John Dizard Has the Right Idea

John Dizard is one of the few FT columnists we actually like to read (much of the paper’s editorial line consists of boring, if in our opinion dangerous, Keynesian shibboleths). Anyway, Mr. Dizard’s most recent column doesn’t disappoint. It contains what is known as “actionable advice” and is entitled “Embrace the contradictions of QE and sell all the good stuff”. It starts with a quote attributed to New York based short seller Ben Smith, reportedly uttered in the fall of 1929: “Sell ’em all! They’re not worth anything!”


the dog gets it

Bail-out or not, one way or another it’s eventually going to become a default …

Photo via


Here are a few excerpts from Mr. Dizard’s article:


“There are two ways for “real money” bond investors to deal with the shortage of high quality assets caused by quantitative easing. They can spend the next few quarters buying five year Bunds with negative yields, and then go home to curl up in a foetal position every night. Or they can look on the current market environment as the cheapest, most liquid offering of hedges against financial disaster they will ever see. I say, embrace the contradictions of quantitative easing, the restrictions on banks’ buying and selling securities, and every other way that regulators and politicians are insisting that risks be taken without taking any risk. The policy regime has now made it mathematically impossible for fiduciaries to meet the beneficiaries’ future needs through the prudent buying of securities.

This is most acutely the case in Europe. Pension obligations or annuity obligations should be discounted at something close to a risk free rate. But if the risk free rate is negative, then the obligations spiral upwards even when the pension sponsor or insurance company shovels in the plan contributions.

The good news is that the usual problem with “tail risk” hedges, the bleeding of money from the “negative carry” of paying out interest or dividends on borrowed securities, is now nearly nonexistent. In the case of Bunds, Swiss governments, and their close corporate cousins, the issuers, or the secondary markets, are paying you to bet against them.

So as Ben Smith allegedly said, “Sell ’em all”. Not the bad securities, such as high cost American oil companies with looming bond maturities. Those might be bought by energy majors in search of cheap reserves, and your short sale will have blown up.

You should be selling short the good stuff, such as those Bunds and near Bunds, the high end of investment grade European corporates, or even the nearer maturities of credit default swap indexes. Get whatever legal opinion you can to support the short selling of high quality corporate or government debt. Call it a hedge, certainly not a speculation. Perhaps you can use a total return swap underwritten by one of the too-big-to-fail American banks. Or a managed account with a hedge fund or a short selling ETF. In these market circumstances, short selling by prudent fiduciaries is not about cynical greed, but an attempt to preserve the beneficiaries’ capital.


(emphasis added)

Hallelujah! Clearly this is an idea the time of which has come. How often is one offered an opportunity to short bonds while getting paid for the privilege? Normally, never. Now however, a whole smorgasbord of bonds is begging to be shorted so you can actually – ha ha! – collect the negative carry, while waiting to get paid off at par. In other words, you’re in the position many governments now find themselves in, as several of them have actually begun to refinance themselves at negative rates (it has recently happened in Switzerland and Germany).

Some of these governments (not necessarily the two just named) are also in fiscally dubious situations, to put it mildly. If one is buying their paper at negative yields, one not only needs an even greater fool to take it off oneself before it matures to ever make a profit, one is in addition fully exposed to their default risk while having to pay for taking this risk to boot! This is obviously totally absurd and essentially a grave insult to thinking human beings everywhere.


Germany, 2 year yieldGermany’s 2 year note “yields” almost exactly minus 20 basis points. Say hello to the perfect short, via BigCharts – click to enlarge.


The Dog Might Get It

What can one say, except: “Sell ’em all!” They really aren’t worth anything! Note here that we are well aware that outright government defaults will always be the sole preserve of peripheral countries like Cyprus and (perhaps) Greece, while the bigger ones will be bailed out by the central bank’s printing press. The only problem is of course that this type of bailout has a strong tendency to eventually transmogrify into a default by another name, as eventually, the dog gets it. The dog would be the currency in this case.

As Mises wrote on this topic in Human Action (and we have little doubt he will turn out to be just as prescient about this as he was with his assertion that socialism would inevitably fail):


“The financial history of the last century shows a steady increase in the amount of public indebtedness. Nobody believes that the states will eternally drag the burden of these interest payments. It is obvious that sooner or later all these debts will be liquidated in some way or other, but certainly not by payment of interest and principal according to the terms of the contract.”


(emphasis added)


Imitating Anglo-Saxon Central Banking Socialism is a Really Bad Idea

Apart from the excellent piece of actionable advice on obtaining the cheapest hedge that has ever been on offer as a result of the incessant market manipulations of central banks, Mr. Dizard’s article also contains a memorable quote by a market observer/participant he has spoken to. We were sitting all alone in our office and literally laughing out loud when laying eyes on this (our neighbors already think we’re crazy, so no harm done):


“The advent of negative yields for the best European government or corporate issuers is usually reported in the media as some sort of curiosity, like a bright object in the night sky that seems to be getting bigger. What it really represents is the breakdown of the policy world’s response to the global financial crisis.

A large European bank’s credit strategist told me: “We have searched through the records, and asked the ECB how they think their (asset purchase strategy) will work, and there is no evidence they know the answer.

“From a cycle perspective, the time for the ECB to carry out QE was back when asset prices were too distorted and low. But credit spreads are already low. They are chasing investors into markets that will create a problem when markets normalize. It is just perverse.


(emphasis added)

Perverse is right. The sentence in the middle of the quote really bears repeating, because it confirms that our recent assertion that the lunatics are now evidently running the asylum, was not far off the mark: “We have searched through the records, and asked the ECB how they think their (asset purchase strategy) will work, and there is no evidence they know the answer.”

Well, duh. There is in fact zero evidence that any of the central planners know what they are doing – not only in this particular case, but generally. The reason why there is such a lack of evidence (or perhaps we should say, why there is in fact quite a bit of evidence that seems to indicate that it is a miracle they can find their own behinds) can be explained by economic theory. Central banks are are victims of a variety of the socialist calculation problem as it pertains to the financial sphere. As Jesus Huerta de Soto has put it (in Money, Bank Credit and Economic Cycles):


“Sooner or later the system will inevitably run up against the impossibility of socialist economic calculation, the theorem of which maintains it is impossible to coordinate any sphere of society, especially the financial sphere, via dictatorial mandates, given that the governing body (in this case the central bank) is incapable of obtaining the necessary and relevant information required to do so.”


De Soto – rightly in our opinion – has concluded that Hayek’s contributions to the socialist calculation debate are merely another side of the the Misesian coin (we should add here some Austrians from the “Mises-Rothbard line” actually believe otherwise).

Hayek’s contributions were partly the result of several very polite conversations, primarily conducted via economic journals, with the so-called “market socialists” Henry Dickinson and Oskar Lange between roughly 1933 and 1940. The market socialists followed the example set by Fred Taylor (who published “The Guidance of Production in a Socialist State” in 1928) and tried to solve the calculation problem mathematically as well as by letting the socialist bureaus “play market like children play war, railroad or school” as Mises would put it later – all under the assumption that (similar to Taylor’s approach) all the necessary information was available to the planners. Hayek inter alia mentioned at one point that the sheer number of equations needed to solve the problem mathematically would post an insurmountable obstacle even if the planners did indeed possess all the necessary information.

It was later thought that he had thereby conceded that in principle, the mathematical solution was feasible, if only it could actually be computed. But this clearly overlooks the “if” in the above sentence. Hayek never conceded that central planners could in fact ever hope to obtain all the necessary information. This is impossible, simply because much of the knowledge of the individuals who together comprise the market is local, personal and above all tacit. Tacit knowledge is the kind of knowledge individuals possess, but cannot even articulate themselves. Imagine a gifted painter if you will: he will never be able to communicate verbally what his talent and skill consists of in a manner that allows any Tom Dick and Harry to paint like he does after listening to his explications. The same applies to entrepreneurs, or any other market actors for that matter.

Moreover, although Hayek employed artificial equilibrium constructions in his theorizing about capital (there is little choice in the matter: the topic is so complex that one must first assume a situation that can never exist in real life, namely some sort of equilibrium like the evenly rotating economy), he did so while remaining fully aware that the market process is dynamic – a process of constant change. Therefore, there can be little doubt that he also rejected the assumption that a mathematical solution to the central planning problem would be “feasible in theory” if only the complexity of the computations could be mastered somehow.

Anyway, we don’t want to digress too much here. The main point is this: Central bankers are not as clueless as they evidently are because they are not sufficiently educated or intelligent, or not applying themselves to their task with the required zeal. The problem is rather that they are simply attempting to do something that is literally impossible. They cannot ever know what the “correct interest rate” or the “correct growth rate of the money supply” is that ensures smooth economic growth. It does not matter how many statistics they pore over, or how many DSGE models their staff economists produce, regardless of their complexity.

We could point to the fact that if they did know these things, there would obviously no longer be any booms and busts, but empirical data always leave the possibility of later falsification open. What we are saying is that this is actually not a matter of empirical evidence, no matter how much of it obviously exists. It is an inescapable logical conclusion that follows from what we know about the nature of knowledge, the market process and economic calculation. It is precisely as de Soto has formulated it above: “[…] it is impossible to coordinate any sphere of society, especially the financial sphere, via dictatorial mandates, given that the governing body (in this case the central bank) is incapable of obtaining the necessary and relevant information required to do so”.



Given the above, it is probably a good time to so to speak “fight the ECB”, especially as it has issued a completely free put option to short sellers as well! This put option consists of the “interest rate floor” the ECB has set for the eligibility of bonds for its “QE” program if they sport negative yields to maturity. So if one finds paper that currently yields close to minus 20 basis points, one is all set for a completely free ride. Probably not what they had in mind, but Mr. Dizard is correct; it is as close to a free lunch hedge as we will ever see (of course transaction costs must be considered as well).


Economic Calculation in the Socialist Commonwealth_Mises
The monograph by Ludwig von Mises that started the “socialist calculation debate” in 1920 (which curiously enough, was still raging up until recently – there is a new generation of “market socialists” up and about, still trying to prove the impossible …). We believe there can be little doubt that the theorem of the impossibility of economic calculation under socialism has a wider sphere of applicability than the very strict one discussed in Mises’ essay and that it applies to central banks as well.




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5 Responses to “Sell ’em All! Central Banks and the Socialist Calculation Problem”

  • charles 2:

    As “VB” said, unless you are Warren Buffet, you will probably have to post margin calls if the market goes against you, but assuming you are Warren Buffet, you are still not out of the woods :
    A) you have to put the money that you get from the sale somewhere, usually as a collateral to the party who lends you the bond. This counterparty can default, and in such case, you would have to give back the bond but the money is gone…
    B) There actually can be chains of counterparties, so if one links default, you get hosed.
    C) You can avoid this counterparty risk is to have a fiduciary deposit with the Central Bank (assuming you deal in a jurisdiction like Switzerland that allows it) , but then the Central Bank will charge you negative rates and spoil the arbitrage.
    D) You must borrow the bond you short on a long term basis : It is difficult to find a lender for such term, and if they do, the ask for a very high lending yield (during the 2008/2009 financial crisis, borrowing cost for Lehman/Barclays aggregate, one of the most liquid bond basket went over 1% per annum…). The other solution is to borrow the bond short term and roll over that borrowing, but then you can get cornered…

  • TheLege:

    VB: Bonds trading at a negative yield will be priced at a premium to par i.e. they will be trading at a price above that at which they will mature. Therefore, held to maturity, a short position must yield a profit (profit = premium to par – total coupons paid – transaction costs). The downside is capped by the fact that the ECB has set an explicit floor (-20bps) below which they will not buy paper therefore there is no reason for the price to be driven up beyond this (yield) floor.

    In other words, if you short paper at -20bps your only risk is that the ECB moves the goalposts (the floor) to more extreme levels but even then you would only have a paper loss for a short period. Held to maturity, profit is a sure thing.

  • VB:

    I am sorry, but I don’t get it. How is shorting 2-year Bunds a risk-free trade?! Clearly, the risk is that during the 2 years to maturity, they will be bid up even higher, and the yields will become even more negative, so it will be a losing trade. The market can remain irrational for much longer than you can remain solvent…

    • rodney:

      More question than answer: Is it possible that the market purchased the bunds well ahead of ECB QE, only to dump them on the central bank’s massive bid (which has just appeared in the scene this month)? That happened with The Bernank’s QE and each time treasury bonds sold off.

      If the same thing happens in Europe, then the timing for shorting bunds could be just spot on.

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