pointed south. Back in 1989 the Dow-Jones index was at 3,000, and by 2012 it was up five-fold to 15,000.  Likewise, the aggregate wealth of the Forbes 400 clocked in at $300 billion back then, and now stands at more than $2 trillion---a gain of 7X.

 And the big gains were not just limited to the 400 billionaires. We have had a share the wealth movement of sorts--- at least among the top rungs of the ladder. By contrast to the plight of the lower ranks, there has been nothing dead-in-the-water about the incomes of the 5 million U.S. households which comprise the top five percent. They enjoyed an average income of $320,000 last year, representing a sprightly 33 percent gain from the $240,000 inflation-adjusted level of 1989.

The same top tier of households had combined net worth of about $10 trillion back at the end of Ronald Reagan’s second term.  And by the beginning of Barrack Obama’s second term that had grown to $50 trillion, meaning that just the $40 trillion gain among the very top 5 percent rung is nearly double the entire current net worth of the remaining 95 percent of American households.

So, no, Sean Hannity need not have fretted about the alleged left-wing disciple of Saul Alinsky and Bill Ayers who ascended to the oval office in early 2009. During Obama’s initial four years, in fact, 95 percent of the entire gain in household income in America was captured by the top 1 percent. 

Some other things were rising smartly during the last quarter century, too. The Pentagon budget was $450 billion in today’s dollars during the year in which the Berlin Wall came tumbling down.

Now we have no industrial state enemies left on the planet: Russia has become a kleptocracy led by a thief who prefers stealing from his own people rather than his neighbors; and China, as the Sneakers and Apple factory of the world, would collapse into economic chaos almost instantly---if it were actually foolish enough to bomb its 4,000 Wal-Mart outlets in America.

Still, facing no serious military threat to the homeland, the defense budget has risen to $650 billion----that is, it has ballooned by more than 40 percent in constant dollars since the Cold War ended 25 year ago. Washington obviously didn’t get the memo, nor did the Harvard “peace” candidate elected in 2008, who promptly re-hired the Bush national security team and then beat his mandate for plough shares into an even mightier sword than the one bequeathed him by the statesman from Yale he replaced.

Banks have been heading skyward, as well.  The top six Wall Street banks in 1989 had combined balance sheet footings of $0.6 trillion, representing 30 percent of the industry total. Today their combined asset footings are 17 times larger, amounting to $10 trillion and account for 65 percent of the industry.

 The fact that the big banks led by JPMorgan and Bank America have been assessed the incredible sum of $100 billion in fines, settlements and penalties since the 2008 financial crisis suggests that in bulking up their girth they have hardly become any more safe, sound or stable.

Then there’s the Washington DC metropolitan area where a rising tide did indeed lift a lot of boats. Whereas the nationwide real median income, as we have seen, has been stagnant for two-and-one-half decades, the DC metro area’s median income actually surged from $48,000 to $66,000 during that same interval or by nearly 40 percent in constant dollars.

Finally, we have the leading growth category among all others----namely, debt and the cheap central bank money that enables it. Notwithstanding the eight years of giant Reagan deficits, the national debt was just $3 trillion or 35 percent of GDP in 1989. Today, of course, it is $17 trillion, where it weighs in at 105 percent of GDP and is gaining heft more rapidly than Jonah Hill prepping for a Hollywood casting call.

Likewise, total US credit market debt---including that of households, business, financial institutions and government--- was $13 trillion or 2.3X national income in 1989. Even back then the national leverage ratio had already reached a new historic record, exceeding the World War II peak of 2.0X national income.

Nevertheless, since 1989 total US credit market debt has simply gone parabolic. Today it is nearly $58 trillion or 3.6X GDP and represents a leverage ratio far above the historic trend line of 1.6X national income---a level that held for most of the century prior to 1980.  In fact, owing to the madness of our rolling national LBO over the last quarter century, the American economy is now lugging a financial albatross which amounts to two extra turns of debt or about $30 trillion.

In due course we will identify the major villainous forces behind these lamentable trends, but note this in passing: The Federal Reserve was created in 1913, and during its first 73 years it grew its balance sheet in turtle-like fashion at a few billion dollars a year, reaching $250 billion by 1987---at which time Alan Greenspan, the lapsed gold bug disciple of Ayn Rand, took over the Fed and chanced to discover the printing press in the basement of the Eccles Building.

Alas, the Fed’s balance sheet is now nearly $4 trillion, meaning that it exploded by sixteen hundred percent in the last 25 years, and is currently emitting $4 billion of make-believe money each and every business day.

So we can summarize the last quarter century thus: What has been growing is the wealth of the rich, the remit of the state, the girth of Wall Street, the debt burden of the people, the prosperity of the beltway and the sway of the three great branches of government which are domiciled there---that is, the warfare state, the welfare state and the central bank.

What is flailing, by contrast, is the vast expanse of the Main Street economy where the great majority has experienced stagnant living standards, rising job insecurity, failure to accumulate any material savings, rapidly approaching old age and the certainty of a Hobbesian future where, inexorably, taxes will rise and social benefits will be cut.

 And what is positively falling is the lower ranks of society whose prospects for jobs, income and a decent living standard have been steadily darkening.

I call this condition “Sundown in America”.  It marks the arrival of a dystopic “new normal” where historic notions of perpetual progress and robust economic growth no longer pertain. Even more crucially, these baleful realities are being dangerously obfuscated by the ideological nostrums of both Left and Right.

Contrary to their respective talking points, what needs fixing is not the remnants of our private capitalist economy ---which both parties propose to artificially goose, stimulate, incentivize and otherwise levitate by means of one or another beltway originated policy interventions.

Instead, what is failing is the American state itself----a floundering leviathan which has been given one assignment after another over the past eight decades to manage the business cycle, even out the regions, roll out a giant social insurance blanket, end poverty, save the cities, house the nation, flood higher education with hundreds of billions, massively subsidize medical care, prop-up old industries like wheat and the merchant marine, foster new ones like wind turbines and electric cars, and most especially, police the world and bring the blessings of Coca Cola, the ballot box and satellite TV to the backward peoples of the earth.

In the fullness of time, therefore, the Federal government has become corpulent and distended---a Savior State which can no longer save the economy and society because it has fallen victim to its own inherent short-comings and inefficacies.

 Taking on too many functions and missions, it has become paralyzed by political conflict and decision overload. Swamped with insatiable demand on the public purse and deepening taxpayer resistance, it has become unable to maintain even a semblance of balance between its income and outgo.

Exposed to constant raids by powerful organized lobby groups, it has lost all pretenses that the public interest is distinguishable from private looting. Indeed, the fact that Goldman Sachs got a $1.5 billion tax break to subsidize its new headquarters in the New Year’s eve fiscal cliff bill--- legislation allegedly to save the middle class from tax hikes--- is just the most recent striking albeit odorous case.

Now the American state----the agency which was supposed to save capitalism from its inherent flaws and imperfections----careens wildly into dysfunction and incoherence. One week Washington proposes to bomb a nation that can’t possibly harm us and the next week its floods Wall Street speculators, who can’t possibly help us, with continued flows of maniacal monetary stimulus.

Meanwhile, the White House pompously eschews the first responsibility of government---that is, to make an honest budget, which is the essence of what the Tea Party is demanding in return for yet another debilitating increase in the national debt.

To be sure, the mainstream press is pleased to dismiss this latest outburst of fiscal mayhem as evidence of partisan irresponsibility---that is, a dearth of “statesmanship” which presumably could be cured by stiffer backbones and greater enlightenment.  Well, to use a phrase I learned from Daniel Patrick Moynihan during my school days here, “would that it were”.

What is really happening is that Washington’s machinery of national governance is literally melting-down.  It is the victim of 80 years of Keynesian error---much of it nurtured in the environs of Harvard Yard---- about the nature of the business cycle and the capacity of the state---especially its central banking branch--- to ameliorate the alleged imperfections of free market capitalism.

As to the proof, we need look no further than last week’s unaccountable decision by the Fed to keep Wall Street on its monetary heroin addiction by continuing to purchase $85 billion per month of government and GSE debt.

Never mind that the first $2.5 trillion of QE has done virtually nothing for jobs and the Main Street economy or that we are now in month number 51 of the current economic recovery--- a milestone that approximates the average total duration of all ten business cycle expansions since 1950. So why does the Fed have the stimulus accelerator pressed to the floor board when the business cycle is already so long in the tooth----and when it is evident that the problem is structural, not cyclical?

The answer is capture by its clients, that is, it is doing the bidding of Wall Street and the vast machinery of hedge funds and speculation that have built-up during decades of cheap money and financial market coddling by the Greenspan and Bernanke regimes.  The truth is that the monetary politburo of 12 men and women holed up in the Eccles Building is terrified that Wall Street will have a hissy fit if it tapers its daily injections of dope.

So we now have the spectacle of the state’s central banking branch blindly adhering to a policy that has but one principal effect: namely, the massive and continuous transfer of income and wealth from the middle and lower ranks of American society to the 1 percent.

The great hedge fund industry founder and legendary trader who broke the Bank of England in 1992, Stanley Druckenmiller, summed-up the case succinctly after Bernanke’s abject capitulation last week. “I love this stuff”, he said, “…. (Its) fantastic for every rich person. It’s the biggest redistribution of wealth from the poor and middles classes to the rich ever”.

Indeed, a zero Federal funds rate and a rigged market for short-term repo finance is the mother’s milk of the carry trade: speculators can buy anything with a yield----such as treasuries notes, Fannie Mae MBS, Turkish debt, junk bonds and even busted commercial real estate securities--- and fund them 90 cents or better on the dollar with overnight repo loans costing hardly ten basis points.

 Not only do speculators laugh all the way to the bank collecting this huge spread, but they sleep like babies at night because the central banking branch of the state has incessantly promised that it will prop up bond prices and other assets values come hell or high water, while keeping the cost of repo funding at essentially zero for years to come.

If this sounds like the next best thing to legalized bank robbery, it is. And dubious economics is only the half of it.

 This reverse Robin Hood policy is also an open affront to the essence of political democracy.  After all, the other side of the virtually free money being manufactured by the Fed on behalf of speculators is massive thievery from savers. Tens of millions of the latter are earning infinitesimal returns on upwards of $8 trillion of bank deposits not because the free market in the supply and demand for saving produces bank account yields of 0.4 percent, but because price controllers at the Fed have decreed it.

For all intents and purposes, in fact, the Fed is conducting a massive fiscal transfer from the have nots to the haves without so much as a House vote or even a Senate filibuster. The scale of the transfer---upwards of $300 billion per year----causes most other Capitol Hill pursuits to pale into insignificance, and, in any event, would be shouted down in a hail of thunderous outrage were it ever to actually be put to the people’s representatives for a vote.

To be sure, all of this madness is justified by our out-of-control monetary politburo in terms of a specious claim that Humphrey-Hawkins makes them do it---that is, print money until unemployment virtually disappears or at least hits some target rate which is arbitrary, ever-changing and impossible to consistently measure over time.

 In fact, however, this ballyhooed statute is a wholly elastic and content-free expression of Congressional sentiment.  In their wisdom, our legislators essentially said that less inflation and more jobs would be a swell thing. So the act contains no quantitative targets for unemployment, inflation or anything else and was no less open-ended when Paul Volcker chose to crush the speculators of his day than it was last week when Bernanke elected (once again) to pander obsequiously to them.

In truth, the Fed’s entire macro-economic management enterprise is a stunning case of bureaucratic mission creep that has virtually no statutory mandate. Certainly the author of the Federal Reserve Act, the incomparable Carter Glass of Glass-Steagall fame, abhorred the notion that the central bank would become a tool of Wall Street.

To that end, the Fed originally had no authority to own government debt or to conduct open market operations buying and selling treasury securities on Wall Street. And Carter Glass would be rolling in his grave upon discovery that the Fed was rigging interest rates, manipulating the yield curve, providing succor to financial speculators by propping-up risk asset markets, placing a Put under the S&P 500 or bragging, as Bubbles Ben did recently, that he had levitated an ultra-speculative stock index called the Russell 2000.

Summing up a wholly opposite Congressional intent in the early 1920s, Senator Glass was almost lyrical:  “We cured this financial cancer by making the regional reserve banks, not Wall Street, the custodian of the nation’s reserve funds… (And) by making them minister to commerce and industry rather than the schemes of speculative adventure. The country banks were made free. Business was unshackled. Aspiration and enterprise were loosened. Never again would there be a money panic.”

Except…except….except that the Fed eventually strayed from its original modest mandate to be a “banker’s bank”----and in due course we got the crashes of 1929, 1974, 1987, 1998, 2000, and 2008,  to name those so far. In the original formulation, however, these cycles of bubble and bust would not have happened: the Federal Reserve’s only job was the humble matter of passively supplying cash to member banks at a penalty spread above the free market interest rate.

In this modality, the Fed was to function as a redoubt of green-eyeshades, not the committee to save the world. Central bankers would dispense cash at the Fed’s discount window only upon the presentation of good collateral. Moreover, eligible collateral was to originate in trade receivables and other short-term paper arising out of the ebb and flow of free enterprise commerce throughout the hinterlands, not the push and pull of confusion and double-talk among monetary central planners domiciled in the nation’s political capital.

Accordingly, the Federal Reserve that Carter Glass built could not have become a serial bubble machine like the rogue central banks of today. The primary reason is that under the Glassian scheme the free market set the interest rate, not price controllers in Washington.

This meant, in turn, that any sustained outbreak of speculative excess---- what Alan Greenspan once warned was “irrational exuberance” and then promptly hit the delete button when Wall Street objected---would be crushed in the bud by soaring money market interest rates. In effect, leveraged speculators would cure their own euphoria and greed by pushing carry trades---that is, buying long and borrowing short---to the point where they would turn upside down. When spreads went negative, the bubble would promptly stop inflating as overly exuberant speculators were carried off to meet their financial maker---or at least their banker.

And, yes, Carter Glass’ Fed did function under the ancient regime of the gold standard, but there was nothing especially “barbarous” about it----J. M. Keynes to the contrary notwithstanding.  It merely insured that if the central bank was ever tempted to violate its own rules and repress interest rates in order to accommodate speculators and debtors, more prudent members of the financial community could dump dollar deposits for gold, thereby bringing bank credit expansion up short and aborting incipient financial bubbles before they swelled-up.

Needless to say, a central bank which could not create credit-fueled financial bubbles could not have become today’s monetary central planning agency, either. Indeed, the remit of the Glassian banker’s bank did not include managing the business cycle, levitating the GDP, targeting the unemployment rate, goosing the housing market or fretting over the rate of monthly consumer spending.

 Certainly it did not involve worrying whether the inflation rate was coming in below 2 percent---the current inexplicable target of the Fed which Paul Volcker has rightly pointed out amounts to robbing the typical laboring man of half the value of his savings over a working lifetime of 30 years.

In short, in the Glassian world the state had no dog in the GDP hunt: whether it grew at an annual rate of 4 percent, 1 percent or went backwards was up to millions of producers, consumers, savers, investors, entrepreneurs and, yes, even speculators interacting on the free market. Indeed, the so-called macroeconomic aggregates----such as national income, total employment, credit outstanding and money supply----were passive outcomes on the market, not active targets of state policy.

Needless to say, no Glassian central banker would have ever dreamed of levitating the macro-economic aggregates through the Fed’s current radical, anti-democratic doctrine called “wealth effects”.

 Under the latter, the 10 percent of the population which owns 85 percent of the financial assets---and especially the 1 percent which owns most of the so-called “risk assets” managed by hedge funds and fast money speculators---are induced to feel richer by the deliberate and wholly artificial inflation of financial asset values.

In the case of the Russell 2000 which is Bernanke’s favorite wealth effects tool, for instance, the index gain from 350 in March 2009 to 1080 at present amounts to 200 percent and that is for un-leveraged holdings; the Fed engineered windfall actually amounts to a 400 or 500 percent gain under typical options, leverage and timing based strategies employed by the fast money.

 In any event, feeling wealthier, the rich are supposed to spend more on high end restaurants, gardeners and Pilate’s instructors, thereby causing a “trickle-down” jolt to aggregate demand and eliciting a virtuous circle of rising output, incomes and consumption----indeed,  always more consumption.

Having been involved in another radical experiment in “trickle down”----the giant Reagan tax cuts of 1981----I no longer believe in Voodoo economics. But at least the Gipper’s tax cuts were voted through by a democratic legislature. The Greenspan-Bernanke-Yellen version of “trickle-down”, by contrast, is a pure gift from a handful of central bank apparatchiks to the super-rich.

Nevertheless, the more virulent form of “trickle-down” being practiced in 2013 is rooted in the same erroneous predicate as the mistake of 1981----namely, the Keynesian gospel that the free enterprise economy is inherently prone to business cycle instability and perennially under-performs its so-called “potential” full employment growth rate.  Accordingly, enlightened intervention---if that is not an oxymoron--- by the fiscal and monetary branches of the state is claimed to be necessary to cure these existential disabilities.

The truth of the matter, however, is that Keynesian monetary and fiscal stimulus has never really been needed in the post-war world. Among the ten business cycle contractions since 1950, two of them were unavoidable, self-correcting dislocations resulting from the abrupt cooling down of hot wars in Korea and Vietnam.

The other eight downturns were actually caused by the Federal Reserve, not cured by it.  After the Fed first got carried away with too much stimulus and credit creation in 1971-1974, for example, it had to trigger a short-lived inventory correction to halt the resulting inflation and speculative excesses in financial, labor and commodity markets. But once these necessary inventory corrections ran their course, the economy rebounded on its own each and every time.

To be sure, the Reagan tax cut intervention of 1981 came in a quasi-libertarian guise. By getting the tax-man out of the way, GDP growth was supposed to be unleashed throughout the economic hinterlands, rising by something crazy like 5 percent annually--- forever and ever, world without end.

But in practice, “supply-side” was just Keynesian economics for the prosperous classes---that is, it ended-up being a scheme to goose the GDP aggregates by drawing down Uncle Sam’s credit card and then passing along the borrowings to so-called “job creators” thru tax cuts rather than to dim-witted bureaucrats thru spending schemes.

Indeed, the circumstances of my own ex-communication from the supply-side church underscore the Reaganite embrace of the Keynesian gospel. The true-believers---led by Art Laffer, an economist with a Magic Napkin, and Jude Wanniski, an ex-Wall Street Journal agit-prop man who chanced to stuff said napkin into his pocket--- were militantly opposed to spending cuts designed to offset the revenue loss from the Reagan tax reductions.

They called this “root canal” economics and insisted that the Republican Party could never compete with the Keynesian Democrats unless it abandoned its historic commitment to balanced budgets and fiscal rectitude, and instead, campaigned on tax cuts everywhere and always and a fiscal free lunch owing to a purported cornucopia of economic growth.

So supply-side became just another campaign slogan---a competitive entry in the Washington beltway enterprise of running-up the national debt in order to perfect and improve upon the otherwise inferior results of the free market economy. In the fullness of time, of course, supply-side economics degenerated into Dick Cheney’s fatuous claim that Reagan proved “deficits don’t matter”.

From there came two giant unfinanced tax cuts and two pointless unfinanced wars under George W. Bush. And then there arose, finally, the GOP’s descent into fiscal know-nothingism during the Obama era--- wherein it refused to cut defense, law enforcement, veterans, farm subsidies, the border patrol, middle class student loans, social security, Medicare, the SBA and export-import bank loans to Boeing and General Electric, among countless others--- while insisting that no tax-payer should suffer the inconvenience of higher taxes to pay Uncle Sam’s bloated bills.  

We thus ended up with the New Year’s Day Folly of 2013. Save for the top 2 percent of taxpayers who were being generously taken care of by the Fed already, all of America got a huge permanent tax cut----amounting to $2 trillion over the coming decade alone.

Never mind that the Democrats had spent the entire prior decade denouncing the Bush tax cuts as fiscal madness. Now, the tax bidding war which had started in the Reagan White House in May 1981 became institutionalized in the Oval Office.

The so-called Progressive Left was in charge of the veto pen, of course, but the latter was found wanting for ink and in that outcome the nation’s fiscal demise was sealed. There was no progressive case whatsoever for extending the Bush tax cuts because, as Willard M. Romney had so inartfully taught the nation during the Presidential campaign, the bottom 47 percent of households don’t pay any income tax in the first place!

In short, the most left-wing President ever elected in America was showering the upper middle-class with trillions in extra spending loot for no reason of policy----except to ensure that they would buy more Coach Bags and flat screen TVs.

The fiscal end game---policy paralysis and the eventual bankruptcy of the state---thus became visible.  All of the beltway players----Republican, Democrats and central bankers alike----are now so hooked on the Keynesian cool-aid that they cannot imagine the Main Street economy standing on its own two feet without continuous, massive injections of state largesse.

Indeed, the lunacy of the Fed’s trickle-down-to- the-rich was justified last week by Bernanke himself on the grounds that the minor fiscal pinprick owing to the budget sequester was keeping the GDP from growing at its appointed rate.

Based on the same logic the GOP’s most fearsome fiscal hawk, Congressman Paul Ryan, proposed a budget which actually increased the deficit by $200 billion over the next three years on the grounds that the economy was too weak to tolerate fiscal rectitude in the here and now.  In the manner of St. Augustine, the Ryan budget got to balance in the by-in-by---that is, in 2037 to be exact--- pleading “Lord, make me chaste--- but not just now”.

In other words, the entire fiscal and monetary apparatus of the state has become a jobs program. Progressives pleasure households earning a quarter million dollars annually with tax cuts so that they will hire another gardener; conservatives support modernization of our already lethal fleet of 10,000 M-1 tanks to keep the production line open in Lima, Ohio----notwithstanding that no nation in the world can invade the US homeland and that the American people are tired of invading the homelands of innocent peoples abroad.

In the same vein, by all accounts the US income tax code is a disgrace--- a milk-cow for the K-street lobbies, a briar patch of screaming inequities and the leakiest revenue raising system ever concocted.

But it also amounts to 70,000 pages of jobs programs. None of these can be spared, according to the beltway consensus, so long as GDP and job growth is not up to snuff---that is, as long as they fall short of the American economy’s so-called full employment potential. The latter is an ethereal number known only to the Keynesian priesthood, led by the great thinker’s current vicar on earth, professor Larry Summers, who during his tenure in the White House turned Art Laffer’s napkin upside down and wrote “$800 billion” on the back.

That was the magic number which, when multiplied by another magic number called the fiscal multiplier, would generate an amount of incremental GDP exactly equal to the gap between actual GDP in early 2009 and potential GDP, as calibrated by the vicar.

This might be called the bath-tub theory of macroeconomics because according to Summers and the White House, it didn’t matter much what  was in the $800 billion package----the urgent matter was to get Washington’s fiscal pumping machinery operating at full-tilt.

 Accordingly, once the magic number had been scribbled on the White House napkin, the nation’s check-writing pen was handed off to Speaker Nancy Pelosi and Harry Reid, who conducted the most gluttonous  feeding frenzy every witnessed along the corridors of K-Street.

In exactly twenty-two days from the inauguration, the new administration conceived, drafted, circulated, legislated and signed into law an $800 billion omnibus package of spending and tax cutting that amounted to nearly 6 percent of GDP.  I had been part of a new administration that moved way too fast on a grand plan and had seen the peril first hand. But the Reagan fiscal mishap did not even remotely compare to the reckless, unspeakable folly conducted by the Obama White House.

In fact, the stimulus bill was not a rational economic plan at all; it was a spasmodic eruption of beltway larceny that has now become our standard form of governance.

 Stated differently, the stimulus bill was a Noah’s ark which had welcomed aboard every single pet project of any organization domiciled in the nation’s capital with a K-street address. Most items were boarded without any policy review or adult supervision, reflecting a rank exercise in political log-rolling that proceeded straight down the gang planks to the bulging decks below.

Indeed, the true calamity of the Obama stimulus was not merely its massive girth, but the cynical, helter-skelter process by which the public purse was raided. At the end of the day, it was a startling demonstration that the power of a bad idea----the Keynesian predicate----when coupled with the massive money power of the PACs and K-Street lobbies, has rendered the nation fiscally incontinent.

This unhinged modus operandi undoubtedly accounts for the plethora of sordid deals that an allegedly “progressive” White House waived through. Thus, the homebuilders were given “refunds” of $15 billion for taxes they had paid during the bubble years; manufacturers got 100 percent first year tax write-offs for equipment that should have been written off over a decade or longer; and crony capitalist investors got $90 billion for uneconomic solar, wind and electric vehicle projects under the fig leaf of “green energy”.

Likewise, insulation suppliers got a $10 billion hand-out via tax credits to homeowners to improve the thermal efficiency of their own properties; congressman on the public works committees got $10 billion earmarked for pork barrel water and reclamation projects in the home districts; and the already corpulent budget of the Pentagon was handed another $10 billion for base construction it most definitely didn’t need---to say nothing of a new headquarters for the insanely bloated  and incompetent Homeland Security Department

Moreover, the big ticket stuff was far worse. Nearly $50 billion was allocated to highway construction---much of it for repaving highways that didn’t need it or building interchanges where the traffic didn’t warrant it; and, in any event, it should have been paid for with user gasoline taxes, not permanent debt on the general public.

Still, the real pyramid building gambit was the $30 billion or so for transit and high speed rail. Forty-five years of mucking around with the abomination know as Amtrak proves unequivocally that cross-country rail can never be viable in the US because it cannot compete with air travel among the overwhelming majority of city-pairs.

Presently, every single ticket sold on the Sunset Limited from New Orleans to Los Angeles, for example, requires a subsidy that is nearly double the cost of an airline ticket, and is indicative of why we pour $1 billion down the drain each year subsidizing the public transit myth ---a boondoggle that will become all the greater owing to the distribution of billions of high speed rail “stimulus” funds which were not subject to even a single hour of hearings.

Then there was $80 billion for education but the only rhyme or reason to it was the list of K-Street lobbies that had lined-up outside Speaker Pelosi’s door: to wit, the National Education Association, the school superintendents lobby, the textbook publishers, the school construction industry, the special education complex, the pre-school providers association, and dozens more.

 In a similar manner, the nursing home lobby, home health providers, the hospital association, the knee and hip replacement manufactures, the scooter chair hawkers and the Medicaid mills were all delighted to pocket an extra $80 billion of Federal funding, thereby relieving pressures for reimbursement reductions from the regular state Medicaid programs.

Finally, there was the Obama “money drop” whereby $250 billion was dispersed in helicopter fashion to 140 million tax filers and 65 million citizens who receive social security, veterans and other benefit checks. But there was virtually no relationship to need: tax filers with incomes up to $200,000 were eligible, or about 95 percent of the population.

And among the beneficiary population receiving a $250 stimulus check, less than 10 percent were actually means-tested--- while millions of these checks went to affluent social security retirees happy to have Uncle Sam pay for an extra round or two of golf.

Indeed, there was no public policy purpose at all to Obama’s quarter trillion dollar money drop except filling the Keynesian bath-tub with make believe income, hoping that citizens would use it to buy a new lawnmower , a goose-down comforter, dinner at the Red Lobster or a new pair of shoes.

 Yet ensnared in the Keynesian delusion that society can create wealth by mortgaging its future, the stimulus-besotted denizens of the beltway blew it entirely on the one true domestic function of the state---even under the regime of crony capitalism that now prevails. That imperative is to maintain and adequately fund a sturdy safety net to support citizens who cannot work due to age or health, and to supplement the incomes of families whose marketplace earnings fall below a minimum standard of living.

Yet notwithstanding the feeding frenzy on K-Street to fill-in the Keynesian vicar’s $800 billion blank  check in a record twenty-two days, only 3.8 percent of the total----a mere $30 billion---was allocated to means-tested cash benefits which actually fund the safety net for the needy. Yet with $17 trillion of national debt on the books already, and the certainty that will double or triple in the decades immediately ahead, indiscriminately filling the Keynesian bathtub with borrowed money is not only reckless, but also a cruel insult to any reasonable standard of equitable justice.

The fiscal madness of the Obama era cannot be excused on the grounds that the nation was faced with Great Depression 2.0. We weren’t and the widespread belief that we were so threatened is almost entirely attributable to Ben Bernanke’s faulty scholarship about the Fed’s alleged mistake of not undertaking a massive government debt buying spree to counter-act the Great Depression.

The latter, in turn, was borrowed almost entirely from Milton Friedman’s primitive quantity theory of money which was wrong in 1930 and ridiculously irrelevant to the circumstances of 2008. Nevertheless, it was the basis for Bernanke’s panicked flooding of Wall Street with indiscriminate bailouts and endless free liquidity after the Lehman event.

But what was actually happening was that the giant credit and housing bubble, which had been created by the Greenspan-Bernanke Fed in the wake of the bursting dotcom bubble, which it had also created, was being liquidated. Most of the carnage was happening within the gambling halls of Wall Street because it was the wholesale money market and the shadow banking system that was experiencing a run, not the retail banks of main street America.

The so-called financial crisis, therefore, consisted first and foremost of a violent mark-down of hugely leveraged, multi-trillion Wall Street balance sheets that were loaded with toxic securities--- that is, the residue of speculative trading books and undistributed underwritings of sub-prime CDOs, junk bonds, commercial real estate securitizations, hung LBO bridge loans, CDOs squared---- and which had been recklessly funded with massive dollops of overnight repo and other short-term wholesale money.

 This was just one more iteration of the speculator’s age old folly of investing long and illiquid and funding short and hot.

By the time of the frenzied bailout of AIG on September 16th, led by Bernanke and Hank Paulson, the most dangerous unguided missile every to rain down on the free market from the third floor of the Treasury building, it was nearly all over except for the shouting.  Bear Stearns, Lehman and Merrill Lynch were already gone because they were insolvent and should have been liquidated----including the bondholders who have foolishly invested in their junior capital for a few basis points of extra yield. 

Likewise, Morgan Stanley was bankrupt, too----propped up ultimately by $100 billion of Fed loans and guarantees that accomplished no public purpose whatsoever, except to keep a gambling house alive that the nation doesn’t need, and to rescue the value of stock held by insiders and bonds owned by money manager who had feasted for years on its reckless bets and rickety balance sheet.

 Indeed, at the end of the day the only real purpose of the September 2008 bailouts was to rescue Goldman Sachs from short-sellers who would have taken it down, had not Paulson and Bernanke bailed out Morgan Stanley first, and then outlawed the right of free citizens to sell short the stock of any financial company s until the crisis had passed.

The case for bailing out AIG was even more sketchy.  It had around $800 billion of mostly solid assets in the form of blue chip stocks, bonds, governments, GSE securities and long-term, secured aircraft leases, among others.

 So the great global empire of dozens of insurance and leasing companies that Hank Greenburg had built over the decades wasn’t really insolvent: the problem was that its holding company, which had written hundreds of billions of credit default swaps, was illiquid.

 It couldn’t met margin calls against the CDS it had written because state insurance commissioners in their wisdom had imposed capital requirements and dividend stoppers on AIG’s far flung insurance subsidiaries----precisely so that policy-holders couldn’t be fleeced by holding company executives and Boards needing to fund their gambling debts.

In short, virtually none of the AIG subsidiaries would have failed; millions of life insurance policies and retirement annuities would have been money good, and the fire insurance on factories in Peoria would have remained in force.

 The only thing that really happened was that something like twelve gunslingers based in London, who sold massive amounts of loss insurance on sub-prime mortgage bonds to about a dozen multi-trillion global banks, would have had to hire protection on their lives in the absence of the bailout. These CDS policies issued by the AIG holding company, in fact, were almost completely bogus and would have generated about $60 billion in losses among Goldman, JPMorgan, Barclays, Deutsche Bank, SocGen, BNP-Paribas, Citi bank and a handful other giants with combined balance sheet footings of $20 trillion.

So the loss would have been less than one-half of one percent of the aggregate balance sheet of the global banks impacted---that is, a London Whale or two, and nothing more

 But by dishing out around $15 billion of bailout money to each of the above named institutions, the American taxpayer kindly protected the P&L of these banks from a modest one-time hit, and kept executive bonuses in the money, too.   It also left AIG under the care of unreconstructed princes of Wall Street whose claims to entitlement know no bounds, as exemplified by Mr. Benmosche’s recent stupefying inability to distinguish between a lynching and the loss of undeserved bonuses.

But as they say on late night TV, there’s more. We were told that ATMs would go dark, big companies would miss payrolls for want of cash and the $3.8 trillion money market fund industry would go down the tubes.

 All of these legends are refuted in the section of my book called the Blackberry Panic of 2008----the title being a metaphor for the fact that the Treasury Department of the US government was in the hands of Wall Street plenipotentiaries who could not keep their eyes off the swooning price charts for the S&P 500 and Goldman Sachs flickering red on their blackberry screens.

But just consider this. Fully $1.8 trillion or 50 percent of total money market industry was in the form of so-called “government only” funds or Treasury paper. Not a single net dime left these funds during the panic and for the good reason that treasury interest payments were never in doubt.

 Likewise, the other half of the industry consisted of so-called “prime” funds which included modest amounts of commercial paper along with governments and bank obligations. About $400 billion or 20 percent of these holdings did leave these “prime” funds.

 Yet, the overwhelming share of these withdrawals---upwards of 85 percent---simply migrated within money fund companies from slightly risky “prime” funds to virtually riskless “government only” funds.  In effect, the much ballyhooed flight from the money market funds consisted of professional investors hitting the “transfer” button on their account pages.

Worse still, the only significant investor loss in this $4 trillion sector, which was supposedly ground zero of the meltdown, was on about $800 million of Lehman commercial paper held by the industry’s largest operation called the Reserve Prime Fund.  The loss amounted to 0.002 percent of the money market industry’s holdings on the eve of the crisis.

In a similar vein, the $2 trillion commercial paper market was said to be melting down, but this too is an urban legend fostered by the nation’s leading crony capitalist, Jeff Imelt of GE. Unaccountably, the latter did manage to secure $30 billion of Fed guarantees for General Electric’s AAA balance sheet, thereby obviating any need to do the right free market thing---that is, to make a dilutive issue of stock or long-term debt to pay down some cheap commercial paper that could not be rolled during the crisis.

Accordingly, GE Capital’s practice of funding long-term, sticky assets with short-term hot money should have caused shareholders to take a hit, and the company’s executives to be brought up short on the bonus front.

Instead, the bailout of GE’s commercial paper gave rise to the urban legend that companies could not fund their payrolls, when the truth is that every single industrial company that had a commercial paper facility also had back-up lines at their commercial bank, and not a single bank refused to fund, meaning no payroll disbursement was every in jeopardy.

 What actually shrank, and deservedly so, was the $1 trillion asset-backed commercial paper market---a place where banks go to refinance credit card and auto loan receivables so that they can book the lifetime profits on these loans upfront---literally the instant your card is swiped--- under the “gain-on-sale” accounting scam.

 Consequently, the subsequent sharp decline of the ABCP market has been entirely a matter of bank profit timing. It never prevented a single consumer from swiping a credit card or obtaining an auto loan.

In short, by the time of TARP and the massive liquidity injections into Wall Street by the Fed------when it doubled its 94 year-old balance sheet in seven weeks thru October 25, 2008---the meltdown in the canyons of Wall Street had pretty much burned itself out.

 Had Mr. Market been allowed to have his way with the street, a healthy purge of decades’ worth of speculative excesses would have occurred. Indeed, the main effect would be that perhaps a half-dozen “sons of Goldman” would be operating today, not the vampire squid which remains----and they would be run by chastened people who would have lost their stake during the free market’s cleansing interlude.

In a similar manner, the one-time hit to GDP and jobs which resulted from economically warranted collapse of the housing, commercial real estate and the consumer credit bubbles was actually over within nine months.

The ensuring rebound that incepted in June 2009 reflected the regenerative powers of the free market, and not the Fed’s mad-cap money printing or the Obama fiscal stimulus.  The Fed did lower interest rates to zero, and thereby it revived the speculative juices on Wall Street. But the plain fact is that household and business credit continued to contract on Main Street long after the June 2009 bottom, and for good reason:  both sectors were massively over-leveraged after three decades of continuous, pell mell credit expansion. 

The household sector, for example, had $13 trillion of debt which represented 205 percent of wage and salary income---compared to the historic ratio of under 90 percent which had prevailed during healthier times prior to 1980. So the Fed’s massive balance sheet expansion did nothing to cause higher borrowing, spending, output or employment on Main Street, even as it put the hedge funds back into the carry-trade business---now with essentially zero cost of funds.

By the time the rebound began in June 2009 not even $75 billion of the stimulus bill—that is, one-half of one percent of GDP---- had hit the spending stream, meaning, again, that the recovery already  underway was self-generating.

 As it happened, the initial wave of business inventory liquidation and labor-shedding triggered by the Wall Street meltdown had burned itself out quickly during the first nine months after the Lehman crisis. Thus, business inventories totaled $1.54 trillion in August 2008, and dropped by a total of $215 billion or 14 percent during the course of the recession. Yet fully $185 billion of that liquidation occurred before June 2009, and inventories started to actually rebuild a few months later.

The story was similar for non-farm payrolls. Nearly 7.6 million jobs were shed during the Great Recession but fully 6.6 million or 90 percent of the adjustment was completed by June 2009. Indeed, the idea that this short but sharp recession had anything to do with the Great Depression is essentially ludicrous, and fails completely to note the vast structural differences between the two eras.

 During the early 1930, the US was the great creditor and exporter to the world, with 70 percent of GDP accounted for by primary production industries----agriculture, mining and manufacturing--- which have long pipelines of crude, intermediate and finished inventory.

 By the time of the 2008 Wall Street meltdown, however, the primary production sector had become a mere shadow of its former self, accounting for only 17 percent of GDP. Accordingly, when recession hit the American economy this time, the downward spiral of inventory liquidation was muted----with the total inventory liquidation amounting to 2 percent of GDP in 2008-09 compared to 20 percent in the early 1930s.

Indeed, the inherent recession dynamics of the contemporary US service economy--- with its massive built-in stabilizers in the form of transfer payment and huge government payrolls--- militated against the entire scare story of a Great Depression 2.0.

 During the nine months thru June 2009, for example, government transfer payments for foods stamps, unemployment insurance, Medicaid, cash assistance and social security disability soared at a $300 billion annual rate, thereby more than off-setting the $275 billion drop in total wage and salary income.

 Likewise, government wages and salaries actually rose during the period, and the vast US service sector payrolls were tapered back modestly, rather than going dark in the form of traditional factory shutdowns. Aerobics class instructors, for example, experienced modestly reduced paid hours, but unlike factories and mines, fitness centers did not go dark in order to burn off excess inventories; they stuck to burning off calories at a modestly reduced rate.

In fact, by 2008 China, Australia and Brazil had become the world’s new mining and manufacturing economy---that is, the US economy of the 1930s. When upwards of 50 million Chinese migrant workers were sent home from idle Chinese export factors, the villages of China’s vast interior became the “Hoovervilles “of the present era.

 In short, Bernanke’s depression call was reckless and uninformed. The real challenge facing the American economy was to get off the massive credit binge which had bloated and inflated output, jobs and incomes for more than two decades.

Instead, Washington poured gasoline on the fire, thereby re-igniting an even great bubble that will ultimately end in state-wreck—that is, in the thundering collapse of the financial markets. Indeed, the nation’s rogue central bank will eventually be engulfed in the Wall Street hissy fit it fears---undone by waves of relentless selling when the monetary politburo finally loses control of panicked day traders and raging robo trading machines.

Likewise, the Federal budget has become a doomsday machine because the processes of fiscal governance are paralyzed and broken. There will be recurrent debt ceiling and shutdown crises like the carnage scheduled for next week, as far as the eye can see.

Indeed, notwithstanding the assurances of debt deniers like professor Krugman, the honest structural deficit is $1-2 trillion annually for the next decade and then it will get far worse. In fact, when you set aside the Rosy Scenario used by CBO and its preposterous Keynesian assumption that we will reach full employment in 2017 and never fall short of potential GDP ever again for all eternity, the fiscal equation is irremediable.

Under these conditions what remains of our free enterprise economy will be buckle under the weight of taxes and crisis.  Sundown in America is well-nigh unavoidable.