He who sells what isn’t his’n, Must buy it back or go to Pris’n Congress

In the financial markets, the catch-phrase ‘He who sells what isn’t his’n, Must buy it back or go to Pris’n’ reminds the short-seller of the potential consequences of his actions – indeed, it keeps him in check. However, when it comes to ‘shorting money’ (i.e. taking on debt), different rules are deemed to apply. The adjusted catch-phrase seems to be rather more comforting; ‘He who sells what isn’t his’n, Must buy it back or go to Pris’n Congress’.

 

Cartoon - 'Go to Congress' instead of 'Go to Prison'

Click to enlarge.

 

Debt as a ‘Short on Money’:

 

Here at greshams-law.com, I often reiterate Richard Russell’s insight that ‘debt is a synthetic short on money’. When a market participant shorts – say – a stock, he borrows said stock, sells it for cash, and buys it back at a later date. If he has speculated well, then he keeps the difference between the sell price (i.e. the number of dollars he got for the stock at the start) and the buy price (i.e. the number of dollars he paid for the stock at the end), otherwise he pays the difference.

 

Likewise, when a market participant takes on debt, he borrows a quantity of money, ‘sells’ that money for something, and ‘buys it back’ at a later date. If he has speculated well, then he keeps the difference between the ‘sell price’ (i.e. the amount of things he got for the money at the start) and the ‘buy price’ (i.e. the amount of things he paid for the money at the end), otherwise he pays the difference.

 

How we got here:

 

Fractional-Reserve banks (i.e. all modern-day banks) essentially own things and owe central bank notes. That is, they take on liabilities where they promise to deliver central bank notes to the deposit owner at any time in the future. Naturally then, they do well when the burden of those redemption liabilities are low compared to their portfolio of assets (loans & bonds mainly). Conversely, they do badly when the burden of those redemption liabilities are high compared to their portfolio of assets.

 

When Paul Volcker hiked the federal funds rate to 20% in June 1980, real rates became so inviting that the fractional-reserve banking system became a metaphorical black hole for federal reserve notes. That is, fractional-reserve banks began a long-term trend of sucking in federal reserve notes and expanding their operations upon them. The momentum of this trend was fierce and so the burden of dollar redemption claims progressively fell for the fractional-reserve banking system. This gave rise to generally favorable business conditions during the 1980s and 1990s and the propensity for the private-sector to lever-up to the hilt.

 

US Real Fed Funds Rates Chart

Click to enlarge. Source: St Louis Fed.

 

The Private Sector’s Propensity to ‘Short Money’ Has Peaked Out:

 

Either in 2000 or in 2008, the ‘natural’ propensity for the private sector to take on debt peaked out. With the momentum gone, we’re left with a generational short squeeze in money in the West. However, as mentioned in the title and introduction, this is no ordinary short squeeze. According to the consensual mind, the usual catch-phrase ’He who sells what isn’t his’n, Must buy it back or go to Pris’n’ doesn’t apply here. Apparently, the ‘social consequences’ are just too unpalatable to allow markets to take their course. Hence, in comes the usual tool – government. By pursing the anti-profit (i.e. wasteful) practice of leveraging up, apparently everyone can be saved.

 

The Investment Implications of these Ideas:

 

Now, putting the moral standing of these actions aside, we should consider the implications of these actions. For when the government is vigorously levering up, the short squeeze in money can be alleviated. Just as with any normal short-squeeze in the futures markets, a large seller acts to ease the squeeze rather than exacerbate it. The same can be said on an economy-wide basis with respect to the private, public and external sectors (see sectoral balances on chart below).

 

Sectoral Balances in the US

Click to enlarge. Source: St Louis Fed.

 

So, the financial undertakings of governmental institutions are highly relevant for investors/speculators. During periods when the government (and its sub-institutions) are spending vigorously in excess of what they bring in, there may be opportunities in betting on a counter-trend bear-market rally. Conversely, when they slow-down their pump-priming, there may be opportunities in betting on a resumption of the general short-squeeze in money. I strongly believe that the best way to think about macro-trends is to think about the entire economy as a rigged futures market. In the usual fashion, one should be asking questions such as; who’s synthetically long dollars? Who’s synthetically short dollars? How do these parties interact with each other? However, upon arriving at one’s conclusions, one should ask; will that be deemed to be entirely unpalatable? What are the implications?

 

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Posted May 2, 2011