Scott Mather Discusses PIMCO’s Total Return Strategy

February 19th, 2015

Bonds have continued to rally so far this year, even as the Federal Reserve contemplates raising interest rates. In the following interview, Scott Mather, CIO U.S. Core Strategies, discusses recent developments in the bond markets, the outlook for the year ahead and the investment implications for PIMCO’s Total Return Strategy. Mather co-manages the strategy with Mark Kiesel, CIO Global Credit, and Mihir Worah, CIO Real Return and Asset Allocation.

Q: Scott, you and the team took over the strategy at a challenging time, considering market volatility and client outflows, yet performance has generally been strong. Have you needed to make adjustments to how you manage the strategy in light of this backdrop?

A: The short answer is no. The important thing to recognize is that Total Return, as a high-quality core bond strategy, operates in some of the most liquid markets in the world. Whether there are inflows or outflows, every day we ensure that the strategy maintains the target exposures we have set for the portfolio in each fixed income sector. Flows are not a reason to change the way we manage the strategy.

Indeed, we are intensely focused on performance for our clients in Total Return, and flows have not been an issue in that regard. I think the generally strong performance across the strategy in the past few months proves that. We believe our performance reflects our time-tested investment process.

Q: Let’s turn to markets. Bonds have rallied since September, and long-term yields have fallen sharply. What’s been driving this move?

A: There are a number of factors drawing yields down in the U.S., including low yields outside of the country and the expansion of quantitative easing programs by the Bank of Japan (BOJ) and the European Central Bank (ECB). Those lower-yielding markets are exerting a gravitational pull on longer-dated Treasury yields.

Another factor is the market’s preoccupation – or maybe fixation – with the drop in energy prices and what that is doing to headline inflation. Unlike some market participants, we do not believe that the lower headline inflation stemming from energy prices might be an omen of a deflationary outcome for the U.S., or that it will push the Federal Reserve’s first interest rate rise out much further into the future. But those beliefs have undoubtedly pushed yields down.

Similarly, while some have pointed to isolated signs of weaker U.S. growth as a reason for lower yields, we do not think U.S. economic growth should have played a large part in the drop of long-term yields.

Q: Looking to the year ahead, what is PIMCO’s outlook for global growth and inflation?

A: In terms of the big picture, we think divergence will be an overarching market theme this year, within both developed and emerging markets. The big changes in commodity prices have created both winners and losers throughout emerging markets, and many will be wrestling with these changes. In the developed markets, we have the divergence between the U.S., which is shifting to a level of growth above potential, and most other developed markets, which are struggling just to reach their own, lower levels of potential growth. Finally, and not insignificantly, we have monetary policy divergence, with the ECB and BOJ on full throttle even as the Fed contemplates its first rate hike in this cycle.

For investors, the key is to take advantage of the divergences. It is going to be a riskier world in many ways, with higher levels of financial market volatility, but investors may be able to find opportunities in the market’s overshoots.

Q: Turning to the Federal Reserve, fed funds futures as of the end of January suggest investors expect only one rate hike this year and for rates to be only 1.5% by the end of 2017. That is a substantial lowering of expectations since September. Is the market too dovish on the Fed?

A: Yes, that appears to be the case; we think the market has overshot the mark in suggesting that the Fed will not move until the end of this year.

The Fed has been very clear that while the data and international developments matter in its decision-making, lower energy prices are positive for growth and should result in an improved labor market and wage growth. While the Fed would like to see faster wage growth and may thus be willing to allow the economy to “run a bit hot,” it is increasingly unwilling to keep rates at zero in the face of a strong economy and a labor market that will likely reach full employment levels in the second half of the year.

Leaving rates at zero would mean that monetary policy is getting more accommodative as slack disappears. This would raise the risk of a more urgent need to abruptly raise rates in the future, which is something the Fed should try to avoid. With respect to inflation, the Fed clearly looks through the energy-induced drop in headline inflation (even though the market appears reluctant to follow this commonsensical approach). The Fed knows that it is wages that ultimately matter most, and all indicators point to rising wage trends. Modest moves upward in interest rates are unlikely to alter the improving labor market and wage trends. Lastly, we do not think a move off of zero would damage economic growth prospects and such a move may actually help prolong and sustain the expansion. Zero percent rate policy is a distortion from equilibrium pricing with diminishing returns, and it increasingly represents a cost and risk to the economy rather than a stimulative benefit.

Monetary policy would remain extremely accommodative and supportive of growth with rates at levels below 2% (which we think is close to the New Neutral equilibrium rate), especially when one also considers the effect of the Fed’s still very large balance sheet, which undoubtedly will continue to ease monetary conditions well into the future. In addition, as foreign central banks ease policy, global financial conditions should also ease and thus allow the Fed to begin to normalize rates sooner than otherwise. So a move off of the “emergency policy rate” as early as this summer makes sense.

That said, given its desire to reflate the U.S. economy, the Fed is going to move at a slow pace and will make sure to continue to let the economy grow above potential and allow inflation to accelerate to target and perhaps beyond in the years ahead.

Q: Turning back to the Total Return Strategy, can you discuss the investment positioning in light of PIMCO’s macro outlook?

A: We have several investment strategies that we think will pay off in the year ahead.

First, we have moved our yield curve exposure out of what we think is the significantly overpriced front end and focused our exposure in seven- to 10-year maturities. Also, certain sectors are misvalued, in our view, including inflation-linked securities. In the TIPS market, for example, 10-year breakeven inflation has been priced as low as 1.5% recently, which reflects very low, and we think unrealistic, 10-year inflation expectations. Once oil prices have bottomed and headline inflation turns back up, we think the market will focus on TIPS as an underpriced asset class.

We also think the dollar is likely at the start of a long-lasting, upward trend, though it may experience volatility along the way. Not only did it rise from relatively cheap levels, but given continued divergences in the global economy, the dollar still has a significant tailwind.

By: Scott A. Mather

In general, more global divergence, more volatility and more overshoots will create great opportunities for active fixed income investors. But a good defense is required as monetary policy is likely to represent a headwind for all financial assets instead of the steady tailwind it has been for the past several years.

Q: With yields persistently low, how would you respond to investors who are wondering about the role of core bonds in their portfolios?

A: All financial assets, not just bonds, have seen their prices elevated over the past several years as a result of monetary policies around the world. Future returns have been pulled forward to today, and that means prospective returns on many financial instruments are going to be lower. Also, one should remember that interest rate rises will happen very gradually relative to history, and that the ultimate destination of equilibrium rates is going to be much lower than it has been at any other time in the past several decades.

Still, it is important for investors to remember why they own bonds: A well-diversified core bond strategy serves as an anchor to the portfolio. It has the potential to provide income and capital preservation and to generally perform well when riskier investments do not.

It is also important to distinguish between a strategy that blindly invests in the index, and is thus completely beholden to the ups and downs of the markets, and an active fixed income strategy. In today’s low-yield environment, the benefits of active management are more important than ever. Alpha will be a larger percentage of return going forward.

Original Article can be found here

Regulation of Shadow Banking Takes a Dark Turn

February 13th, 2015

Photo: Corbis

Written by: Peter J. Wallison- The Wall Street Journal- 2.9.2015

Recent statements by senior Federal Reserve officials show that the agency is stepping up efforts to investigate and ultimately regulate what they call the “shadow-banking system.” As the regulators define that term, it is nothing less than capital and securities markets—the industries principally responsible for the growth of the U.S. economy over the past 40 years.

In December, Stanley Fischer , the Fed’s vice chairman and head of its internal systemic-risk committee, told an asset-management group that the New York Fed is “mapping” the relationships between and among financial institutions with a view to determining the scope of the shadow-banking system. The Fed, he said, is considering whether it has sufficient authority to regulate shadow banks. If it doesn’t, he said, the Fed will turn the matter over to the Financial Stability Oversight Council—created by the Dodd-Frank law and made up of the heads of all federal financial regulators, with the Treasury secretary as chairman—for appropriate action.

And on Jan. 30, Daniel Tarullo , a Fed governor, told a conference of financial regulators that the agency was working to corral financial activities that “migrate outside the regulated perimeter”—that is, financial activities that are not regulated like banks. The Fed, he said, wants to “serve the macroprudential aim of moderating the build-up of leverage” in shadow banks.

Most people probably imagine that the term shadow banking refers to large nonbank financial institutions that do what regulated banks do—borrow short-term funds like deposits and turn them into long-term assets like loans. Maturity transformation, as it is called, can be risky, because a firm that has lent out funds it has borrowed short-term may be pressed for cash if its short-term creditors want their funds returned immediately. The fear is that large firms facing this difficulty could fail, creating a “systemic” event.

For this reason, Dodd-Frank is based on the idea that all large nonbank financial institutions, including investment banks, finance companies and insurers, should be subject to designation by the FSOC as systemically important financial institutions, or SIFIs. Once designated, SIFIs are turned over to the Fed for stringent regulation.

The regulators apparently want to cast an even wider net. A 2012 report by the international Financial Stability Board—made up of central bankers and bank regulators of which the U.S. Treasury and the Fed are members—stated that systemic risks are created in the shadow-banking system through “a complex chain of transactions, in which leverage and maturity transformation occur in stages.”

What is a “chain of transactions”? As former Fed Chairman Ben Bernanke explained that year, a finance company might create a pool of auto loans for securitization. Afterward, “an investment bank might sell tranches of the securitization to investors. The lower-risk tranches could be purchased by an asset-backed commercial paper (ABCP) conduit that, in turn, funds itself by issuing commercial paper that is purchased by money market funds.” In other words, a “chain of transactions” involving many different firms can create the same systemic risks as a single large firm.

These are normal transactions in the securities and capital markets. So when Fed officials say that they are investigating and hope to regulate shadow banking, what they mean is that they want to regulate what kind of transactions occur in the securities and capital markets. What is necessary, Mr. Tarullo noted, is a “significant building out of a regulatory regime” for shadow banks, “and so I think that’s where attention is going to be paid.”

One big, threshold question: Where do the Fed and FSOC imagine that they obtained the grant of such power? It can’t be from Dodd-Frank. As capacious as this legislation is, it doesn’t provide authority to regulate financial firms that by themselves are not systemic but become systemic because they participate in a “complex chain of transactions.”

The most likely possibility is the Financial Stability Board, an entity little known outside the financial industry. This group was deputized by the G-20 leaders in 2009 to reform the international financial system, and since then—with the explicit approval of the G-20—has made the regulation of the shadow-banking system a major objective. Perhaps the FSOC and the Fed see the decisions of the G-20—of which President Obama is a member—as authority for their actions in the U.S.

While this might be true in other countries, the U.S. Constitution provides for a separation of powers in which Congress makes the laws and the president carries them out. The fact that a president has agreed with other G-20 leaders to take international action of some kind would not give federal agencies the authority to act in the absence of explicit legislation.

And yet if Congress fails to insist on a recognition of its authority, the Federal Reserve and the Financial Stability Oversight Council will be free to take control of and regulate sectors of the economy that even the drafters of the far-reaching Dodd-Frank law saw fit not to include.


Mr. Wallison is a senior fellow at the American Enterprise Institute. His most recent book is “Hidden in Plain Sight: What Really Caused the World’s Worst Financial Crisis and Why It Could Happen Again” (Encounter, 2015).

The Stronghold: How republicans captured Congress but Surrendered the White House

February 12th, 2015

The Stronghold

Once the party of presidents, the GOP in recent elections has failed to pull together convincing national majorities. Republicans have lost four of the last six presidential races and lost the popular vote in five of the last six. In their lone victory, the party incumbent won—during wartime—by the slimmest of margins. In this fascinating and important book, Thomas Schaller examines national Republican politics since President Ronald Reagan left office in 1989. From Newt Gingrich’s ascent to Speaker of the House through the defeat of Mitt Romney in 2012, Schaller traces the Republican Party’s institutional transformation and its broad consequences, not only for Republicans but also for America.

Gingrich’s “Contract with America” set in motion a vicious cycle, Schaller contends: as the GOP became more conservative, it became more Congress-centered, and as its congressional wing grew more powerful, the party grew more conservative. This dangerous loop, unless broken, may signal a future of increasing radicalization, dependency on a shrinking pool of voters, and less viability as a true national party. In a thought-provoking conclusion, the author discusses repercussions of the GOP decline, among them political polarization and the paralysis of the federal government.

Thomas Schaller

Thomas F. Schaller is a professor of political science at the University of Maryland, Baltimore County, and author of “Whistling Past Dixie.”  He writes a political column for the Baltimore Sun and currently resides in Washington, DC.

Mr. Schaller will be joining me on Your Financial Editor this Saturday 2/14/2015. You can listen live from anywhere Saturday morning at 8am on AM 930 WFMD by logging on to and clicking the “listen live” button! If you can’t tune into the show, there will be a podcast available the week following the show here.

Is Fiscal Stimulus a Good Idea?

February 6th, 2015

The article, Is Stimulus a Good Idea? written by Ray Fair was featured in Business Economics. Below is the Abstract from the paper. Mr. Fair will be joining me on Your Financial Editor tomorrow 2/7/2015. You can listen live from anywhere Saturday morning at 8am on AM 930 WFMD by logging on to and clicking the “listen live” button! If you can’t tune into the show, there will be a podcast available the week following the show here.


The results in this paper, using a structural multicountry macroeconometric model, suggest that there is at most a small gain from fiscal stimulus in the form of increased transfer payments or increased tax deductions if the increased debt generated must eventually be paid back. The gain in output and employment on the way up is roughly offset by the loss in output and employment on the way down as the debt from the initial stimulus is paid off. This conclusion is robust to different assumptions about monetary policy. To the extent that there is a gain, the longer one waits to begin paying the debt back the better. Possible caveats regarding the model used are that (1) monetary policy is not powerful enough to keep the economy at full employment, (2) potential output is taken to be exogenous, (3) possible permanent effects on asset prices and animal spirits from a stimulus are not taken into account, and (4) the model does not have the feature that in really bad times the economy might collapse without a stimulus.


Ray Fair

Ray Clarence Fair (born October 4, 1942 in Fresno, California) is the John M. Musser Professor of Economics at Yale University.

Fair received his B.A. from Fresno State College in 1964 and his Ph.D. from MIT in 1968. He spent several years at Princeton University before moving to Yale. He is now a professor within the Cowles Foundation and the International Center for Finance.

Fair’s teaching and research interests include macroeconomic theory, econometrics, and macroeconometric modeling. He is the author, along with Karl Case ofWellesley College, of the economics textbook Principles of Economics. He has also authored several books pertaining to modeling, including Testing Macroeconometric Models(1994) and Estimating How the Macroeconomy Works (2004).

He is noted for his methods for predicting the outcome of presidential elections, and his record of success in doing so (a record respectable but blemished, as for example 1992).. (2000 was a special case). He has published on this subject, Predicting Presidential Elections and Other Things (2002).

Ray Fair maintains a macroeconomic model, data, software and forecasts on his home page and that are also available for free downloading for use on a personal computer. The Fair Model macroeconmic model forecasts for the United States and 38 other countries.

Fair lives in New Haven, Connecticut, with his wife Sharon Oster, a professor at the Yale School of Management. He is the father of Emily Oster, an economist at the University of Chicago.

U.S Retirement Worries Go Global

February 6th, 2015

Here’s the good news: In the past two decades, average life expectancy around the world has increased by six years, from 65.3 in 1990 to 71.5 in 2013, according research funded by the Bill and Melinda Gates Foundation and conducted by the University of Washington’s Institute of Health Metrics and Evaluation. The primary reason: improvements in health care.  In higher-income countries fewer are dying from heart disease; lower-income nations have seen a sharp decline in deaths from childhood diseases.

Now the flip side: Living longer costs more. Governments around the world have said they can’t afford it. Neither can employers. Thus, the responsibility for funding a longer lifespan is increasingly up to each individual.

Sound familiar?  Americans have been exhorted to save for retirement for thirty years or more.  “Social Security is not enough!” “Maximize your 401(k) contribution- at least up to the company match.” “Stash additional money in an IRA.” “Consider an annuity.”

Now, the rest of the world is finally catching up. And from Malaysia to Turkey to Brazil, they’re not happy. Based on a massive study by the global financial firm HSBC (HSBC), on average 25% of retirees around the world say their standard of living is lower than when they were working. There is wide variance. While 16% of U.S. retirees agree, nearly half of Turkish retirees feel that way, as well as 41% of those in France.  Retirees report they are coping by reducing their expectations about how they would spend retirement (less travel, for instance) and cutting back on daily expenses.

Their kids have noticed.  Globally, 34% of those who are still in the workforce are worried they face the same fate.  “Even among pre-retirees with household income of more than $80,000/year, about one-fifth are not confident they will be able to maintain a comfortable standard of living,” says Andy Ireland, Head of Wealth Management at HSBC.

The Problem: Words vs. Actions

Still, just like their parents, the majority of those in the global workforce are not seriously saving for retirement.  The reasons also sound a lot like their parents’: too many other, more pressing financial obligations, i.e. debt.

To Ireland, it sounds like a big e-x-c-u-s-e.

“Are you living within your means? Why do you have credit card debt to begin with? Individuals need to take responsibility and learn discipline. When you’re 25, 35 [retirement] doesn’t resonate,but you need to have a general savings plan so that if something occurs, you don’t need to “borrow” in order to pay for it.

Despite the fact that 69% of working adults around the world say they are actually worried they will run out of money in retirement, 38% admit they are not currently saving for their later years at all or do not plan to start. That includes a third of those who are over age 40.(1)

Listen To Your Parents

“What retirees are telling us,” says Ireland, “is ‘If I’d known then what I know now I would have done more to be self-sufficient financially.’”  Two-thirds of retirees around the world say they didn’t realize until they were already retired that they had not saved enough.

If they had a second chance, 38% of retirees say they would start saving for retirement at a younger age.  In Malaysia, Mexico and India, the number is significantly higher.  Nearly 40% say 30 is the latest age to begin.  However, only 26% of those in the workforce agree.

[Side note: American retirees are much more adamant. Nearly half think you should start saving for retirement by age 30 or sooner in contrast to 34% of working Americans.  Geography (or perhaps exposure to sunshine?) apparently makes a big difference. One out of three pre-retirees in Miami and Los Angeles thinks you can start saving for retirement after age 40 and end up with a nest egg large enough to maintain your pre-retirement standard of living!]

The Solution: Actions vs. Words

No matter where in the world you live, in Ireland’s view, the solution is the same.  “You have to have a plan. You can’t say, ‘The numbers are too large, so I’m going to ignore it.’”

It is a plan that is both simple and difficult:

1. Live within your means.

“Sort through your expenses and determine what is essential and what you don’t need to spend money on.”

2. Save as much as you can.

“Create a discipline of saving, even if you start small.”

In contrast, 25% of working Americans say they are not saving for retirement.  This includes 20% of those over age 40.


You can find the original article here.

The Big Lie: 5.6% Unemployment

February 6th, 2015


By: Jim Clifton

Here’s something that many Americans — including some of the smartest and most educated among us — don’t know: The official unemployment rate, as reported by the U.S. Department of Labor, is extremely misleading.

Right now, we’re hearing much celebrating from the media, the White House and Wall Street about how unemployment is “down” to 5.6%. The cheerleading for this number is deafening. The media loves a comeback story, the White House wants to score political points and Wall Street would like you to stay in the market.

None of them will tell you this: If you, a family member or anyone is unemployed and has subsequently given up on finding a job — if you are so hopelessly out of work that you’ve stopped looking over the past four weeks — the Department of Labor doesn’t count you as unemployed. That’s right. While you are as unemployed as one can possibly be, and tragically may never find work again, you are not counted in the figure we see relentlessly in the news — currently 5.6%. Right now, as many as 30 million Americans are either out of work or severely underemployed. Trust me, the vast majority of them aren’t throwing parties to toast “falling” unemployment.

There’s another reason why the official rate is misleading. Say you’re an out-of-work engineer or healthcare worker or construction worker or retail manager: If you perform a minimum of one hour of work in a week and are paid at least $20 — maybe someone pays you to mow their lawn — you’re not officially counted as unemployed in the much-reported 5.6%. Few Americans know this.

Yet another figure of importance that doesn’t get much press: those working part time but wanting full-time work. If you have a degree in chemistry or math and are working 10 hours part time because it is all you can find — in other words, you are severely underemployed — the government doesn’t count you in the 5.6%. Few Americans know this.

There’s no other way to say this. The official unemployment rate, which cruelly overlooks the suffering of the long-term and often permanently unemployed as well as the depressingly underemployed, amounts to a Big Lie.

And it’s a lie that has consequences, because the great American dream is to have a good job, and in recent years, America has failed to deliver that dream more than it has at any time in recent memory. A good job is an individual’s primary identity, their very self-worth, their dignity — it establishes the relationship they have with their friends, community and country. When we fail to deliver a good job that fits a citizen’s talents, training and experience, we are failing the great American dream.

Gallup defines a good job as 30+ hours per week for an organization that provides a regular paycheck. Right now, the U.S. is delivering at a staggeringly low rate of 44%, which is the number of full-time jobs as a percent of the adult population, 18 years and older. We need that to be 50% and a bare minimum of 10 million new, good jobs to replenish America’s middle class.

I hear all the time that “unemployment is greatly reduced, but the people aren’t feeling it.” When the media, talking heads, the White House and Wall Street start reporting the truth — the percent of Americans in good jobs; jobs that are full time and real – then we will quit wondering why Americans aren’t “feeling” something that doesn’t remotely reflect the reality in their lives. And we will also quit wondering what hollowed out the middle class.

Jim Clifton is Chairman and CEO at Gallup.
Original Article can be found here.

CBO’s January 2015 Budget and Economic Outlook January 26, 2015

February 3rd, 2015



The Congressional Budget Office (CBO) released its Budget and Economic Outlook today, showing their budget and economic forecasts through 2025. After falling to post-recession lows below $470 billion this year and next, CBO projects deficits will again start to rise, exceeding $1 trillion by 2025.

Over the next decade, CBO projects deficits of $7.6 trillion (3.3 percent of GDP), with deficits growing from a low of $467 billion (2.5 percent of GDP) in 2016 to $1.09 trillion (4.0 percent of GDP) by 2025. As a result, debt will rise over the next decade, from $13 trillion today to $16.6 trillion at the end of 2020 and $21.6 trillion by the end of 2025.

As a share of GDP, debt will remain stable at current post-war highs of about 74 percent of GDP through 2020, but then rise continuously to almost 79 percent of GDP by 2025 and continue to grow unsustainably over the long run.

The gloomy debt and deficit outlook is the result of rising spending and relatively flat revenue collection. Despite discretionary spending falling as a share of GDP, Social Security, health care, and interest spending will grow substantially, pushing spending from 20.3 percent of GDP in 2015 to 22.3 percent by 2025. At the same time, revenue will remain roughly flat at near 18 percent of GDP through most of the next ten years, reaching 18.3 in 2025.

You can read the full report here.

Asking Tough Questions about Stewardship and Education

February 2nd, 2015




By  on January 26, 2015

On January 9, 2015, President Obama announced a proposal subsidizing two years of community college education for students who attend at least half time and maintain a minimum of a 2.5 GPA.

If all states participate, the proposal claims that as many as nine million students may be affected. Students attending community college full time could receive as much as $3,800 a year to cover tuition.

This news has been greeted with varying emphatic responses and deservedly so. Affordable, quality education is in high demand, and it merits careful thought as we go about trying to meet this need.

The Changing Nature of Education

As a professor, I have a front row seat in the debate.

In the last century, it has become increasingly important for some to attain at least a college degree as many jobs require greater depth of study that is often best gained in the classroom.

Recently, however, common wisdom is shifting as even individuals holding a bachelor’s degree or higher have experienced underemployment or unemployment while holding significant levels of debt. I’ve seen many of my students struggle with this.

Alternative forms of education will become more popular as individuals seek more cost effective options suiting their particular vocational needs and callings.

This being the case, many are looking to the government to fund what they consider a human right – education. If we were to look at this in terms of stewardship, how should we make decisions regarding the nature of and funding for this education?

Principles of Stewardship

We often look at the parable of the talents to guide our thinking about stewardship.

As I read through the passage more recently, I was reminded again of something striking about the Master’s attitude toward his servants upon his return.

Rather than praising each of them for saving the coins he gave them, his praise mirrored the return each received from the original investment.

We must be careful not to confuse this investment with charity. Charity is given without expectation of return, while an investment necessitates accountability and proof that the investment was a wise one.

The Master praises those who make the best of his gifts to them. This distinction underlies the discussion about education.

Stewardship and Education

What does this policy actually incentivize? As Reason magazine points out, “it’s not the students being subsidized, it’s the college.”

Rather than the student facing financial ramifications for not meeting or exceeding standards, schools experience the temptation to bend standards to retain students simply to receive the funding.

  • Yet, as Reason’s article notes, even in an era of grade inflation, community colleges don’t have a very good graduation rate.
  • Furthermore, students who are held to a higher standard of financial accountability are likely to do better. Having a clear sense of the connection between the investment and the expected result is essential to success.
  • “Free community college” is a misnomer. As any good economist will quip, there’s no such thing as a free lunch. Someone—in this case, taxpayers—is footing the bill. When the money is handed to the school or student by way of another entity, the actual donor doesn’t have any way of tracking the effect of his or her money.
  • Even tax dollars are limited, and we need to be wise with how we allocate them. As demonstrated when California made inexpensive community college available, the system was unable to match the high demand for classes. As many as 470,000 students were stuck on waiting lists in 2012, and many students were cut to meet the already exceeded budget.

Rather than endorsing a method that could further entrench our nation in debt and cause the value of a degree to decrease, how should we approach this issue of higher education?

We often talk about the specific nature calling, and it’s helpful to recall here that each individual is gifted in and inspired by different things. No two students will follow exactly the same path, and it would be a mistake to assume that a single policy can address needs as different as the individuals receiving the education.

Instead of trying to solve the dilemma of education with charity, let’s look at it as an investment in the students and hold them – and ourselves – to a higher standard.

- See more at:

Fracking — A New Bubble for a New Year

January 23rd, 2015
JANUARY 22, 2015


Another year is under way, and we are in the midst of yet another central bank-induced credit bubble. This time, the culprit is shaping up to be the oil and gas industry. Hydraulic fracturing, or “fracking,” has seen a marked rise in usage in the United States over the last six years. It represented a new and innovative way to extract hydrocarbons from rock formations deep underground. Many may be tempted to say that the emergence of fracking, as well as the jobs it has created, is further evidence of the free market at work. However, as David Stockman makes clear in this excellent article, the fracking bubble would never have materialized if not for artificially low interest rates instituted by the Federal Reserve in the advent of the 2007–2009 financial crisis.

Oil and natural gas exploration and extraction via hydraulic fracturing is a highly capital-intensive venture. Given that the shelf life of a typical oil well is only two years, these firms need to establish new ones as maintaining existing wells proves too expensive. If not for the six years of Zero Interest Rate Policy (ZIRP) and several rounds of Quantitative Easing (QE) from the Federal Reserve, many of these upstart wildcatting firms would not be able to sustain the cost of exploration and extraction. Having record low borrowing costs has led to massive increases in production, and an influx of new jobs in the field due to economies of scale. In fact, a large percentage of the job gains we have seen since 2008 have been in the fracking industry.

The situation bears strong similarities to the inflating of the housing bubble from 2002–2007. Overproduction due to expectations of increasing demand because of the false impression of a strong economy, a large spike in job growth in the sector that will surely reverse as the bubble bursts, and companies (oil and gas wildcatters in place of homebuilders) issuing large sums of debt to fund their seemingly profitable ventures. However, just as in the case with the housing bubble, this boom was not induced by market fundamentals and an increased demand to feed this increase in supply. Firms, able to see energy as an indispensable sector just as housing, began directing their resources there and had no reason to believe oil prices would crash (sound familiar?).

Now companies and media outlets are scrambling to discover what the break-even oil prices are, because as the price continues to fall so does the collateral underpinning the large sums of bank debt. It is also worth mentioning that these oil and gas companies comprise approximately 17 percent of the overall high-yield debt market. This is a debt market for businesses with shorter track records of debt service and lower credit ratings, and offers slightly higher interest rates than standard investment-grade corporate bond markets in order to compensate the investor for heightened risk of default. A wave of defaults from these fracking companies would lead to ripples in the overall high-yield debt market, contributing to a market sell-off in the asset class that drives bond prices down sharply and inversely raises borrowing costs for other firms in the junk bond space.

Given the tentative strategy of the Federal Reserve in raising the benchmark interest rate, a sudden and unexpected increase in borrowing costs for businesses in the high-yield debt space is a serious cause for concern. The potential damage could be severe, as many of those bubble-created jobs would be in jeopardy. Whatever the result, the slowly unwinding fracking bubble should serve as a stark reminder about the importance of the Austrian business cycle theory. Years of QE and ZIRP have recreated an asset bubble in our economy with tremendous implications, and as the specific asset class may continue to change the same underlying problem of malinvestment and misallocation of resources will persist if central bankers do not change course.


Original article can be found here.

Markets Restrain Bank Fraud, But Central Banks Enable It

January 23rd, 2015
JANUARY 20, 2015


Originally, paper money was not regarded as money but merely as a representation of a commodity (namely, gold). Various paper certificates represented claims on gold stored with the banks. Holders of paper certificates could convert them into gold whenever they deemed necessary. Because people found it more convenient to use paper certificates to exchange for goods and services, these certificates came to be regarded as money.

Paper certificates that are accepted as the medium of exchange open the scope for fraudulent practices. Banks could now be tempted to boost their profits by lending certificates that were not covered by gold. In a free-market economy, a bank that overissues paper certificates will quickly find out that the exchange value of its certificates in terms of goods and services will fall. To protect their purchasing power, holders of the overi-ssued certificates naturally attempt to convert them back to gold. If all of them were to demand gold back at the same time, this would bankrupt the bank. In a free market then, the threat of bankruptcy would restrain banks from issuing paper certificates unbacked by gold. Mises wrote on this in Human Action,

People often refer to the dictum of an anonymous American quoted by Tooke: “Free trade in banking is free trade in swindling.” However, freedom in the issuance of banknotes would have narrowed down the use of banknotes considerably if it had not entirely suppressed it. It was this idea which Cernuschi advanced in the hearings of the French Banking Inquiry on October 24, 1865: “I believe that what is called freedom of banking would result in a total suppression of banknotes in France. I want to give everybody the right to issue banknotes so that nobody should take any banknotes any longer.”

This means that in a free-market economy, paper money cannot assume a “life of its own” and become independent of commodity money.

The government can, however, bypass the free-market discipline. It can issue a decree that makes it legal (or effectively legal) for the over-issued bank not to redeem paper certificates into gold. Once banks are not obliged to redeem paper certificates into gold, opportunities for large profits are created that set incentives to pursue an unrestrained expansion of the supply of paper certificates. The uncurbed expansion of paper certificates raises the likelihood of setting off a galloping rise in the prices of goods and services that can lead to the breakdown of the market economy.

Central Banks Protect Private Banks from the Market

To prevent such a breakdown, the supply of the paper money must be managed. The main purpose of managing the supply is to prevent various competing banks from overissuing paper certificates and from bankrupting each other. This can be achieved by establishing a monopoly bank, i.e., a central bank-that manages the expansion of paper money.

To assert its authority, the central bank introduces its paper certificates, which replace the certificates of various banks. (The central bank’s money purchasing power is established on account of the fact that various paper certificates, which carry purchasing power, are exchanged for the central bank money at a fixed rate. In short, the central bank paper certificates are fully backed by banks’ certificates, which have a historical link to gold.)

The central bank paper money, which is declared as the legal tender, also serves as a reserve asset for banks. This enables the central bank to set a limit on the credit expansion by the banking system. Note that through ongoing monetary management, i.e., monetary pumping, the central bank makes sure that all the banks can engage jointly in the expansion of credit out of “thin air” via the practice of fractional reserve banking. The joint expansion in turn guarantees that checks presented for redemption by banks to each other are netted out, because the redemption of each will cancel the other redemption out. In short, by means of monetary injections, the central bank makes sure that the banking system is “liquid enough” so that banks will not bankrupt each other.

Central Banks Take Over Where Inflationist Private Banks Left Off

It would appear that the central bank can manage and stabilize the monetary system. The truth, however, is the exact opposite. To manage the system, the central bank must constantly create money “out of thin air” to prevent banks from bankrupting each other. This leads to persistent declines in money’s purchasing power, which destabilizes the entire monetary system.

Observe that while, in the free market, people will not accept a commodity as money if its purchasing power is subject to a persistent decline. In the present environment, however, central authorities make it impractical to use any currency other than dollars even if suffering from a steady decline in its purchasing power.

In this environment, the central bank can keep the present paper standard going as long as the pool of real wealth is still expanding. Once the pool begins to stagnate — or, worse, shrinks — then no monetary pumping will be able to prevent the plunge of the system. A better solution is of course to have a true free market and allow commodity money to assert its monetary role.

The Boom-Bust Connection

As opposed to the present monetary system in the framework of a commodity-money standard, money cannot disappear and set in motion the menace of the boom-bust cycles. In fractional reserve banking, when money is repaid and the bank doesn’t renew the loan, money evaporates (leading to a bust). Because the loan has originated out of nothing, it obviously couldn’t have had an owner. In a free market, in contrast, when true commodity money is repaid, it is passed back to the original lender; the money stock stays intact.

Original post can be found here.