With the ongoing debacle in DC and the prospect of the once unthinkable US debt default, I thought it would be a good time to revisit the concept of a structural trap. A structural trap is different than the more commonly cited US economic condition known as a liquidity trap. The structural trap was first introduced by former managing director of Tudor Investment Corp, Robert Dugger.
In 2004 Dugger along with Tudor colleague Angel Ubide wrote a paper titled Structural Traps, Politics and Monetary Policy
; it described a structural trap with regard to the Japanese economy:
"In this paper we develop the concept of structural trap, where the interplay of long-term economic development incentives, politics, and demographics results in economies being unable to efficiently reallocate capital from low- to high-return uses. The resulting macroeconomic picture looks like a liquidity trap -- low GDP growth and deflation despite extreme monetary easing. But the optimal policy responses are very different and mistaking them could lead to perverse results. The key difference between a liquidity trap and a structural one is the role of politics."
An economy is deemed to be structurally trapped when capital gets “trapped” in unproductive uses in unproductive industries on unproductive balance sheets. This trapped capital is not allowed to flow into economically optimal productive uses because of the role of politics and the tendency for government to artificially prop up unproductive industry due to the politically connected corporate executives. There is probably no better example than TARP and the Fed’s quantitative easing program.
We know our political environment is a nightmare, and no doubt the debt ceiling as well as the Affordable Care Act are products of a structurally trapped economy. The will to execute the most basic function of government is nowhere to be found. Therefore it would be mildly optimistic at best to think we are going have the will to do what is critical to implement the necessary restructuring of industries that keep the US economy structurally trapped. I instead want to focus on Dugger’s prescribed monetary response. Recall this was written in 2004 (emphasis mine):
"If the economy is structurally trapped, the central bank cannot simply implement an aggressive easing policy focused on ‘triggering an inflationary expectation’ in the context of its price stability mandate. It has to take into consideration that its easing could make the situation worse.
"The Federal Reserve mandate is the most troublesome. The Federal Reserve appears to be more ‘demand-oriented’ with a mandate shaped by Keynesian views arising out of the 1930s depression and the 1970s recession and reflected in the 1978 Humphrey-Hawkins Act. If the USA were to descend into a structural trap, the FOMC would be under extreme and statutorily justifiable political pressure to do whatever necessary to support employment in the near-term. An argument that restructuring is needed and that unemployment will rise for an indeterminate time but thereafter decline as growth returns would not likely be a defence against political attack.
"The presence of a structural trap not only makes the traditional solution harder (need higher inflation), it may make it impossible absent a currency crash. The reason is, the nature of a structural trap is such that it makes the creation of credible inflation expectations impossible. Deflation is the result of massive excess capacity, and economic agents know this. Unless the excess capacity is eliminated, no credible inflation expectation can be created. Extreme monetary ease without excess capacity reduction perpetuates deflation, because it prevents restructuring from happening."
Brilliant. Dugger is describing the exact situation the US economy finds itself in today. The reason the Fed elected to forego tapering is because once it lets the market know that it was thinking about it, inflation expectations collapsed. This has become a primary focus. However quantitative easing can’t generate inflation expectations because there is too much spare capacity in the banking system relative to the demand for credit. There is simply too much money (savings) and not enough investment.
We are seeing this in the performance of LIBOR rates, which have been drifting lower. On Friday, October 4, 12-month LIBOR fell to the lowest level in history at 0.6186%. Remember that time when the demand for money increased and the price of money decreased? Neither do I. The persistent fall in “money rates” is a product of a lack of demand for credit. Banks are flush with cash (deposits) and there is no demand for funding (LIBOR) because there is no demand for credit.
12-Month LIBOR Vs. Total Loans and Leases and Loan-to-Deposit Ratio
This lack of credit demand can be seen in the Fed’s H.8
report on commercial banking assets and liabilities. On Friday the Fed reported commercial bank total loans and leases to be $7,318.1 billion, down $9.1 billion on the week for year-over-year growth of 2.3%. Year-to-date through September 25 there has only been $48.6 billion in credit created with $31.8 billion of that coming in the first quarter alone, thus only $16.8 billion created in Q2 and Q3. Quantitative easing’s sole purpose is to stimulate credit creation.
This past week in an interview that was reported by Bloomberg, First Pacific Advisors portfolio manager Thomas Atteberry gave some pointed comments about this monetary quagmire:
"'To ask about the unemployment rate or economic data is asking the wrong question on a short-term basis,' Atteberry, who manages $6.1b in bonds, said in interview yesterday. 'There’s been no real credit growth even though you made credit cheaper and more available. Why continue to make it cheap?'"
“We have to go back to the beginning and ask, ‘Why did you do this?’ To make asset prices go up, make people feel wealthier and spend more money, help the economy do better and earnings rise, and create a virtuous cycle.”
“We look at this like, ‘Is the economy growing faster today than it did then?’ No. Nonfarm payrolls are up and unemployment is down, but the labor-force participation rate has declined and median income has failed to keep up.”
“The Fed needs to exit QE so that yields can rise to a level where the non-central bank sector of the market will become interested in owning those securities in a greater number.”
“Yields need to go up because 'you need to price assets correctly in order to attract investors.'"
"You need a day of reckoning in the markets. The sooner you do that, the sooner the marketplace gets back to an equilibrium level of risk and return."
I sent these comments to my friend Kevin Ferry of Cronus Futures, who I often cite in my articles.His response was, “He’s describing a structural trap but he doesn’t know it.”
I had never heard of a structural trap until Kevin introduced me to the concept. It’s had a profound effect on how I asses the current situation. Back in February on his blog The Contrarian Corner, Kevin channels his inner Robert Dugger in Paging Dr. House
"We continue to believe the diagnosis is wrong and thus output remains constrained. Structurally trapped economies exhibit similar symptoms but the vast majority of monetary easing is directed at debt support from the prior cycle and political 'reform' is timid and tilted toward inefficient industries. The primary beneficiaries of US stimulus were the banks and the auto industry. When the financial system absorbs the principle amount of CB ease, the structural trap calcifies in the political arena."
Boom! Forget the shutdown. With the debt ceiling we are about to hit the vortex of the structural trap. It’s like we are approaching the place where the structural trap, politics, and monetary policy all converge at zero. The economy, the government, and the central bank are all at maximum ineffectiveness. What is the endgame?
I think both Washington and market participants are being a bit too sanguine about the ramifications of a US Treasury default as we approach the precipice. It’s quite possible there is little market reaction to a default because participants realize that a coupon default does not mean we will see a principal default. However it’s also quite possible a default makes the Lehman bankruptcy look like a game of tiddlywinks.
A large contingency of Treasury owners don’t necessarily hold these securities for income. They hold them for collateral against other loans for other investments. The risk-free securities are ironclad collateral for leverage all around the world. There is a scenario that a default could wreak havoc in the repo market, which would ripple throughout asset market for which the repo market provides funding. If margins get called, assets get liquidated. Trying to determine were the necessary bid develops is unquantifiable. You could see asset price dislocation like never before.
You have been seeing hints of this phenomenon in the Treasury bill market where the 1-month T-bill that matures on 10/31/13 has inverted to the balance of the bill curve with 1 million bills trading as high as 18.5bps on Friday with 3 million bills trading at 2bps. This is not because investors fear getting paid their interest, it’s because they fear they aren’t going to be able to access the cash to pay off their loan. There is no liquidity in this market because of the uncertainty, so the need for cash is driving extreme volatility. The closer we get to D-Day (default day) the more this market will pucker up.
The Street’s primary dealers are coming off one of the most tumultuous quarters since the financial crisis, and trading numbers look grim. They will be in no mood to step up and provide liquidity if the market is freezing up. With enactment of Dodd-Frank, Congress decided that it would be a good idea to reduce the market-making capacity of broker dealers in attempt to reduce systemic risk. Now it has decided it might be a necessary evil to risk igniting the biggest liquidity event in history by reneging on the full faith and credit of the world reserve currency. This is a dangerous game to be playing with a highly leveraged bond market.
I don’t think Dugger or Ferry could have scripted a structurally trapped economy any better, and it does not appear the fiscal authorities have the will -- or for that matter. the intellectual wherewithal -- to do what it is necessary to get us out. Everything up until now has been in the opposite direction, and the implications are severe.
The only hope is through monetary policy, but we need the Fed to chart a different course. A structurally trapped economy is immune from quantitative easing and forward guidance, thus the current trajectory of monetary policy will continue to be ineffective. If that continues under a new regime, it portends a deflationary monetary morass for years to come.