The Heart of the Economy

Great article

2009-12-03T17:47:00.000-08:00

Written by a fellow named Porter Stansberry at DailyWealth.com.

Strong and Weak Money

2009-12-03T17:43:00.000-08:00

Vietnam recently decided to depreciate their currency, the dong, by 5%, raising concerns throughout Asia about the possibility of competitive currency depreciations. Vietnam has a strong export sector, which is facing heavy competition from other Asian producers, including China and Thailand. If labor costs cannot go lower, if productivity cannot be raised, why not make Vietnam’s exports cheaper by simply making the dong worth less, meaning a dollar or Euro goes further than it did before.
The contradiction of Asia is that every country wants their currency to be strong and weak at the same time. Strong currencies are viewed as stable, and attract investment. Yet weak currencies allow the country to export goods that seem cheap in other countries.

How will China respond to this move? They might like to depreciate the Yuan, which has strengthened 17% against the dollar since 2002. After all, that would make their exports more competitive with Vietnam’s exports. China has been marked by a very slow and consistent approach to foreign exchange. There do not seem to be any sudden changes when it comes to policy about the value of the Yuan. It’s been assumed by most observers that the strategy is simply to capture the American market with low prices (which they know we can’t resist).

China’s goal may be far more ambitious: to create a new global reserve currency. Could the Chinese Yuan be a contender for that illustrious role? Such a possibility seems unfathomable. The natural contender to the dollar is clearly the Euro, the currency of the world’s largest trading economy, the Eurozone. After the Euro perhaps is the Yen. But China’s growth is far more vigorous than that of the Eurozone or Japan. Investors of all kinds want to get in on China’s growing markets, exchanging Euros or dollars for Yuan, which steadily pushes up the value of the Yuan. Since the Yuan is stable (and in fact, standing behind it is the largest currency reserve the world has ever seen), investors have faith it will keep its value.
What does China do with it’s growing foreign exchange surplus? It’s much more than they need to stabilize the Yuan’s value. They buy assets of real value: gold, copper, rare earth elements, stocks, real estate, and of course, government bonds, many of them US Treasurys. As long as China’s growth continues to be vigorous, the Chinese economy will draw in more and more outside capital. The lion’s share of the world’s Foreign Direct Investment is in the Eurozone, but utilized FDI in China has increased 10% a year since 1999, on average.

It’s unclear whether China’s goal can succeed. But they seem to be pursuing it with some vigor, and if they cannot be the world’s reserve currency, they can at least be part of a few key currencies, finally accepted as a great industrialized power. It seems increasingly clear that the US dollar will lose its spot on that list, particularly with the recent decision to commit even more troops to Afghanistan, which will add billions to the US fiscal hole.

A Very Interesting Animation: Empires Decline

2009-12-02T14:36:00.000-08:00

Look at this fascinating visualization of the decline of the great imperial powers of the 19th and 20th centuries. Who might be next, I wonder?

Visualizing empires decline from Pedro M Cruz on Vimeo.

Holiday Spending and the Fed

2009-11-30T14:38:00.000-08:00

The veil of illusion that says the dollar has value is being torn away.

Last week’s “Saturday Night Live” had an actor playing President Obama giving a press conference with an actor playing China’s President Hu Jintao, who repeatedly reminded Obama that the US owes China a lot of money. At one point, Hu asks, “Do I look like Mrs. Obama?”, answering the question soon after with: “Then why you try to make sex with me like I was Mrs. Obama!”

Some things can be said in a joke that can’t be said with a straight face.

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Imagine telling someone back in 1989 that in twenty years China would be the world’s emerging power, and the US would be running to China to ask for more money to plug its enormous deficits, while reassuring China that its money is secure, and politely asking China to respect copyright rules and ensure free internet access (which China will politely ignore).

So where will we be in twenty years from now? The dollar will be discredited, a shell of its previous value, no longer a reserve asset. The world will want currencies backed with real assets, not fiat paper which can be printed at will with the touch of a keystroke.

In the US, anger is rising about the massive financial bailouts engineered by the Fed and the Treasury, which so far have not caused any reduction in unemployment or real economic stimulus. Perhaps this sentiment is why Rep. Ron Paul’s amendment to audit the Fed has passed a vote in committee and is gathering support in both houses of Congress. In a surprise move, Rep Barney Frank delayed a vote on the bill until after the Thanksgiving recess.

Why does the Fed oppose being audited so vociferously? Bernanke says he doesn’t want the Fed to be too influenced by short-term politics, but it’s hard to see how the current veil of secrecy prevents politics from entering into the Fed’s deliberations. The country ought to know what the Fed is doing (or was doing, as the bill calls for the release of information only with a 6 month lag).

Early reports on Black Friday, the largest single shopping day in the US, indicate a very small increase in spending over last year of 0.5%. Strangely enough, articles on Black Friday never seem to adjust sales figures for inflation. Given that the CPI rose 0.5% in the last two months, it’s more accurate to say that spending is flat or declining in real terms. We’ll have more details on the numbers in a few days, but the trend toward more frugal spending is still in force. Even if an increase is recorded, we have to keep in mind that retailers are offering massive discounts, which may pull sales to Black Friday at the expense of other days. We’d also do well to recall what products are being discounted: mostly electronics, which are rarely produced in the US. Increases in retail spending on imported goods puts the US economy in a deeper hole. We need to come to balance, and that won’t happen because of an unsustainable surge in retail spending, but rather will be due to growth in the productive sectors of the economy.

What Exactly Would a Stronger Yuan Do for the US Economy?

2009-11-19T14:44:00.000-08:00

Obama’s trip to China was mostly photo-ops and talk about the importance of trade. The one topic on which Obama spoke sharply was the need for China to allow the Yuan (officially called the Renmimbi) to strengthen against the dollar. Many analysts are criticizing the Chinese government for ‘manipulating’ the Yuan, keeping it too low relative to other Asian currencies. Paul Krugman, perhaps the best-known economist in the US, calls it ‘outrageous’, and accuses China of making its export-oriented neighbors poorer through unfair currency manipulation. Leaving aside the obvious point that all currencies are manipulated—in a world of fiat currencies, no item of intrinsic value stands behind the dollar or the Yuan—let’s explore the question of how the US might benefit from an strengthening of the Yuan.

Back in 2005, the World Bank estimated the Yuan to be undervalued by 10%, based on purchasing power parity. Other economic analyses have concluded an undervaluation of 20 to 25%. Let’s take the upper end of the these estimates and assume the Yuan is undervalued by 25%, and that China, acting for the good of the world, allows the Yuan to appreciate 25% against the dollar. What would that do for the US economy?

The most obvious and immediate effect would be an increase in prices. Consumer price theory tells us that that increases in exogenous costs such as tariffs are not fully reflected in final prices, but the cost is shared by producer and consumer depending on the elasticity of demand. The increase in prices directly translates into increased prices for consumer goods, for apparel, electronic goods, raw materials, food items, etc. It’s hard to see how that rise in prices would benefit American households, who are feeling the effects of 10.2% unemployment and falling home prices. It’s more likely that increased consumer prices would bring significant hardship.

In theory, an appreciation of the Yuan should narrow the trade deficit between the US and China. But it’s likely that the trade deficit won’t fall much (if at all), because consumers driven by low prices are likely to select goods from other low cost producers (Thailand, South Korea, the Phillipines, or India, for example).

Would an appreciation of the Yuan cause an increase in American employment? It’s hard to see how. There aren’t many US industries that are in direct price competition with Chinese exporters. Overall, the US economy is in a process of shifting back toward productive activity (including manufacturing), but such a shift is the product of many structural economic forces, not simply the relative value of the Yuan and the dollar.

As Obama urged China to allow the Yuan appreciate, Zhou Xiaochuan, the head of China’s central bank, fired back that the US needs to get its fiscal deficits under control and raise interest rates. Zhou is clearly correct that currency manipulation (in whatever direction) cannot help the US economy out of its malaise. Only fundamental economic changes can do that. But cutting the deficit in this economy will require massive spending cuts, while raising interest rates will cut off the monetary stimulus, no doubt deepening the recession.

If only it were as easy as blaming China.

Cash-for-clunkers, Dollars-for-dishwashers, and Other Government Consumption Stimulus Ideas

2009-11-12T12:41:00.000-08:00

The news of the week is rising auto sales in the US, stimulated by the Federal program called ‘cash-for-clunkers’ where you trade in fuel-inefficient car for a more efficient one, and get thousands of dollars from the government. The program has been such a ‘success’ that it has made lawmakers think of other possible ways to stimulate consumer spending, such as the dollars-for-dishwashers program, which gives $300 mil in federal rebates for new appliance purchases. Of course, a larger version of this same theme is the new-home purchase credit. All these efforts are attempts to stimulate consumer spending, and all go in exactly the wrong direction.

Why should we be trying to stimulate consumption? We ought to be attempting to stimulate saving and investment, for these are the keys to long-term prosperity. Perhaps the most pernicious economic fallacy is revealed in the oft-repeated phrase: ‘consumption spending is the driver of the economy’. Before one can consume, one must produce. The best way to stimulate production would be to allow market competition to determine interest rates, and to eschew the pro-cyclical tendencies and distortions of fractional reserve banking. During the Panic of 2008, money destruction took place even as the Fed cut interest rates, because banks restricted their lending faster than the Fed created liquidity.

Banks had good reason to restrict lending; they were over-exposed to bad loans, their balance sheets crammed with assets of dubious value. Bank reserves shot from $44 bil to $800 bil in a year, going from less than 1% of deposits to over 10%. At the same time, lending fell (although there was massive borrowing from the Fed by banks to increase their reserves).

All parties in the economy, from the government, to corporations, to households, must reduce their debt, or ‘de-leverage’. Consumers see the wisdom in this, recognizing the frailty of their situation when they live paycheck-to-paycheck, without any cushion of savings, while debts steadily mount. The government cannot reverse the process of de-leveraging. When it tries, it loses credibility. We still remember the spectacle of Fed chairman Alan Greenspan urging consumers to take on adjustable rate mortgages. The best that can be done is to allow de-leveraging to proceed swiftly. And let’s look on the bright side; while many businesses will fail, most will survive, and they will be stronger for it, because the market, given time, rewards prudence at the same time as it punishes foolish risks.

Gold Prices Continue to Climb

2009-11-12T09:50:00.000-08:00

So far in 2009, the S&P 500 is up 21%, while gold is up nearly 25%. Gold and stocks have been moving in tandem for much of the year, an unusual situation, to say the least.

The rising stock market has been one of the few bright spots of the economy. While it’s difficult to say what causes short-term movements in stock prices, the year’s increases in the stock market is probably not connected to the performance of the economy, actual or perceived.

I say this because the rally has not been driven by outside events. At the low of the market, in March 9, 2009, the sentiment was bleak. Analysts who had previously been known as solid bulls began to say, “the sky is falling!” News since then has been solidly bad, with continuing job losses, rising unemployment, trade deficits, budget deficits, and a rising disillusionment with the Obama Administration. Now sentiment has reversed; everywhere the talk is of green shoots and growth; all experts agree: the recession is over. They point to the performance of the stock market and the recent rise in GDP (mostly driven by debt-funded government consumption).

It seems more likely that the rally is a correction of the long slide in stock prices that took the Dow down 7500 points over a period of about 17 months. The nature of markets is action and reaction, movement followed by countervailing movement. The stock rally of 2009 is simply a long counter-movement, where the market recoups a portion of its losses. The general rule to look for is a counter-movement of 50%, though it may be as large as 75%. The former has basically been achieved. That means extreme caution is warranted about future market moves. Indeed, it seems to me that the sentiment has become so uniformly bullish that the only possibility is a sharp downward movement, even an eventual violation of the lows of March 2009. This possibility is not driven by sentiment alone, but by the fundamentals of a weak economy coupled with the multiple threats to the dollar’s reserve currency status.

Right now it seems unthinkable to nearly all observers that the dollar could be displaced. That alone should give us pause. The last two years have been a time when most observers have been disastrously wrong. Most did not foresee the crash of October 2008. Most did not foresee the rapid downturn of February 2009, nor the rally that began in March. Early in 2009, when oil prices dove to below $40, most analysts predicted they would stay there; instead, they doubled within the year, in the face of worsening economic deterioration.

Yet India’s purchase of 200 tonnes of gold from the IMF at near-record prices shows that nations are increasingly distrustful of the dollar. Individual investors should take note.

Where are all the posts?

2009-11-12T09:47:00.000-08:00

Well, my writing activity has really fallen off over the last few months. But I have been writing for the Borsen-Kourier, just not posting it on the blog. I know, very lazy... so what I'm going to do is go backwards, and post the articles I've written over the last couple of months on the day I wrote them. (I won't make any changes to make myself look more prescient!)

US GDP Swings to Growth

2009-11-05T09:53:00.000-08:00

For the first time during this recession, US GDP is registering solid growth of 3.5% for Q3 of 2009.

Declining businesses inventories played a large role, but much of the growth was caused by increases in consumption spending: 40% of the increase in consumption was cars, driven by the cash-for-clunkers program, and another big slice was new home construction, driven by the $8,000 first time home buyer credit.

Those of us who were skeptical about these Federal programs to prop up consumption, may now be shown the rising GDP numbers as proof that these kind of government actions work. Well, yes, they work. But at what cost, and for how long? When the government borrows in order to give money to home buyers and car buyers, not only is that a dubious redistribution of resources, it causes a distortion in prices and in perceived demand. It causes sales from the future to happen in the present, inflating both automakers’ view of demand for cars and homebuilders’ view of demand for new homes.

It’s painfully obvious that the government cannot keep borrowing in order to funnel money toward consumption. When it ceases to do so, growth will fall, perhaps to negative territory.

Federal spending was up sharply, though state and local spending fell, due to declining revenues. States have a budget constraint that the Federal government doesn’t have.

Though the weakness in the dollar pushed up exports by 14.7%, imports increased by 16.4%, underscoring Americans’ addiction to low-priced foreign goods. The tendency to buy imports is true for cars as well as clothing and electronics: an often-overlooked feature of cash-for-clunkers was the fact that people often bought Hondas and Toyotas, which helps to stimulate Japan’s economy more than the US (with the exception of those Hondas and Toyotas produced in the US).

The Obama Administration claims the $160 billion that has been spent (of the $787 billion stimulus bill) has created or saved 640,329 jobs. Do the math: that’s $249,000 per job. That seems a bit expensive to me. For that price, we could’ve given 3.2 million Americans $50,000. Of course, the number of jobs ‘created or saved’ is already a bit dubious. Could it be that the government agencies who received stimulus funds had an incentive to say more jobs were ‘saved’ then actually was the case, to secure future stimulus funding? The Bureau of Labor Statistics doesn’t have a category for jobs saved, but it does have a category for net job creation, which has been massively negative for nearly 2 years, adding up to a total number of jobs lost of over 7.2 million. Given that the Bush administration also did a stimulus of $170 bil in Feb 2008, if $330 bil gives us only 640,329 jobs, how much would have to be spent to give us 7.2 million jobs? The answer is a staggering $3.6 trillion.

The reality is that the massive stimulus efforts have produced only small numbers of jobs, which have been swamped by the restructuring occurring throughout the economy. But such restructuring is necessary and unavoidable, and should be allowed to happen quickly rather than being dragged out through massive government consumption schemes.

Downsizing and Consolidation

2009-10-28T10:59:00.000-07:00

The American household continues the path of downsizing and consolidation. Electricity usage, which hardly ever declines, has fallen 2.3% in the US since August 2008, reflecting mostly the decrease in industrial output.

Rents have been dropping, as vacancy rates rise. This is perhaps an odd finding: shouldn’t the tightening of credit mean fewer people can buy homes, channeling more demand into the rental market? Similarly, shouldn’t rising foreclosures push more people into the rental market? It seems that these forces were overwhelmed by the drop in household income caused by the recession, and the resultant tendency to live more frugally.

Some condo developers expected the baby boomer generation to consolidate and move to smaller spaces in urban centers as they retired, but because home prices fell, they haven’t really done so. They can’t sell their homes at the price they think the homes are worth. There hasn’t been a movement away from suburbs en masse (in fact, there isn’t much moving at all: moving rates are the lowest they’ve been since 1948, when the Census Bureau began tracking them) though the preference for smaller homes seems to be increasing over the last 2 years. But that is probably a counter-reaction to the excesses of enormous McMansions, with their costly heating and electricity bills.

One hot trend is the tiny home. Several home builders are bucking the trend and moving toward very small homes. Often modular or mounted on trailers, tiny homes are less than 300 sq ft. People are going small for financial reasons, but also because of concerns over the environment and the impact of consumption. Large homes seem to engender large collections of things.

How does all this saving and decreased consumption affect the economy?

Keynes called it ‘the paradox of thrift’. Though saving is good for individuals, it can be bad for society, because it moves society to an equilibrium of lower spending, which Keynes considered the driver of economic growth. Here is where I part ways with Mr Keynes. Investment is the driver of economic growth, not spending, and higher rates of savings allow us to achieve higher rates of investment. But that won’t happen until businesses clean up their balance sheets and eliminate debt. That process will require some inefficient and overleveraged firms to enter bankruptcy. The sooner they do so, the quicker they can emerge and the sooner the economy can recover.

Individuals are curtailing their spending because that seems the smart thing to do, given the circumstances. My guess is that we’ll find a silver lining in this, for even though consumption is likely to grow more slowly in the coming years, we may be taking a path that is more sustainable.

The 'Soft Budget Constraint' Hardens

2009-10-21T11:01:00.000-07:00

The fate of the US empire depends on access to debt and the ability to service the existing debt burden at low rates. We could’ve chosen a different path. During the 2000 election, Al Gore spoke of paying down the entire public debt. Perhaps things may have gone a different way in the absence of the Bush/Cheney bloodless coup of 2000.

But now we seem to be committed to sky-high deficits, despite recent talk of health care being ‘deficit neutral’ and plans for reducing the deficit. Even the tough talk hints at the reality: we speak of reducing the deficit, not eliminating it, not running a surplus, not reducing the total debt outstanding. The only thing that qualifies as a plan is to increase the debt at a slightly slower rate than the economy expands, so that the debt burden becomes smaller in relative terms, while growing in absolute terms. The economist James K. Galbraith calls it a ‘soft budget constraint’. But how long can it remain soft?

The Fed has poured money into the US Treasury market, a practice called ‘monetizing debt’; this has made Treasury yields fall across the board. That makes the debt easier to service, but if taken too far, it makes US Treasurys unattractive relative to other investment-grade debt.

Fed chair Ben Bernanke criticizes China for having a ‘savings glut’. While they have been spending more, he warns them, don’t save too much! America, with the exception of government, is not following his advice. Americans have gone from being like the fabled grasshopper who fiddles all day long to the ant who works and saves. (If only finding steady work was that easy. There are now six job seekers for every available job.) A new culture of frugality is spreading to every corner of American society. Americans are planting vegetable gardens, learning to preserve food by home canning, even raising chickens. (Not that the average American is doing all this, but things spread from the leading edge to the center) Fashion designers are bringing out new looks inspired by the 1930s, as designers and artists embrace the new ‘rough luxe’ aesthetic, elevating old, vintage, weathered, used objects.

There is a lot of talk about recovery, but state unemployment figures for September indicate that payroll unemployment declined in 43 states. Pressure is beginning to mount on the Fed to raise rates. A recent Barron’s cover story argues that the Fed should raise the interbank lending rate from 0% to 2%. If the Fed does raise rates, we’ll see how strong the recovery truly is. If that rate increase takes place while states continue to trim spending, residential foreclosures continue to escalate, followed by increases in commercial foreclosures, that looks like the making of the return of the credit crunch of 2008, and the double-dip recession of 2010.

War and Peace

2009-10-14T11:05:00.000-07:00

Obama’s surprise Nobel peace prize has caused a reality rift in the US; On the right, Peggy Noonan writes that the Nobel peace prize has always been “an award by liberals for liberals”. She can’t believe Reagan didn’t get one. Yeah, Reagan. The guy who called the Soviet Union “the evil empire” and pushed for the star wars program to militarize space. Bret Stephens wants to give one to Harry Truman. You know, the guy who killed 300,000 civilians by dropping the bomb on Hiroshima and Nagasaki. No serious historian puts forth the claim that this barbarous act was necessary to get Japan to surrender. On the left, Howard Zinn asks, how can you give a Nobel peace prize to a man who’s continued two disastrous wars?

Meanwhile, Australia’s central bank has reversed the course of slashing rates to raise their overnight loan rate by a quarter point. Glenn Stevens, Australia’s chief central banker, warns of the danger of being ‘too timid’ in raising rates. Australia, it seems, wants to avoid the pitfall of being the world’s carry trade sop. Could that award be coming the US? If so, the strategy of borrowing in dollars, then dumping them to buy stocks or bonds in other currencies will weigh on the dollar’s value. The dollar hit a 14-month low recently.

US Fed chief Bernanke and Treasury Secretary Geithner talk of wanting to maintain a ‘strong dollar’ but actions speak louder than words. It seems more plausible that what is wanted is a steadily weakening dollar, which will make the government’s large and escalating debt easier to pay.

The average worker is likely to see continued pain from such a strategy, as wages continue to fall. Colorado has decreased its minimum wage, as their standard is tied to the CPI, and deflation slightly reduced the CPI last year, mostly due to falling oil prices. However, the weaker dollar places pressure on import prices, such as the prices of goods at Wal-mart and other low-cost retailers relied upon by the lowest-paid workers in the US. During a recession, prices and wages tend to fall, but not necessarily by the same amount. However, certain prices are rising again. Oil is now at $75, and gold is over $1060. We could easily see the worst of both worlds, stagnating economy combined with inflation.

The Fed has injected trillions of dollars of money into the economy, in a bid to prevent deflation. But all that money has to go somewhere; so far it seems to have gone into the stock market, and commodities like copper, oil, and gold. It’s hard to believe that the Fed could reverse course anytime soon and start raising rates like Australia. Imagine what a rate increase would do to the still-weak economy. Without one, the dollar will continue to slide.

Maybe the Nobel peace prize should be given to the economy. As the dollar loses value, the US will find it difficult to finance the imperial adventures in Iraq and Afghanistan; at least, that is my hope, though it hasn’t happened yet.

Greed vs Fear

2009-10-07T12:27:00.000-07:00

Treasuries and gold are fear investments. Investors have bid up the price of 10-year Treasury bonds, driving down the yield to 3.178%. Fear. Gold has just hit a new high, $1038. More fear. Stocks are a greed investment, and stocks are looking tired, moving sideways after a 7 month rally. As the rally has continued, volume has seen a mild but steady decline.

If Wall Street is torn between greed and fear, what about Main Street? Unemployment continues to rise, hitting 9.8% as of last month. The economy seems to be continuing to shed jobs, albeit at a slower pace. Incomes are falling, as is the average workweek. More are working part-time when they’d like to have full time jobs. The housing market continues to decline, offering a benefit for some Americans: falling rents. Thousands of condos that cannot be sold, and thousands of homes that were bought by speculators who don’t want to sell at current prices but need cash to pay the mortgage hit the rental market, have pushed rents steadily downward. In addition, people are consolidating, doing with less.

People are even borrowing less. Total consumer credit has declined by 3.6% during this recession. Comparable declines haven’t been seen since 1991. Even with those declines, the consumer remains heavily mired in debt, so it seems reasonable to expect it will take consumers some time to lower their debt levels, as seems to be their preference. Many consumers are saying now that they wouldn’t return to their ‘spend now, pay later’ ways.

Corporations are facing the shock of billions of dollars of worthless assets clogging their balance sheets, or, even worse, these toxic assets are not on the balance sheet, because they are not being valued honestly. New accounting rules have allowed corporations more flexibility in their amortization of gains and losses, i.e., less transparency for investors, meaning more risk. Corporations have been hollowed out by two decades of mergers, acquisitions, restructurings, layoffs, and re-brandings. The CEO and upper management—facing little opposition from the Board of Directors, shareholders, workers, or other stakeholders—have looted the corporation. New models of leadership will be needed for corporations to move forward. I expect the wild executive compensation of the boom years will swiftly fade away.

Meanwhile the various levels of government struggle with massive revenue shortfalls and budget deficits. Most states are cutting spending and raising taxes. The former is good during a recession, the latter, disastrous. Many are following California’s example, turning toward debt to put off their budget problems. In the face of all this, the Federal government considers a health plan that will fine people who don’t have health insurance, and we debate over whether to call this a new tax or not.

In the battle between greed and fear, there is no contest. Indeed, I’ll believe in the recovery when I see some genuine signs that greed has returned.

Price Levels

2009-10-01T12:30:00.000-07:00

Everyone’s attention seems to be focused on whether we’ll see deflation or inflation in the US economy (and in the global economy) as we move forward.

On the deflation side, we have the moribund housing market, falling or stagnant consumer spending, along with falling incomes and rising unemployment, and on the inflation side we have truly massive money creation led by the Fed, followed by the Treasury, and finally by the Federal government in the form of federal stimulus packages, all on borrowed money.

Which of these two forces will prove to be more powerful?

I live in San Francisco, one of the more expensive urban centers in the country. In my neighborhood, I see flyers posted that say “One Hour Massage, $40”. It caught my attention because I think that price is half to a third the price you would have paid two years ago. Basic economics: if goods and services won’t sell at a given price, then the price will fall.

The bond market may provide us with a clue, as bond investors are highly concerned about inflation. The yield on the bellwether 10-yr US Treasury bond has been dropping rapidly. Since mid August, the yield has fallen from 3.8% to close below 3.2%. This may mean that bond investors are taking a stand on deflation, but it may also mean that investors see the rally in the stock market ending soon, and they’re getting back into Treasuries for a safe haven. The surge in gold prices to close above $1,000 for six days seems to lend support to the safe haven thesis, but it also could support the inflation thesis.

Oil and copper are also important signals to the strength of the global economy. Both seem indecisive after strong gains this year. The same can be said for the CRB commodities index, which is up 25% from its low this year, recorded back in March.

Given all this indecision, we may see a bifurcation, with certain commodities and services rising while others fall. We await, with bated breath, the next round of economic developments. The latest labor market data indicate that the US economy shed 263,000 jobs last month, for a total of about 7.2 million jobs lost so far during this recession. That is a truly stunning number, made all the more serious when one considers that the economy must create 150,000 jobs or so each month in order to simply keep pace with population growth.

Ambivalence on Health Care

2009-09-23T12:31:00.000-07:00

My wife and I had to take our baby girl to the emergency room because she had a high fever, some diarrhea, and we worried she’d get dehydrated. We were there a few hours, during which time she was checked on several times by very conscientious doctors, who spent a total of maybe 30 minutes of total person-hours on her care. The bill? Over $10,000. We have health insurance through my job, but we continue to get seemingly-random requests for co-payment. Every few months it seems they want another $50.

In places like Japan, Canada, and much of Europe, it is thought to be rather curious that Americans have such resistance to universal health insurance coverage. This incident provides a clue as to why it is so. For those lucky enough to have health insurance, the outcome we observe seems pointlessly mediocre. This is the land of customer service. Yet most experiences with health care delivery tend to involve long lines, ample doses of frustration, Byzantine rules and regulations, and a complete lack of alternatives. I thought markets were about free choices and clear prices. Asking how much a medical procedure costs is itself an exercise in futility. It depends on your coverage, because different deals have been made with different parties. Health insurance seems to have wrought a system that is complex and delivers rather poor overall results. There are over 100,000 deaths in American hospitals per year due to infections contracted in those hospitals; experts estimate two-thirds of those deaths could be wiped out by instituting simple procedures involving hygiene, such as hand-washing.

Unbelievable. Can you imagine any other business that is not affected by thousands of needless deaths? If one restaurant has an outbreak of E coli, it gets shut down. But not for hospitals.

I’m not an expert in health care. But it seems to me that the health insurance system effectively shields the industry from the competition in price and quality that every other business faces, to the detriment of consumers, and indeed, to all of us, because the care we get is overpriced and of poor quality. While many helpful people work in health care, people who genuinely care about helping people, the overall experience tends to be poor. When we were in the emergency room, were taken to an uncomfortable, poorly heated, poorly lit facility with little privacy. Nearby are several drug addicts in various stages of overdose. We would much prefer to see a doctor, as our situation is hardly a complex medical issue, just a simple matter that could be handled by a general practitioner, even a nurse, and an IV. But it’s pretty hard to see a doctor on the weekend, so one is left with the ER.

Where this all leaves me personally is with the same ambivalent attitude toward health insurance that I think is shared by many other Americans. I’m very thankful that the system is there for me if I were to have a truly catastrophic accident. But in almost every interaction I’ve had with it, I’ve been left with the feeling that there’s got to be a better way. While I don’t know exactly what that way is, it seems clear that the insurance system that we have isn’t working very well, even for those that have good insurance plans. So while I support Obama’s plan, and indeed it seems to be the outcome of a thoughtful analysis by a person who cares deeply about the country, I doubt that it will give us high-quality health care at an affordable price.

Stimulus Blues

2009-09-17T12:36:00.000-07:00

I recently had the opportunity to take an unoffical poll of my economist colleagues a the City College of San Francisco, where I teach. One of the areas of very strong agreement was that the US dollar is the most serious risk to the US economy (there was one dissenter out of six economists). The other area of agreement was that the US needs another stimulus, on the order of $500 billion. Here, I was the lone dissenter. (Several of my colleagues didn’t feel another stimulus was politically feasible; I don’t think another stimulus is desirable economically.)

My colleagues are in good company; Paul Krugman, the 2008 Nobel prize-winner in economics has called for a second stimulus, as has Robert Reich and many others. A majority of economists were in favor of the first stimulus, though there were also some prominent dissenters. I think the views of economists tend to mesh with the conventional wisdom that the government has to do something.

The problem is that doing something is rarely a good substitute for doing the right thing.

Economics has largely scrapped the distinction between necessary and surplus value; necessary value is the portion of value that reproduces the capital and labor that went into producing a good or service, while surplus value is the additional value of the product above the cost of production. Without this key distinction, it becomes impossible to distinguish between economic activities which are productive (directly produce surplus value) and unproductive (those that do not); we’re left with only GDP numbers, without a notion of where the value flows came from.

To try to increase GDP without considering whether we’re increasing productive or unproductive economic activity is dangerous in an economy like the US, where unproductive activity has been steadily rising over the last 60 years. This rise has been financed by growing debt and capital inflows to the US economy, but as these flows slow, unproductive activity becomes less and less viable. To put it simply, the future of the US economy is in agriculture and manufacturing, not in finance, retail, or advertising. While there will always be a place for finance and other unproductive activities in the economy, it must be recalled that government is also an unproductive activity. As government spending increases, it absorbs a greater portion of the economy’s total surplus, at the very moment when that surplus is most needed to restructure, innovate, and re-invest. That is a recipe for a lingering malaise, such as what Japan experienced in the 1990s.

This is the time for government to cut back, do less and spend less, to balance the budget, and to trim taxes. In short, the government should take the advice given to a man in a small pond, thrashing about in an effort to make the muddy water clear:

Be still; it will happen best on its own.

The IMF Unravels the Global Monetary Order

2009-09-09T12:39:00.000-07:00

On August 28^th, the International Monetary Fund quietly made history.

The IMF was a product of the Bretton Woods summit of economists that created the post-war global monetary order of the same name. The IMF was envisioned as a global central bank, that would act as a lender of last resort to countries facing balance-of-payments crises. The IMF has traditionally lent by raising funds among the wealthy nations, but in 1969 it created a special kind of currency, called the Special Drawing Right. SDRs aren’t used as a means of payment anywhere in the world; SDRs are used as an accounting device between countries for international settlements. Perhaps SDRs were created in the hope that one day the IMF may be able to issue its own fiat currency, a step toward a global ‘super-currency’. If so, that day has arrived.

The IMF announced on August 28^th that it would create $283 bil worth of SDRs, and distribute them to member countries. I know of no other instance of fiat currency being issued by a non-governmental organization that has no economy behind it. Countries can exchange their SDRs for one of the four hard currencies that underlie the SDR’s value (the US dollar, the pound sterling, the euro, and the yen). The US will receive one-sixth of the new SDRs, worth about $47 bil. Small change next to the magnitude of the deficits, but every billion helps.

What’s the game here? The US desperately needs to fill the hole caused by continuing trade and budget deficits and is increasingly sensitive to the criticism (made by many world leaders and central bankers) that it plans to do so by printing dollars. Could this be a sneaky move where the US receives the benefit of free money but sticks the IMF with the bill? It won’t work, of course, as global markets will simply respond by increasing prices. Increasing the money supply without increasing the supply of goods will always create inflation.

The global recession was caused by reckless money creation, which inflated the value of assets from stocks to commodities to real estate, while encouraging astounding degrees of leverage. The financial house of cards was simply not built to last, and pumping more fake money into the deflating credit bubble won’t work. Debt leverage isn’t available like it was in the past, and even if it were, a more important illusion has been punctured, namely that all this risk was essentially free. Risk always comes with a price tag, and the sooner that price is accurate, the better for the global economy.

Important Article on the Global Monetary Order

2009-09-03T10:46:00.000-07:00

Take a minute and read this important article by Paul Nathan on the changing role of the IMF's fake currency, the SDR, or special drawing rights.

I'll have more to say on this article shortly.

Is Inflation Coming Soon?

2009-08-27T17:28:00.000-07:00

Most economists will tell you that there’s a tradeoff between inflation and unemployment (called the Phillips Curve), making it unlikely that a high unemployment economy generates unemployment. Well, expect to see the unlikely happen soon.

Here’s a chart of monthly inflation, as measured by the Consumer Price Index, since 2007:

The Federal Reserve is waging war against deflation, funnelling trillions of new dollars into the financial system in an attempt to defeat deflation.

The Fed will win; in fact, they’re already winning. Inflation has simply been channeled into the stock market. Oil has doubled in price. Gold has recovered from its low of the fall of 2008, when it dipped below $700, and is currently pushing $950. These are early signs of inflation.

An interesting feature of the CPI is that it’s not designed to measure changes in the cost of living. It’s designed to provide a measure of how much money it takes to maintain a constant level of satisfaction. That means the Bureau of Labor Statistics must do a very difficult thing: instead of merely measuring prices, they must measure our satisfaction. They do this by imputing value to technological changes, and by using sophisticated averaging techniques which attempt to measure how consumers make substitutions between products in response to price changes. The outcome of this fancy guessing-game is the most widely-quoted measure of inflation in the US, but CPI has little to do with what most think the CPI measures.

My guess is that we’re already seeing the kind of inflation that the Fed so fears: consumer price inflation. Prices ought to fall during a recession, and some have. But I think prices have not fallen as much as they should, given the extreme weakness in consumer demand. If the effect of money creation is the prevention of falling prices, that’s inflation, it just doesn’t look like it when we look at the CPI.

It’s clear that the Federal government would prefer inflation to deflation. With the ten-year deficit now officially projected to add $9 tril to the public debt (which would bring it above $20 tril), some inflation sure makes the interest easier to pay in depreciated dollars. I wonder if the American consumer will go along for this ride. Sure, inflation will probably kill your real wages, but it can also zap the value of your debts. Perhaps the average American won’t complain too much if inflation begins to roar. Much depends of what happens to the unemployment numbers as we move forward.

Unemployment in the US

2009-08-23T17:31:00.000-07:00

I’ve got a friend who has been unemployed for a year. She has a PhD in archaeology, and experience in both non-profit and for-profit organizations. A graduate degree tends to insulate one against unemployment; for many years the rate of unemployment for those with master’s degrees and higher was less than a third that of the rate for those with only a high school education. But this recession doesn’t spare the educated. Though the disparity between unemployment rates by educational attainment is still large, the recession has narrowed it.

California’s unemployment rate is pushing 12%. Michigan’s is 15%. (They were 7.3% and 8.3% a year ago). Unemployment rates have skyrocketed in the last year, and though this month’s national rate shows a slight improvement (9.5% to 9.4%), these numbers are still eye-popping.

An interesting feature of the numbers is that the labor force participation rates are also declining for all levels of education, as those who cannot find work become discouraged, or move to another activity, such as school, caregiving, or work in the informal economy. The Bureau of Labor Statistics’ U-6 unemployment rate attempts to capture the effect of people moving out of the labor force (or moving to part-time employment when they’d prefer full-time); the U-6 stands at 16.8%.

And these numbers have been getting steadily worse (or holding more or less steady) since the beginning of 2009. Even the BLS’s narrowest measure, called U-1, those unemployed 15 weeks or longer, is at a frightening 5.1%. That’s truly unreal. Over 5% of the labor force has been unemployed 3¹/₂ months or more. In the face of this, the stock market has rallied 45%.

Why should unemployment be so high? It’s a grave sign that the economy has become sclerosed, and cannot quickly adjust the forces of supply and demand. This is the Great Contraction: you lose your job, you must cut expenses, more people per square foot of real estate, fewer hours spent on leisure. This is still the richest country in the world, with 90% of Americans still working. For the labor market to clear, wage rates would have to fall, and with them, so would the housing market, (both prices and rents would be relentlessly beaten down until they reached a proper proportion to household incomes). Many other prices would also fall. All those overpriced services will cost an awful lot less: think of haircuts, dog walkers, personal shoppers, personal assistants. These services and more will be driven down in price by falling demand and price competition on the supply side, as those remaining in these fields attempt to keep a portion of their sales.

What I’m saying has become anathema to the field of economics, yet it’s a simple truth: falling prices can be healthy for the economy. Yet we’re spending trillions to try to keep inflated prices high. If we simply stay out of the way, markets will clear and prices will find their natural level. Then a truly robust recovery can and will begin.

Economic Medicine and Poison, part 1

2009-08-11T18:30:00.001-07:00

The most helpful thing we could possibly do for the economic corpus is to create a sound currency that is linked to a stable banking system.

Right now we have neither, and so we have risks to the economy that are simply unknown. A risk that you don't know is always worse than one you can understand. Will your bank be around tomorrow? This is no longer an idle question.

Creating a stable currency would not be hard. It's a simple matter of pricing, and there is nothing that markets do better than pricing, when they are allowed to function without interference. Take an item of real value, one that cannot be produced by the printing press. Let's say, I don't know, how about the gold standard of money?

Gold has been used as money for 5000 years or more. Let's say we go back to using gold as money. You want to sell something. OK, how many grams of gold would you accept to part with it? You want to buy something. How many grams would you give up to obtain it?

The thing is, we're used to using dollars as our standard. We think, "how many dollars is that worth?", not "how many grams?" Like visitors in another country, we'll be running the numbers through our heads, converting to dollars. At least for a while. Pretty soon we'll get the hang of it.

If we get rid of the risky fractional reserve system (perhaps following this great plan by Kotlikoff and Leamer), then we have the absolute best basis for economic prosperity. Systematic inflation becomes impossible. And deflation has no power to wreak economic havoc. Deflation becomes your friend, because deflation is simply falling prices. We only associate deflation with the end of the world because deflation has typically occurred only at the end of a credit bubble, as the harbinger of deep recession, bringing with it financial panic and high unemployment.

The problem is how the stable currency would interact with the dollar. The dollar decays like a radioactive isotope. A stable currency operating in parallel with the dollar would instantly reveal what a poor currency the dollar really is. Fewer assets would be held in dollars, and fewer transactions would be made in dollars. Both would cause a reduction in the demand for dollars, and a depreciation in the value of the dollar. Perhaps that would be viewed as an "attack" on the dollar. It's not an attack to remove lipstick from a pig. (My apologies to Mrs. Palin.)

The dollar is worth about what the paper it's printed on is worth, and to put it next to a commodity with real value simply reveals that truth.

What Will It Take to Pay Off the Federal Debt of the US?

2009-08-07T17:34:00.000-07:00

The US is awash in debt on every level: Federal, state, local, as well as households and businesses. But for the private part of the economy, there is a different consequence for bankruptcy than for the public side. If a private individual or business goes under and fails to pay their bills, the creditors lose money, of course. But when a government goes under, it tends to go under in a way that inevitably affects everyone, for it devalues the currency.

Of course no government destroys its own currency with malice aforethought, but the pressures that come to bear on governments are such that destroying the currency seems at the time to be the right thing to do, given other options. Circumstances are already headed in that direction now, and pressure on the dollar continues to build in the face of rapidly expanding Federal debt.

The current Federal debt is $11,659 bil, and with the stimulus and other unfunded expansions in Federal spending, it’s widely believed to expand by at least another $1,800 bil in the next year alone, and to nearly double in ten years. It’s an open question as to how the Federal government expects to get the funding for that level of debt, as our foreign creditors are already reducing their purchases and seeking to ‘diversify’ their assets. China is inking trade agreements with Brazil and Argentina to conduct trade in the Renmimbi rather than in dollars. China is also channeling more of its massive currency hoard into durable commodities like copper, gold, and oil. Every day it seems, the discussion of the status of the dollar becomes a bit more open, a bit more honest, as countries seem to feel increasingly free to point out that the dollar’s days as the reserve currency of the world are numbered. Dollar-denominated Treasury debt is like a game of musical chairs: in the end, not everyone will get a seat.

In the past, the US has relied on economic growth to reduce its debt. Is that possible now? Total Federal government revenue was $2,554 bil in 2008. Let’s say that average rates of US growth resume immediately (3% per year) and continue indefinitely. Say that Federal revenue increases at the same pace. Say we immediately run surpluses, so that we can pay the interest on the debt plus an additional 1% of Federal revenue to pay the principle. (In 2008, that combination would cost $451 bil in interest plus $25 bil in principle, instead of the $458 bil deficit that actually occurred). Even with these rosy assumptions, it would take about 90 years to pay back the debt. Ninety years of solid economic growth and perfectly balanced budgets (plus the 1% surplus). No government on earth has such a record. (This analysis doesn’t include all the unseen obligations the US government has, such as Social security and Medicare, which add up to trillions more).

It seems likely that at some point, the United States’ largest creditors will demand repayment in some other form than dollars. Perhaps they would demand payment in their own currency, but that seems unlikely. The traditional asset for international settlements is gold, so gold is the most likely candidate, especially given that our two largest creditors, China and Japan, have relatively low gold reserves, while the US has the largest gold hoard in the world.

Let’s consider what would happen if the debt would have to be paid off in gold. According to the US Treasury (www.fms.treas.gov), the US government is in possession of 261,498,899 Troy ounces (8,133 tonnes) of gold, which at a gold price of $964, is worth $252 bil. The US gold stock is unaudited, and since it is also routinely leased to other parties, how much of it is owned free and clear by the government is unclear. The way that gold is leased is through a kind of repurchase agreement called a gold swap, which gives the US Treasury cash in exchange for a firm commitment to buy back the gold at a specified point in the future. For example, Goldman Sachs may give the US Treasury $1 bil today, using the gold as collateral, to receive $1.05 bil in one year, whereupon the gold reverts to the Treasury’s possession, though the gold has never left the vault. While 5% isn’t a great return, I’d say that Goldman can use the contract as an asset, since it’s backed by gold and the full faith of the US Treasury, which allows Goldman to obtain a risk-free return on the $1 bil, and still put the money to work in other ways to obtain returns.

The Gold Anti-Trust Action Committee (GATA) has estimated that the total amount of gold that is leased through gold swaps is between 12,000 and 15,000 tonnes, about half the total of all gold held by central banks. Individual nations don’t publish the extent of their gold swaps, but let’s say that half of the US Treasury’s gold has been leased, meaning that the gold is no longer an asset, but rather an obligation. If the Treasury really owns just half the gold in its possession, then it has about 131 mil Troy ounces of gold, worth $126 bil.

Now let’s imagine that a few of the large holders of US Treasury debt were to demand that the debt be repaid in gold rather than in dollars. The US Treasury holds its gold at a book value of $42.222 per Troy ounce, rather far below market prices. (If only one could buy a few ounces at that price!) Say that China and Japan (which own $1,477 bil) demand repayment in gold. Of course, these countries wouldn’t be so unreasonable as to ask for all the money all at once; let’s say they simply stop buying new debt, and ask for the interest on the debt outstanding to be paid in gold. If any large buyers were to stop or even slow their buying, yields would rise. Let’s say the yield rises only to the historical mean of about 6.5% (an event like this would probably push the yield far higher). At that yield, the interest would come to $96 bil a year, which would quickly drain the US Treasury’s entire gold stock. In fact, it would be gone in less than 18 months. If China and Japan started asking for gold, other countries would no doubt follow, as would large domestic holders, both institutional and individual. If the entire interest bill had to be paid in gold, it would come to $63 bil per month, and the Treasury would be out of gold in two months.

Now if there are no new buyers for Treasury debt, either the Federal government must immediately balance the budget, which seems unlikely, to put it mildly. More likely the Fed will step in and buy the debt directly, with money it conjures out of thin air. This leads to further depreciation of the dollar against gold, and would probably lead to a lot more demands for payment in gold, as creditors realize that their dollars will get less gold than before.

So we can’t grow our way out, and we can’t fall back on gold. The only other possible avenue is to depreciate the dollar. But how much depreciation would it take to reach the equilibrium that markets demand? If the situation arises where gold is sought for repayment rather than dollars, the question is, at what price? The US government will have give up the accounting fiction that the gold is worth $42.22 an ounce, and set an exchange rate between the dollar and gold. The rate chosen will not be below the market price, it will be well above the market price. How high is anyone’s guess—I’ll say $10,000 an ounce just to get the guessing started. This option allows the US to service its debt without the humiliation of an outright default, though it will still probably result in chaos, just as it did when the US last tried it, in 1933. It also creates a de facto gold standard. With gold at $10,000, the Treasury’s gold is worth $1,310 bil, and can now be used to pay the interest on the debt!

Where things go next is hard to foresee. But it’s clear that the debt is far too large to pay off, and that the United States’ creditors will demand payment in an asset that the US government can’t depreciate at will. The signal to investors is pretty clear: get out of Treasury debt and into gold. One way or another, the US will repudiate its debt. The other lesson is equally clear: the inevitable depreciation of the dollar simply follows the logic of the market, and cannot be denied by either money creation or fiscal stimulus.

The Rally Continues!

2009-08-06T15:27:00.001-07:00

Well, I went on vacation and that market made a fool out of me while my back was turned!

Far from the rally running out of steam, as I predicted (here and here) the rally merely paused, then continued steeply upward, revitalizing the talk of recovery and green shoots.

Gold has gone back to tracking the market, and has also done well, as has oil. This makes me wonder if the surging stock market isn't really an early sign of inflation. This is what can happen in financial markets - they act as a canary in a coal mine, sending off inflationary signals well before consumer prices are affected. But these signals are hard to read. We generally think a rising market is good, and it carries us along in a bullish daze. Even my phrase "done well" to indicate "rising price" is a sign of the positive spin we put on it.

But I wonder what the market is up to. All that money the Fed created has to go somewhere. A lot of money is still on the sidelines, waiting to get back in. Barron's asked recently, should you get in or get out? Could this be the time that the Dow chooses to get back above 10k, even claim 11k?

I do not believe that the worst is over. The economic restructuring that is inevitable has barely begun. But a rising market has a way of making us all feel better. The sooner we face the need to restore the balance between productive and unproductive labor, the better. We need to shake out the debt, and we need a sound currency under the dollar, which is sadly and hideously overvalued.

This Ain't Your Grandma's Statistics!

2009-08-06T15:19:00.001-07:00

An interesting article in the NY Times about career opportunities in statistics. Getting a doctorate in stats can bag you a starting job pulling down $125k. Statisticians are the new rock stars at Google and Yahoo.

Getting to the Source of Systemic Risk

2009-07-09T17:41:00.000-07:00

Recent articles on the US and world economic crisis have often been focused on the concept of ‘systemic risk’. For example, Robert Pozen, author of Too Big to Save?, argues in The Wall Street Journal (7/9/09) that the Federal Reserve ought to be given the job of monitoring systemic risk. What this refers to is certain kinds of financial ‘products’ and practices that have often graced the headlines of late: credit default swaps, collateralized debt obligations, and other kinds of credit derivatives.

The idea that the financial crisis has been caused by exotic new financial instruments—from credit derivatives to adjustable rate mortgages—has become part of the conventional wisdom. But is it true?

No doubt there is always a tendency to find fault in new practices that seem to be responsible for disasters, such as humbling the titans of finance with billions of dollars of losses, charmingly called ‘write-downs’. But how does that lead to systemic risk? If a large corporation (financial or otherwise) loses billions or even hundreds of billions, how does that threaten the system as a whole? Well, corporations often owe money to other corporations, and perhaps if a large lender goes under, other firms are placed at risk. That does indeed sound bad. But how is it different from the usual course of events? Companies rise and fall. Taking risks can lead to success or failure. When an idea leads to a failure, that strategy tends to be repeated less than those that are successful. A failure, even a large one, poses no threat to the system. Failures are an integral part of the system. Even the largest corporations are subject to market forces. And thank goodness for that. Big corporations must be exquisitely sensitive to quality and reputation, or else they are at risk of losing market share and potential takeover.

In the same way that nature rewards certain kinds of risks and penalizes others—successful strategies lead to greater propagation of a species—an evolutionary market-based process is the best enforcer of risk. The Fed or any regulator will always be 10 steps behind. Even if the government regulator happens to be on time, what should the penalty be? Will such penalties be subject to political forces—such as those that determined that Lehman should fail while Bear Stearns or AIG is rescued?

The nature of markets is the equalization of risk and return. Risky activities ought to have high returns, while less risky activities yield lower returns. Financial markets are filled with risky products that are hundreds of years old. Short-selling (the practice of borrowing shares in order to buy them back later, hopefully at a lower price) exposes the seller to potentially unlimited risk. Out of-the-money options that are close to expiration are also extremely risky. But these options are priced accordingly, not by government regulators, but by the market.

Yet even when markets are functioning well, it’s true there is a systemic risk lurking. At any moment, banks could collapse, for their reserves are only a tiny fraction of their deposits. Any threat to the banking sector sets off a damaging spiral: bank failure leads to bank runs, leading to loss of faith in banks, leading to further contraction in lending and paralyzing the conduit that runs from savings to investment.

This is why economists Kotlikoff and Leamer argue for a new financial architecture, one that does away with this source of systemic risk once and for all, while channelling society’s savings into investment, and providing prices for financial assets that correctly equalize risk and return. (See “A Banking System We Can Trust”, Forbes, 4/23/09). Their brilliant proposal would essentially to do away with the fractional reserve system. Unfortunately, this proposal has received little attention or discussion in the US. I get the sense we’re sick of the topic here. We’d rather believe in the green shoots that are supposedly sprouting. They say ‘less bad’ is the new ‘good’. My guess is that as the rally fades and new risks to the system are revealed, there will be an surge of interest in reforming the fractional reserve banking system, the source of systemic risk to the economy.

Gold Correction

2009-06-18T13:46:00.000-07:00

Gold is one of the few assets in the world which is in a primary bull market, meaning that the asset is rising overall, despite periods of downward movement. We're in one such period now, which is going to act as a brake on all gold-related assets, including mining stocks like Seabridge Gold SA which I've recommended.

I still think the stock is a long term win, but I must say that it's likely it will go into correction mode (in fact, it already has fallen $6 or so from its recent peak, a 20% decline). Those with a short-term frame may think about selling, even at a loss, in order to get back at a lower price.

Since I expect the overall market to begin another period of decline, I like a stock that will move inversely to the market, like DXD. (Remember, DXD is for short-term trading only; it has mathematical characteristics that make it a poor long-term investment.)

I suppose I now have to break my 10 grand bit into two groups: long term and short term. Long term, stay with Seabridge, even though you're down right now. It'll come back. Short term, take the loss and move into DXD while you wait for SA to bottom out.

Cheap Gas

2009-06-17T13:01:00.001-07:00

Detroit!

Stop tempting us with your cool new muscle cars, like the new Camaro, which gets 22 mpg (on a completely flat road, driving the speed limit, which I'm sure I will be with a 304 horsepower engine).

What with the fall in gas prices and all, the Camaro is destroying the Honda Insight in the sales department.

I guess the thinking behind the muscle car resurgence is, wouldn't it be nice to go back to a simpler time, when all that mattered was how many horses you had under the hood?

It just doesn't seem like the best move, to stake the fate of the American car industry on denial.

Deflation

2009-06-17T07:10:00.000-07:00

The Bureau of Labor Statistics released the Consumer Price Index yesterday, which shows a very small monthly increase since April (0.1%), but the story that's grabbing the headlines is the 12-month drop in prices, or deflation, to the tune of negative 1.3%.

It's a bait and switch story. What number do we emphasize? The scary number, about the deflationary monster? Or perhaps the core inflation number, which excludes food and energy, and shows a 12-month increase of 1.8%? Only two categories in the CPI fell: transportation and energy. Both are tied to the fall in oil and gas prices. Every other category increased.

What does this tell us?

Expect inflation, not deflation to prevail in the coming months.

Ah, Krugman!

2009-06-16T21:09:00.000-07:00

To sum up: A few months ago the U.S. economy was in danger of falling into depression. Aggressive monetary policy and deficit spending have, for the time being, averted that danger. And suddenly critics are demanding that we call the whole thing off, and revert to business as usual.

The above is a quote from the marvelous Paul Krugman. I love him; and yet, he's so wrong right now.

Let's be clear: aggressive monetary and fiscal policy have not averted any danger to the economy. The danger is not inflation, nor is it deflation. The danger is economic distortions. That is, massive investment in unproductive economic activity (retail, advertising, finance, etc.). This kind of economic activity does not produce anything, and hence it is the major threat to the economy.

Why are there economic distortions? Why should it be the case that the market, which often gets things right, ought to be disastrously wrong? What causes the distortions is the massive inflation of the money supply. That may lead to inflation or it may even lead to stable prices, even deflation for a time. It all depends on how the extra dollars are used. If they are saved, no inflation in consumer prices. If dollars are spent elsewhere in the world, no inflation (at least in the US). If those extra dollars are spent in the US, expect to see some inflation.

Rising or falling prices is not the danger. The danger is that there is a prolonged period of confusion: what are my assets worth? Is my business viable? Should I start this business? What is the market saying?

If the answers to these questions are unusually obscure for a long period of time, the result will be stagnation, low growth, and unemployment. This is the danger. And it's in full bloom now. More aggressive monetary and fiscal policy will worsen the situation, not make it better.

Stocks Fall

2009-06-15T10:20:00.000-07:00

The Dow has, as of this moment, taken a big hit. It feels like the rally is over.

I expect that there may be an upward movement tomorrow, but I think the rally is basically out of steam.

Seabridge took a big hit today, falling to $25. I expect it will go up to $29, but then follow the market down. I think gold may have a big day tomorrow, as a new wave of fear washes investors out of stocks and into the safety of gold.

I'm going to try to sell SA at or around $29, and get into DXD at or around $45.

Arthur Laffer on Inflation

2009-06-10T18:44:00.000-07:00

Arthur Laffer created the Laffer Curve, a rather dubious piece of economic theory that entered the economic canon without ever passing through the peer-review cycle.

He has a rather good piece on inflation and monetary expansion in the Opinion section of the Wall Street Journal.

His argument is that the monetary base has increased dramatically, and that this should result in inflation. Since I've been saying the same for some time, I like the argument.

As Gold Continues to Slide, Treasuries Crater, World Openly Debates the Fate of the Dollar

2009-06-08T15:50:00.001-07:00

{I wrote this on 6/8, but didn't get around to publishing it until 6/11, which was after the WSJ wrote a cover story on the rising 10-year Treasury!]

The yield on the 10-year US Treasury note is up to 3.88%, [now it's gone up to 3.93%, then slid back to 3.86% today] as prices for the note continue to crater. (Recall that as bond prices fall, yields rise) The battle continues. Since this yield is tied to so many other interest rates, the hazard is that the rising yield will soon become higher interest rates for mortgages, car loans, credit cards, etc. The bigger problem perhaps is, are there borrowers?

It's an economic distortion that interest rates should fall when the economy moves into recession and credit tightens after being loose for so long. What's being revealed is that the risk of default is much, much higher than was previously thought. Naturally, interest rates should rise to compensate for the increased risk. But instead, the Fed tries to go against the market and lower interest rates.

The Keynesian logic is straightforward: because credit is tending to tighten, money destruction ensues through the action of the fractional reserve banking system. However, that destruction of money results in far less aggregate demand. The solution: create money through the central bank (the Fed) equal or greater to the money destruction, lowering interest rates, encouraging firms and consumers to borrow, and stimulating the economy when it most needs it.

Unfortunately, what this Keynesian story overlooks is that the economy has a hangover. The best cure isn't a couple of (trillion) shots of booze, it's a reorganization, a re-thinking of priorities and activities.

The economy has binged on unproductive economic activity: a frenzy of finance, retail, advertising, lawyering and lawmaking. Corporations have turned their attention away from productive investment (the kind that is designed to produce better things) and toward unproductive investment, designed to capture an ever-larger piece of the economic surplus. But since efforts to capture a bigger piece of pie don't actually grow the pie, only so much of US capitalism can be engaged in such endeavors.

Meanwhile, the International Monetary Fund, seeking to retain some kind of relevance, jumps in to say that the world could potentially use a different reserve currency than the US dollar. Of course, their solution is the bogus Standard Drawing Right, administered by an impartial, international central banking organization. I wonder who that would be. Of course, they call for "liquidity", a silly central banking code word which means "fake money". It's obvious that the IMF does not have in mind the creation of a currency backed by an item of real tangible value, such as gold. After all, Keynes called gold a "barbarous relic".

Of course the IMF thinks we're years away from such a "revolutionary" move. Only slowly can we change the global monetary order.

Right.

The world has a way of changing faster than you think. The dollar is already dead. Each country in the world is simply trying to figure out how to edge away from the dollar's corpse before every other country in the world does so. Gold has tripled in price since the year 2000. The technology of producing gold hasn't changed much.

The world faces a choice: either we descend into a morass of distrust, reversing the tide of globalization, retreating behind border walls and tariffs, or we create a new global monetary order that no country, no individual, no corporation can game. That order simply must be based on an item of real value, that no government can manipulate, that holds its value over time, that cannot be destroyed through the printing press. We need the gold standard of money. What could that be?

I'll Be Off For the Rest of the Week

2009-06-03T21:20:00.000-07:00

Treasuries are up today, pushing the yield back down to 3.55%. Still too high. With the ten year US Treasury note at that yield, a lot of other interest rates are going to be higher. Still a lot of volatility in this market; today's swing was 2.55%. A lot of movement for any market in one day.

How can the Fed possibly re-inflate this impossibly flaccid credit bubble with high rates?

Commodities took a pause; gold is back under $970, oil retrenched to $66, copper's down to $2.22. A bit of backfilling is in order. I wonder when the next big move up will happen. Next week?

Meanwhile, banks are doing their best to resist honesty and transparency. Here's a piece about their off-balance sheet assets. Isn't it a bit absurd that a corporation would have off-balance sheet assets? What possible rationale could there be for keeping an asset off the books besides lying about its true value?

I'll be traveling for the rest of the week. Have a great weekend!

Ferguson vs Krugman

2009-06-03T21:13:00.000-07:00

Historian Niall Ferguson takes Paul Krugman to task in a recent Financial Times piece.

Ferguson is right of course, that the debt load of the US is onerous and that our creditors are starting to wonder if we'll ever pay it back.

While Ferguson is correct that we have not entered a repeat of the Great Depression yet, I think he lays a bit too much emphasis on that fact. Yes, we're not there. Yet. The big difference, of course, is the status of the dollar as the world's reserve currency. That will change, and as it does, a series of painful adjustments will take place in the US.

GM Bankruptcy...

2009-06-02T11:18:00.000-07:00

(The picture is of Alfred P. Sloan, the man who created GM as a consolidation of several smaller automakers)

I feel I have to say something about the GM bankruptcy, simply because the story is dominating the news: WSJ, NY Times, USA Today.

Frankly, the story bores me. It's full of wailing and gnashing of teeth, sound and fury, signifying nothing.

Why should I care that GM is going bankrupt? Is it simply because it's a venerable corporation? That doesn't do it for me. A corporation (or any institution) doesn't deserve to continue just because its been around for a while.

In an earlier era, the economist Joseph Schumpeter called capitalism "creative destruction". Like living organisms, corporations are born, they flourish, they fail, they die. When they fail or die, the corporate body (redundant, I know, because both words mean the same thing) becomes food for other economic agents: other corporations, individuals, institutions.

It is only our tendency to cling to the past that makes us think it is somehow wrong that a big corporation should go bankrupt. It's not wrong, merely part of the artificial garden of capitalism. People say, what about the workers? What about the jobs that will be lost?

It's better to clear out an institution that is not functioning, so that new jobs can be created. Americans will still buy cars. So other producers will buy GM's plants and equipment, hiring some of the workers, while others will find new jobs doing other things.

Change is hard. Some people may have to leave the communities they know to find work elsewhere, or they may need to start new businesses, or accumulate new skills. But this change is the cornerstone of the economy. To resist it, to go against it, to prop up these companies and others like GM that made disastrous errors during the boom years, is wasteful, inefficient, and rewards incompetence instead of productivity.

Treasuries Crumple... Again!

2009-06-01T16:34:00.000-07:00

Crash... recover... crash.

The price of the bellwether 10-year US Treasury note cratered Thursday, recovered Friday, and now has crumpled again, sending the yield skyrocketing to close at 3.715%.

This is exciting stuff. It's like a pitched battle is being waged over Treasury notes. The yield is like the front line. Meanwhile, the kings of the commodities (oil, copper, gold, silver) are all up sharply. Oil is above $68, gold is above $975, silver is above $15.60 and copper has shot up to $2.30. (Check out NYMEX for a good source on all these commodity prices.)

Remember, this may be a harbinger of higher interest rates, signaling a loss of confidence in the dollar, which would mean the Fed would have a very hard time using monetary policy to stimulate the economy.

What will happen is that interest rates will rise as investors edge away from the dollar and US treasury debt. That will deepen the recession. (Why do I say recession instead of depression? Habit, I guess. There is no technical distinction in economics. There is a joke (sort of): a recession is when your neighbor loses his job. A depression is when you lose yours.) The best strategy for dollar depreciation is investing in hard assets with no debt or leverage whatsoever.

Geneen Roth Interview

2009-06-01T16:11:00.000-07:00

Geneen Roth, author of When Food Is Love (and many other books), and a friend of the family, has a podcast of interview she gave after losing nearly everything to the Bernie Madoff fraud. She also has a nice piece in the Huffington Post on the same topic.

It's very touching to me how mature, responsible, yet real are her reactions to losing so much money. The same goes for my mom and my stepdad, my stepmom, and so many of the people I know who lost all or nearly all.

A Funny Madoff Video

2009-06-01T07:44:00.000-07:00

This video is by a family friend, Matt Weinstein, who, together with his wife Geneen Roth, is part of the circle of family friends that includes my family that invested with Madoff and lost everything. (I wrote about it in an earlier post)

Now Treasuries Recover!

2009-06-01T07:43:00.000-07:00

This is getting exciting.

After a massive sell-off that sent the yield on the bellwether 10-year Treasury note skyrocketing to an intraday high of 3.75%, investors snapped up the debt Friday, sending the yield back down to close at 3.465%. That is one wild ride.

Remember that the Fed would like to see the yield below 3%. A rapid increase in the yield is the market's way of rejecting the Fed's monetary stimulus.

It's interesting that the market had such a rapid snap-back. No doubt some investors were seeking bargains. Was one of those investors the Fed?

The dollar is coming apart. Was this a warning shot or the beginning of the final conflict?

Stay tuned...

Krugman: Don't Worry About Inflation

2009-05-29T16:06:00.000-07:00

Paul Krugman is at it again. (Here's a picture of him with former President Bush)

This time, he reassures us of two ideas: 1) all that money the Fed is creating won't push up prices, and 2) the US would never default on its debt obligations by inflating away the debt.

So, for Krugman's first assertion, while he is correct that the contraction in bank lending has counteracted the increase in money created by the Fed, it flies in the face of logic to think that the Fed can create trillions of dollars out of nothing and that this will have zero effect on prices. Doesn't it seem more likely that certain prices are being prevented from falling to their equilibrium level by the Fed's monetary mischief, thus distorting the price mechanism?

See, the thing is, the US is approaching this psychological level, where the debt of the Federal government approaches 100% of GDP. This is only important because people often fail to see that the two can't be compared directly - GDP is a flow, like your yearly income, and debt is a stock, like the value of your stock portfolio (except in reverse!). So just as a person who makes $50,000 a year could owe $75,000, so it is possible that the US debt exceeds GDP, and nothing really changes from debt being 90% of GDP to debt being 100% or more. However, GDP is a good reference point for understanding the level of debt, because it shows our capability for paying back the debt, and also gives us a yardstick which adjusts for changes in the price level and economic growth.

Now there's this thing called denial. When a lot of people say "you don't need to worry about that," they're often saying, "I get why you're worried about that - you should be". Krugman's denial of inflation is similar to his denial of debt default. There's no way the US would default on its debt, he shouts. No way in hell!

In other words, it's extremely likely. All signs point toward default: escalation in borrowing, continued current account deficits, falling dollar, rising yields.

Paul Krugman, I salute you. You're a great economist. You've made important contributions to the theory of international trade. You were right about the war in Iraq. But you're wrong on this: the US will default on its debt, and the method we'll choose is inflation. I'd suppose you have 5 or 10 years before you have to admit your mistake.

I'll be waiting!

The Rise of Oil and Gold Is An Early Sign of Inflation

2009-05-29T10:42:00.000-07:00

(This filthy-looking pool of oil is from the Exxon Valdez oil spill)

The Federal Reserve must be happy now; they're doing their job: fighting deflation by creating money out of thin air.

The oil price is over $65 now, and gold is over $978. This is an early sign of inflation. We're in an odd situation economically; certain items are in deflationary mode. Deals are

everywhere on housing, furniture, cars, appliances, clothing, travel. These are items that consumers are cutting back on.

Since oil and gold are investment commodities, they are seeing appreciation now because of fears of inflation and the desire to protect assets. A good way to get exposure to the oil price easily is through the oil ETF USO. (This is good for long-term exposure; USO doesn't always track short-term movements in oil prices accurately, because it is the target of arbitrage)

What about the ethics of investing in oil? My dad won't touch it; he says it's a dirty business. Similar concerns have been raised about gold, which is produced by crushing tons of rock into a fine powder, then using acid to dissolve the metal, a process that uses copious amounts of energy.

Each person's ethics come from within. For me, I don't rule out profits from oil or gold, because it doesn't seem helpful to me to say I won't invest in something but I will use other products. I own a car, I own electronics, I have gold in my teeth. If I touch it as a consumer, I'll touch it as an investor, where at least there is an opportunity to make a profit. These things have to be decided on a case-by-case basis. Every corporation is guilty of something, as is every individual.

As Treasuries Swoon and the Dollar Falls, Gold Advances

2009-05-29T07:10:00.000-07:00

Gold has been on a tear the last few days, taking back its role as the bomb shelter of financial assets. During the tail end of the boom years (2006-2008) gold began to move in tandem with stocks. The market would be up, and so would gold. That was unusual.

Now gold is back to moving inversely to markets. As I wrote yesterday, US Treasuries are falling, causing yields to rise. (Check out ^TNX) As I write this, the market is experiencing a bounce as it absorbs the activity of the last few days. The dollar is also falling, and has breached the psychologically important 80 level.

Seabridge Gold (SA) is now up to $30.66. If you bought Seabridge Gold back when I said, your money would've grown to $11,927 by now. I see SA going to $40, so hold on to what you've got. I also own Exeter Resource Corp (XRA). Exeter is a small-cap gold mining company from Canada, which is home to many such mining companies. Many of these are unsound, and will get shaken down by the movements of the gold price, but Exeter is one that will remain, I think, as they have very low levels of debt and they seem to have a solid business plan.

It's a good idea to have some GLD, the exchange traded fund that holds gold bullion, as well as some SLV, and some physical gold and silver in your possession. Another good way to invest in gold is through Goldmoney.com.

Treasuries Crumple!

2009-05-28T08:00:00.000-07:00

The price of the bellwether 10-year US Treasury note cratered yesterday, sending the yield skyrocketing.

This chart (^TNX) shows the yield of the 10 year US Treasury note. (As the price of a bond falls, the yield rises)

Look at the pattern of the last few days. The yield is up rather sharply. Keep in mind that this 10 year Treasury yield drives a lot of other interest rates, including mortgages. People often think that it's the Fed that controls interest rates. Not really. The Fed influences interest rates, and has been struggling to influence the yield on the 10 year US Treasury note, but the Fed is only one player in a big and very complex game. Sure, the Fed is one of the few players that can (semi) credibly print money at will, which is what they do when they want to push the 10 year Treasury yield down. They print money, then spend it buying Treasuries, which pushes prices up and yields down.

The Fed is losing a massive, behind-the-scenes battle. The Fed must keep this yield under control. But it must do it quietly. If investors get to thinking the Fed is the only buyer of Treasuries, they will sell, sending the price down even further. Also, it looks as though foreign central banks, which hold a lot of US Treasury debt, are starting to quietly edge toward the exit, and see the Fed's buying sprees as a good opportunity to sell off some of their holdings. The more money the Fed creates to manipulate markets, the more precarious becomes the state of the dollar, because it becomes more and more obvious that the plan is to inflate away the debt.

About the size of this market: check out the Treasury direct website. The total US Federal government debt is about $11.3 trillion. The US stock market, by comparison, is about $9.3 tril, as measured by the Wilshire 5000.

If money really begins to flee the US Treasury market, where will it go? Keep in mind that when someone sells a US Treasury note, they are paid in dollars. If the idea is to avoid the depreciation of the dollar, then the money must go into another currency or asset that is outside the ability of the Fed to depreciate. The obvious candidate is gold, but I expect we'll see continued movement into the Euro (note that the Euro is up strongly against the dollar recently, which tells us that many investors don't buy the rally. If the worst was over, why would the dollar be falling against the Euro?)

Interview with Robert Prechter

2009-05-28T07:17:00.000-07:00

Here's a video from Feb 2008 with legendary investment advisor Robert Prechter, author of Conquer the Crash and founder of Elliot Wave International. His company uses a variety of data, but his training is in psychology, and you see the influence. He looks a great deal at how people feel on an unconscious level; he calls the approach Socionomics.

Barron's has a nice interview with Prechter in which he argues that we're entering a long-term recession with deflationary tendencies. He sees further declines in the stock market, based on the fact that P/E ratios have not fallen enough to mark a bottom. Optimism is also high.

I agree with his analysis in general, though I think the Fed will win the battle against deflation by creating trillions of dollars of new money, as they have been. So far the Fed has avoided all but a slight amount of deflation. Prices over the last year have been flat overall, despite large decreases in the price of housing.

My Family Was Madoff-ed

2009-05-27T08:00:00.000-07:00

Investing with Bernie Madoff was, for the most part, a family tradition. By now nearly everyone knows that he was running a massive Ponzi scheme, paying out investors "returns" of 12% a year from the money coming in from new investors.

My step-mom, Saphira Linden, my dad's third ex-wife, had been investing with Madoff since the late 1980s. She believed in the fund and Madoff himself so strongly that she urged me to invest in it, even in my grad student days, when I was taking on large amounts of student loan debt. She gave me a gift once, $1000 that was invested with Madoff. She only asked that I add $100 to $200 per month to it.

The account was through a family friend named Richard Glantz, who got lots of people involved with Madoff. The pitch was always the same: this guy is a financial genius, and he doesn't take on new clients, but I can get you in. Ritchie was what later became known as a "bundler". It doesn't seem like he knew what was going on, but at the same time, it doesn't seem like he asked too many questions about where the money was coming from. This is the pattern all the way down the line: nobody asked too many questions. Why bother? The returns were there, the money was there. Until it wasn't.

My mother and stepfather, Ken Macher, were also heavily involved; they had all their assets with Madoff, and as Ken moved into semi-retirement, and then full-retirement, they lived off their returns. (My stepdad is also a talented musician, and he recently released his first album, which I highly recommend)

In the summer of 2006, I got worried about a financial crash, so much so that I gathered the family and close family friends together and delivered a truly apocalyptic lecture and slideshow about the risks to the financial system: spiraling consumer debt, corporate debt, and government debt, massive trade deficits, the weakness of the US dollar, etc. I recommended holding all or a substantial portion of assets in gold. I predicted the stock market would take a major hit. (I was thinking it would be on the order of 90% or more; which I still believe will occur). There was a lively discussion, and one of the questions was, how do we hold assets in gold when we're living off our returns from Madoff, which are steady and reliable, 10-12% a year, every year?

I said buy gold and sell a bit of it each month to live on. The gold price was about $550 an ounce back then. Any money put in gold would've nearly doubled, even considering the hit that gold took during the fall of 2008, when it fell to $700 from over $1000. But now gold is back, pushing against the $950 mark. No doubt we'll look back on the days when gold was below $1000 with awe, wishing we could go back in time and buy more at those prices. (Compare the performance of gold to the Dow, which went from about 11,000 in the summer of 2006 to over 14,000 before heading down to its current level of about 8500; over this period, a 23% decline)

The results of my slideshow were as much as I could've hoped: my family and friends took it very seriously, and began to explore the reasons for owning gold, immersing themselves in the economic literature which argued such a financial crash was a strong possibility, and in the end, they shifted 5-10% of their assets into gold and silver. (Ritchie wasn't at that lecture. I wonder what he would've said, or if it would've influenced him in any way.)

I never criticized Madoff directly; to do so was the question the financial acumen of the family, substituting my own. Each time I asked questions about what his strategy was, where the returns came from, it was a blank. I said that the investment strategies of the past would probably not work in the future, because what's coming is a new paradigm. I had no idea the whole thing was a fraud. I just knew I didn't like the secrecy. I had taken out the money my stepmom gave me (I never added anything to it).

My father and stepmom never got involved with Madoff. My dad never believed in the returns. He had worked in the mutual fund industry, and didn't really believe that the market could be beaten over the long term.

My mom and my stepdad, having lost everything except the gold (a small percentage), were philosophical. My mom said, "it's exciting to think about living more sustainably." They began growing vegetables and composting, and are exploring all kinds of different options.

When the news hit, back in December of 2008, I felt a lot of regret. Why hadn't I tried harder to learn more about Madoff? Why hadn't I done more? I should've been more forceful.

I'm proud of how my family has responded to the crisis. It's been hard, but they have used it as an opportunity to look within, to grow, to turn the trash into compost, out of which comes something alive and new. May we all learn to do the same.

WSJ: The End of Bling

2009-05-26T11:01:00.000-07:00

Hey, remember what I wrote a while back about the End of Bling? Well, the folks at the Wall Street Journal must've read it, because today's headline says much the same: Culture of Bling Clangs to Earth as Recession Melts Rappers' Ice.

It seems rappers are turning to lower-quality (or even outright fake) gold and gems for their big necklaces and grills.

The article mentions Lil' Jon and his record-breaking, 5 lb gold and diamond pendant that says Crunk Ain't Dead, but to me, Damien Hirst's skull piece For the Love of God is even more emblematic of the era. If any piece represents the end of the first decade of the 21st century, this is it.

Green Shoots?

2009-05-26T07:28:00.000-07:00

The other day I wrote that there are no green shoots of recovery. Perhaps that is unnecessarily dour. Like any living organism, the economy is continually growing and dying away at the same time. So at any given moment, there are green shoots, in the form of new businesses, new ideas, new innovations. At the same time, at any given moment someone is being laid off, a business is failing, and so on.

The phrase green shoots suggest that the winter of recession is over and the spring of recovery has begun. I don't think we're close to the recovery, because while the process of deleveraging is occurring, it's still incomplete. When household, corporate, and government debt burdens have been reduced to something like their historical levels, then I'd say the process of deleveraging has been completed. But we're far from that point now. Consider the graphs to the left. The top two show rapid rates of issuance of government debt securities, far in excess of economic growth rates. The third shows the escalation of debt within corporations, most of it led by the financial sector, which has made leverage into an art form. The last shows the debt burden among households. These last two show debt as a percentage of GDP, which corrects for increases in wealth, productivity, inflation, etc. What we see is basically a tripling of the relative debt burden of households, and even more of an increase in the corporate sector.

What must happen is a purging of bad debts. There is no way that all the debts that have been incurred by households, the various levels of government, and corporations will be repaid. That means lenders are in for a serious hit. The carnage we've seen in the financial sector (for example, look at the DJ Financial Services Index) is just the beginning. What is needed is a shift away from finance toward productive economic activity, a sort of de-financialization, to use a fancy term. (there's a nice post on this at Below the Crowd)

It's clear that massive bailouts to the financial sector will be costly failures. No amount of money creation can prevent de-financialization from occurring. If we test my thesis, it will only come at the expense of inflation. But high inflation would also threaten financial firms, for high inflation cuts into interest rates, lightening relative debt burdens in favor of the debtor, harming the creditor, making it more difficult to both borrow and lend. High inflation would also make nominal interest rates rise, encouraging further deleveraging.

Happy Memorial Day!

2009-05-25T08:11:00.000-07:00

I don't know if it's right to say "Happy Memorial Day". It is a rather somber occasion, no matter how much beer you drink over the holiday weekend. I have mixed feelings about the day. On the one hand, I celebrate the idealism and sacrifices of the nation's soldiers over the years. People willing to die for their country, for the ideal of liberty, that is both noble and deeply moving.

At the same time, it seems right to recognize that some of these sacrifices were made in the name of extending the American empire. Many of the wars we've fought have been wars of choice, with horrific consequences.

In honor of the day, I want to consider what we spend on war; not just spending within the Department of Defense, but all spending that could legitimately be considered war-related, including the interest payments on past debts that are due to war, the spending on veteran's care (not part of the DoD), the spending on maintaining our nuclear arsenal (part of the Dept of Energy, believe it or not). In fact, when all the accounting chicanery is laid aside, we find that a surprisingly large portion of the US Federal budget is war-related. The pie chart, from The War Resisters League, is a categorization of the Federal budget that takes into account the various ways the government tries to hide the true extent of war spending.

I believe we'd honor our fallen soldiers best by decreasing our spending on warfare, recognizing that with a smaller military presence, there will be fewer conflicts and fewer lives lost in those conflicts.

Is the Price of Gold Being Manipulated?

2009-05-22T10:32:00.000-07:00

A recent article by Brad Zigler at Seeking Alpha argues that it is not. Zigler runs a site called Hard Assets Investor, and has a lot of interesting things to say about commodities.

I like that Zigler marshals some evidence for his claim, by looking at some of the short positions relative to the long positions that banks take on.

But I find myself unpersuaded by his overall case.

Zigler argues that the ratio of shorts to longs in the gold futures market is 3.7 to 1, and that this is therefore hardly the strongest case that banks are manipulating gold. Perhaps they merely believe that gold prices will head downward. I agree with his skepticism in principle, but I don't follow his interpretation of the evidence.

Just to take the other side of the story, notice that 3 US banks hold nearly one-third of all short positions in gold. That seems at least a bit suspicious. Non-US banks holdings are much more evenly balanced between long and short. Why would these three banks do this? Perhaps they've decided that gold is overvalued, and they hope to reap massive profits as gold corrects downward. I don't think that will happen, but surely banks are allowed to lose money if they choose, right?

I'm surprised that Zigler didn't take a look at some of the arguments put forth by the Gold Anti-Trust Action Committee. For instance, a recent article by James Turk, author and President of Goldmoney.com, argues that central banks lent considerable quantities of gold (between 12,000 and 15,000 tonnes) to create what he calls a 'gold carry trade', where investors borrowed at low rates in order to invest at higher rates elsewhere.

Reading Turk's article, I'm struck by how sensible his argument is, but also by how little hard evidence he has. Yes, central bank officials have made statements in the press that they manipulated gold or should have; yes, Barrick Gold has admitted to assisting in such gold manipulation; yes, the motive is there: central banks want to support the value of fiat currencies, and gold is the main competitor. But where are the hard numbers? Where is the smoking gun?

All of this shows that it's very hard to prove that someone is manipulating a price of anything. So perhaps this argument will never be decisively won or lost, and people will take whichever side they find most convincing. It seems likely to me that the Fed and the Treasury are manipulating the price of gold through the cooperation of some of the big investment banks and gold producers like Barrick. But honestly, who really cares? Markets are behaving strangely these days.

In a sea of overvalued financial assets and fake wealth, gold will sustain.

China and Brazil Plan to Evade the Dollar

2009-05-21T20:47:00.000-07:00

An important article in the Financial Times reveals that China and Brazil are working around the dollar.

It's interesting that the public denunciations of the dollar's reserve status are growing steadily more blunt, less circumspect, and now include China's unveiled ambition to replace the dollar. It is surprising indeed that the dollar has not reacted with more vigor to the news. Perhaps it's because it was not widely reported in the US, or because we seem to have a curious sense of denial about the future of the US$, which is clearly not bright.

In an earlier post, I discussed China's (non)-manipulation of the yuan, noting that Paul Krugman thinks China's position is weak. I wonder if it still seems so weak to him. Check out the chart of the dollar's recent performance in the broad dollar index, taken from Dow Theory Letters. Pretty exciting stuff - the dollar has fallen from 88 to 82 since March. It looks like the rally may not make it to 10,000 as I thought previously.

As I wrote recently, the status of the dollar is likely to be the next big blow to the financial system. When a currency depreciates, it causes severe stress on the financial sector, including panicked runs on banks, which are, of course, entirely rational given the fall in the value of the currency. Wouldn't you want to withdraw your assets from banks and put your money in some other currency, or even in commodities? Bank runs lead to bank failures, which lead to shocks to financial markets, and panicky interventions by authorities. Expect such interventions as we move into the next phase.

I've considered an ETF called UDN, which is comprised of dollar short positions, but I think that Seabridge Gold is the safer bet (and indeed, may have better upside potential), as it is a Canadian company, with assets in Canadian dollars, and perhaps more importantly, it is tied to gold which will almost certainly respond strongly and favorably to a decline in the dollar.

Bernanke on Financial Innovation

2009-05-21T20:05:00.000-07:00

While there are legitimate financial innovations, e.g. the stock market, options, shorting stocks - many financial innovations are merely more sophisticated ways to gamble or rip someone off.

Fed chair Ben Bernanke offers an interesting argument about three financial innovations that he considers worthwhile and important. These are: credit cards, mortgages, and bank overdrafts.

There is a certain wolf-in-sheep's-clothing aspect to Bernanke's speech.

He says, in effect, gosh, some of these financial innovations haven't gone all that well. It's very challenging for regulators, because on the one hand, we don't want to stifle innovation, because that makes all our lives better. On the other hand, sometimes things get out of hand, we ought to consider how these innovations will react when they are "stressed", and recognize that regulation may be needed. Who could argue with these mild-mannered banalities?

Yet if we step back and ask the question, why should the Fed have a role to play in preventing people from getting fleeced? That doesn't seem like the Fed's role. People get ripped off all the time. It seems to me that a better defense against that than the Fed could ever be is this device called the internet. It sure seems like a great way to spread information to other consumers not to do things that end up being a huge rip-off.

And why would the Fed place restrictions on financial activity at all? We already have laws against fraud. What else is needed?

We have to recognize that the Fed has an impossible task: to prevent a house of cards from collapsing. The fractional reserve system is fundamentally insolvent. This is what creates a danger to financial stability in the first place. The reason that somebody not paying their mortgage may mean I lose my job is because banks are running the biggest fraud in history, an epic pyramid scheme that makes Bernie Madoff seem insignificant. And the job of the Fed is to oversee this fraud, to make sure that we keep it up, to continue to shovel an ever-increasing share of society's surplus value into the coffers of the banks. This is why it strikes me as rather disingenuous for Ben Bernanke to worry that complex mortgage products may not ultimately help the consumer. Talk about dodging the real issue.

Ron Paul Grills Bernanke

2009-05-21T12:32:00.000-07:00

Here's a good video of Ron Paul giving Fed chair Ben Bernanke the business.

Much has been said about how Ron Paul sounds crazy, conspiratorial, etc., but at least he's up there questioning the economic guru of the day.

Ben Bernanke firmly believes that the reason the Great Depression happened was that the Fed did not act aggressively enough, and allowed monetary policy to tighten, worsening the Depression. In fact, the Fed was quite aggressive. Consider that the Fed flooded the banking system with liquidity, raising the money supply by 10% in a single week. However, this was counteracted by the contraction in bank lending, because banks were in the process of deleveraging.

If that doesn't sound familiar, it ought to.

The very same thing happened in the Fall of 2008. The money supply actually tightened, despite the Fed creating massive amounts of money and injecting it into the system. This is because the money supply is not controlled directly by the Fed, but rather it's a product of the fractional reserve system. If banks lend less, the money supply falls, perhaps as much as $10 for every $1 fall in lending. That's the magic of the fractional reserve system. Banks create and destroy money, and the process is not under the direct control of the Fed.

The Case for Seabridge Gold

2009-05-21T12:06:00.000-07:00

(click on the image to enlarge)

Those of you who know me know that I've been recommending Seabridge Gold (SA) for some time now. (Just so you know, I hold a substantial amount of this stock) The company is designed to provide a leveraged investment which is tied to the price of gold. Their purpose is to turn cash to gold, rather than the opposite, which is what most miners do.

Let me now present a brief analysis of the value of Seabridge stock. (As of now, it is selling for $29.30 a share, so if you bought it yesterday when I suggested it, you've already made money.) Seabridge owns properties which contain gold and copper. When these holdings are considered at current prices, we find they are worth a rather large sum: about $63 bil. Of course, the problem with resources in the ground is that they have to be extracted and refined, a costly process. But even with very stringent extraction costs of $800 an ounce for gold and $1.80 a pound for copper, we find that the company's resources are worth about $9 bil. If we divide that by the total amount of shares outstanding (about 38 million, including stock options) we get a price per share of $234, a rather far cry from the price of the stock now. Even if we take only the reserves that have been measured, rather than inferred, we get $136.

This company is undervalued by the market, and hence it represents a great opportunity.

10 Grand: Sell DDM, Buy SA

2009-05-20T08:38:00.000-07:00

The time has come to sell DDM (for now). I recommend Seabridge Gold (SA). Seabridge is a "resource hoarding" company, and their resource of interest is gold. They do no mining, but rather they buy the best gold mining land they can.

If you sold your 370 shares of DDM now, (for $29.45) you'd have $10,912.42 (assuming your trades cost $9.99; that is what I pay over at Ameritrade.) If you buy SA at $28, you can afford 389 shares (assuming you don't use margin, a wise move in these difficult times). You are now up 9.1%.

Only invest what you can stand to lose.

It Pays to Be Bipolar

2009-05-15T08:07:00.000-07:00

This fellow Andrew Behrman, author of Electroboy, was paid $400,000 by Bristol Meyers Squibb to promote the bipolar drug Abilify. Not bad. I love the name "Abilify"; it's the perfect name for a drug: nonsensical, but with the right connotations. While drugs for bipolar conditions are no doubt helpful in some cases, it seems like the overwhelming majority of the time these drugs are used to mask symptoms that are important psychological and emotional signals.

The corruption of this system of paid shills who promote drugs via their own experience with it is unbelievable.

Microsoft Issues Bonds, Contemplates Drinking Own Urine

2009-05-14T08:00:00.000-07:00

Microsoft has completed a new bond issue, its first ever, for $3.75 billion. The company says they have no real plans for the money, though the move has sparked speculation about possible acquisitions. They say they're just taking advantage of favorable market conditions.

Apparently some analysts think that the most likely use of the money would be a stock buyback, where the company buys its own stock, attempting to push prices up. Microsoft stock has been hit by the falling market, along with everything else. The stock was at $30 early in 2008, and it fell below $15 by March 2009.

The stock buyback is a corporate strategy that is emblematic of the first decade of the 21st century. Stock buybacks exploded during that time, as they did during the end of the 1990s. Of course, most buybacks are done with borrowed money. The tactic is considered an acceptable way of paying out profits to shareholders.

A company buying its own stock with borrowed money is doing something as sensible as drinking your own urine. At best, it keeps you alive in the desert. But it sure won't make you thrive. Borrowing money imposes an economic logic: you must pay back more than you borrowed. So if you're borrowing to invest, you'd better make sure that what you invest in has a higher return than the interest rate, plus some for inflation, and a normal rate of profit. How does a share buyback accomplish any growth whatsoever? If all goes well, and the stock price remains high, (far from certain in this volatile market) how exactly does that insure the future growth of Microsoft?

The real motivation for the skyrocketing use of buybacks is so that management can give themselves fat bonuses covertly, in the name of shareholder value. Now that the credit teat has been taken away, my guess is that we'll see far fewer share buybacks by corporations. It was a strategy of the bubble years, one that is doomed to extinction.

SNL on the Banking Crisis

2009-05-13T08:00:00.000-07:00

This clip speaks volumes about how the Treasury Dept deals with banks.

Oil and Stocks

2009-05-12T10:53:00.001-07:00

After skyrocketing to a high of $147, then crashing to $30, crude oil has rebounded to nearly $60 a barrel. (Some good analysis of the oil market can be found at wtrg.com)

Will this cause the economic "green shoots" to wither?

Nah. Unfortunately, there are no green shoots. And the oil rebound is a technical matter, caused by the rising stock market. This market rally is causing "mini-rallies" in other assets; this is because at the end of the great market boom of 1980 to 2007, every asset in the world had become severely overvalued, from stocks, to real estate, to commodities, to art; you name it, it was overvalued. An ocean of fiat money was pushing up prices in everything that could possibly be an investment good. The bear market in stocks has also been a bear market in all of these alternate investment assets, including the king of bear market commodities: gold. (Let me hasten to say that the fall in gold prices is a temporary phenomenon, a secular bear market within a bull market that began in 2002.)

Oil presents us with a paradox. Are prices rising because demand is stronger than we thought? That would be a good thing. Or will the rising demand quash consumer spending? I'd say neither. Look for oil prices to continue upward as the stock market rally continues, but I expect oil to correct down sharply as the rally ends. Of course, the long term trend of oil is up, both because of inflation and because of the geological reality of peak oil.

The Dollar

2009-05-11T07:44:00.000-07:00

The financial system has weathered its greatest challenge in decades. The bear market has been as intense a decline as any since the Great Depression. (Yeah, I know, that comparison is getting to be a cliche.) But what hasn't happened is a fall in the value of the dollar. In fact, just the reverse has occurred. After years of swooning, the dollar had a sharp rise as the financial crisis hit.

The reason for the strength of the dollar was the process of deleveraging created an intense and immediate surge in demand for dollars. I think the deleveraging process has passed its first phase. The Fed has created trillions of dollars of new money, much of which has been absorbed into the financial system, into an immense hole of losses. But it has prevented insolvent firms from failing, and of course, each new dollar dilutes the value of the rest.

I think the end of the stock market rally may be caused by a fall in the value of the dollar. As the rally continues, stocks will climb "the wall of worry" until they fall, which I see happening around the 10,000 mark. We'll have to watch closely as the rally continues. Bear market rallies seem to go on much longer than you would think.

When Bad News Looks Good

2009-05-08T08:04:00.000-07:00

As predicted, unemployment has indeed increased. The latest number from the Bureau of Labor Statistics is 8.9%, bringing the total number of people unemployed to 13.7 million.

The ranks of the marginally attached (those who want work and have looked in the recent past, but have given up and haven't been looking in the last 4 weeks) has been sharply increasing during the recession, and now stands at 2.1 million.

This is pretty bad news, but Wall Street seems to be giving it a positive spin; as the Wall Street Journal reports, job losses are "decelerating". Unfortunately, the slowing growth of job losses doesn't really count as good news, as much of the reason for the

lessening slack is new hiring by the government. Given the fiscal realities that the various levels of government are facing, it seems unlikely that government can pick up the slack for long.

The second piece of bad news is that the stress tests results are in: the Federal Reserve reckons that bank losses may be as high as $599 billion. It almost sounds like a sale, doesn't it? Act now, bank losses only $599, that's right, $599 billion!

The WSJ also has a poll, asking readers: Do the stress tests results paint an accurate picture of the financial services industry? When I checked the results, 88% had said no.

The table is from the Fed's report; it gives some of the assumptions that led to their results about the extent of bank losses.

The interesting thing about these numbers is how big they are. Under the baseline view, loss rates in subprime mortgages of 15-20%! That's the optimistic scenario! And 12-17% for credit cards - unreal. So given these huge loss rates, why didn't banks see it coming? Why did they make these loans? And why should they now rush in to lend more, with these kind of loss rates?

San Francisco Real Estate

2009-05-08T07:38:00.000-07:00

San Francisco is the real estate market that couldn't fall. It has now fallen 45% from its peak in 2006. Here's a graphic that compares the three California cities in the Case Shiller Index to the housing market in SF if it had followed the increases in the Consumer Price Index. The reasoning here is that housing prices should roughly follow the growth in other prices, given no new technological changes in the cost of producing houses, as well as no unusual changes in demand.

Of course, weakened lending standards did lead to an unusual surge in demand, because millions of people who would not have qualified for mortgages under the old standards suddenly did, and they bought houses, bidding up prices.

The graph shows that despite spectacular carnage in the SF real estate market, prices still have not converged to the CPI. To consider another measure, prices have not reached the level of historical affordability either.

The median income in SF was $68,023 in 2007, while the median home (or condo) price was a staggering $830,700. The median home price to median income ratio was therefore 12.8, as compared to a historical ratio of about 4.5 to 5, (according to the Metro Affordability Study) which is already much greater than the national historical ratio of between 2.5 to 3. (This ratio gives rise to the old banker's rule that you never give someone a mortgage that is more than about 3 times their income.)

(Check out the Calculated Risk blog for some good analysis.)

Imagine what SF real estate would look like if median home prices here fell to their historical relationship. That would mean that the median home price would be $280k to $350k. That would be good news for people who don't want to leverage themselves into mortgage oblivion, creating an odd state of poverty by overconsuming housing.

The 2008 Cost of Living index for SF was 180.3, compared to a nationwide average of 100. This means it's about 80% more expensive to live in SF as compared to a place that tracked the national average (like Mongomery, AL, which has an index value of 97.3).

It seems logical to me that in the boom years, cities do extremely well. Wages and incomes rise, along with real estate and asset prices. But in the bust years, the situation changes. I have an anecdotal sense that SF is losing young people. I hear about them moving to places like Portland, or less dramatically, moving across the bridge to Oakland.

Will SF go through an abrupt reversal, seeing declines in the cost of living that are far sharper than declines elsewhere? We'll see.

Stocks Continue to Rise

2009-05-06T14:25:00.000-07:00

The Dow had a good day today, rising 101 points to break the 8500 mark.

If you bought 370 shares of DDM at $26.93 when I recommended it, you'd now have $10,807, an 8.3% return after trading fees (assuming $9.99 per trade).

It feels like the conventional wisdom is that the market has bottomed, and a new bull market has begun. A substantial minority opinion holds that the Dow is in a bear market (or "sucker's") rally. But the big money seems bullish, judging by a recent Barron's survey finding that 59% of money managers are either "bullish" or "very bullish". Since big money drives the market, it is wise to heed what the big money managers are thinking and feeling. As the rally continues, their doubts will fade, and bullish sentiment will increasingly dominate.

The strategy I'm proposing is a risky one, requiring some vigilance to carry out. I believe that the primary trend of the market is bearish, so this strategy looks to the secondary trend, which is even less predictable than the primary trend. Use caution, only invest as much as you're willing to lose.

At some point, when the market rally is nearing its end, we'll want to switch to DXD, which moves inversely to the Dow.

Workers Own the Means of Production

2009-05-05T07:57:00.000-07:00

The government's proposal that the United Auto Workers take their pension-fund payment in Chrysler stock gives the labor union a 55% stake in the company, making the union the effective owner of the company.

It's interesting that the UAW only gets 1 seat out of 9 on the Board of Directors. That immediately weakens their authority.

From a Marxian economic perspective, this is a case of workers owning the means of production. As some cutting-edge Marxian theorists have argued, ownership of the company may not be the same thing as appropriation of the surplus value created by the workers. In the modern joint stock company, there is a separation between the owners (the shareholders) and the appropriators, a responsibility which is given to the Board of Directors. While shareholders interests are supposedly represented by the board, it is unusual for shareholders to get involved in the appropriation process. If they do, they are labeled activist investors, like Carl Icahn.

An insight from Marxian theory is that there is always conflict over the distribution of the surplus, no matter what class structure exists. For example, there is conflict over the surplus within a corporation between the management and the shareholders. How much of the corporation's profits go to dividends or share buybacks vs new investment in the firm?

For the UAW, being an owner could create a new kind of thinking. Instead of being focused on higher wages, better retirement packages, better benefits, etc., they could begin to focus on the labor process and think in larger terms about what would be in the interests of the workers. That would be an interesting shift.

GDP Plunges, Unemployment Remains High

2009-05-01T07:54:00.000-07:00

The Bureau of Economic Analysis reports that GDP contracted at an annual rate of 6.1% last quarter (the first quarter of 2009), following on a 6.3% rate of decline the quarter before.

Meanwhile, unemployment seems to be headed for further increases. The latest number from the Bureau of Labor Statistics is 8.5% for the headline unemployment statistic, which the BLS calls U-3. If workers who are "marginally attached" and underemployed (that is, they have given up searching for work, or they would like full time work but are working part time) are counted you get an unemployment rate of 15.6%. Incredible.

What ought to be done?

Given the circumstances unique to this recession, we ought to cut government spending, remove subsidies, cut taxes, refuse to prop up failed and insolvent corporations and banks, and simply allow the market to reach equilibrium.

Creating a system of sound honest money that is tied to a commodity (I favor gold) would stabilize the international monetary order, though it would cause some immediate pain in the short term. Abolishing fractional reserve banking would immediately solve the banking crisis, allowing banks to begin lending.

Reasons for Economic Optimism

2009-04-30T08:00:00.000-07:00

I was inspired by Justin Fox's recent post in Time, 5 Reasons for Economic Optimism (he gives 4). Although I differ with him rather sharply on what exactly are the reasons to be optimistic, I agree with his premise: it's vital to look for the ways in which the current economic situation is or will be, for the greatest good. Before I give you my list of reasons, let's take a look at Mr. Fox's list.

1. The Stock Market Is No Longer Overpriced

My response: stocks are still heavily overvalued. The current bear market has taken stocks more than 50% below their peak, to a low of 6548. As of 4/21/09, the dividend yield for the Dow was 3.51%, while that of the S&P 500 was 2.61%. A bear market historically reaches its bottom when the dividend yield is 6 to 8%. The stock market is coming off a 27-year bull market, which took the Dow from 800 to over 14,000. (check out my earlier piece on this) A bull market of this magnitude is not corrected in a few months. As a matter of mass psychology, we'll be near a bottom when the overall consensus is that putting money into stocks is as wise a thing to do as setting fire to your money.

2. The Government Is On The Case

My response: Unfortunately, much of what the government is doing is interfering with the process of adjustment which is necessary to restructure the economy, clear out losses, bring an end to corporate strategies that were essentially unsound, and move the economy toward productive economic activity. Expect the government to engineer massive amounts of inflation, as Greg Mankiw and others believe would be helpful.

3. Consumers Are Adjusting to the New Economic Reality - And Fast

My response: Mr. Fox argues that the speed at which consumers are cutting spending is a good sign, for it will lead to a rebound in consumer spending that will help the economy. Interesting point, but I don't find it persuasive. What we need is more investment, not more consumption. To that end, saving is needed, for ultimately, there is a macroeconomic equality between savings and investment. Though we have been able to avoid that equality for some time because of financial out-flows (i.e. the financing of US current account deficits and budget deficits through foreign buying of financial assets), savings ultimately equals investment. So more saving is good in itself, not only as a sign that the carnage of lower consumption is almost over.

4. Reinvention and Change Are What the US Is All About

My response: It's hard to argue with this one. And Mr. Fox also correctly identifies that many economic activities of the boom years were unproductive: he singles out finance and real estate as two of the big culprits. Unfortunately, he believes this means that the US dollar will continue to be the world's reserve currency forever. Does he fail to see the many signs that the reign of the dollar is nearly over? The strength of the dollar since Fall 08 is only a temporary response to fears of financial armageddon.

* * * * *

OK, so here's my list.

1. Moving from an economy dominated by unproductive activity to one dominated by productive activity will be good for America. For too long, American innovation and entrepreneurship went into venues that were basically deceitful, put others at risk in order to generate profits, or were unsustainable. We've gotten to be masters of finance, real estate sales, and retail sales. It will good for our innovation to be re-channelled into activities based on sustainable growth.

2. As I mentioned above, consumer saving is a good sign. Living with a zero or negative savings rate is unstable and tends to lead to volatile investment. A high savings rate should ultimately lead to a high level of investment. The fact that consumers are spending less means they are facing reality. That's a good thing in itself.

3. The End of Bling focuses our attention less on conspicuous consumption and more on the things that really matter. That will differ for each one of us, but it seems likely that the recession will lead to a decreased level of materialism in society, and an increased understanding that consumption should be in the service of the purpose of our life, not the other way around. Once one's basic survival needs are met, the kinds of things that tend to make people happy in a lasting way are having deep relationships, being able to meet one's responsibilities, and making a meaningful contribution to the world. This crisis offers us the opportunity to re-evaluate our lives.

4. The environment will be a beneficiary of decreased consumption among the rich nations. America cannot continue to consume 25% of the world's resources.

5. The financial crisis will end the international hegemony of the US dollar, and encourage nations to consider sound, honest money, based on an item of real value. The natural choices are money based on gold, silver, copper, or other metals. There are other possibilities for backing money, including a basket of commodities. (These are less desirable to me, for reasons I'll describe in a future post) Moving away from a world monetary order based on fiat currencies will be good for the US and good for the world, because fiat currencies are essentially dishonest.

6. The crisis will end US military adventurism in the Middle East and elsewhere. The reason for this is that as the dollar loses its status as a reserve currency, we will not be able to afford to continue to occupy Iraq, Afghanistan, or any other country. We will have to dramatically cut all government spending, for deficit spending will no longer be an option. When we have to balance the budget, these foreign military adventures will simply become untenable. They were only possible based on the unrealistic idea that we wouldn't have to pay for them. Americans are not motivated enough to go to war in distant lands when they realize it will mean fewer schools, hospitals, roads, and smaller pensions.

So take heart America! This crisis will return us to our core values.

New Forecast for the Dow, New Feature for the Blog

2009-04-29T20:09:00.000-07:00

In a previous post, I gave a prediction for the Dow to rise to 8300. Given what has now happened, I'd like to revise that. The Dow has just broken through its most recent high mark (of Apr 17th), and I now see the rally taking the Dow back above 10,000.

Which brings me to the new feature of the blog. I give my calls, and we'll see how a hypothetical $10,000 invested as I say will do over time, assuming a trading fee of $9.99.

Since I see the market rally continuing, I'm taking a position in DDM, which is a leveraged ETF (exchange-traded fund) that returns twice the daily performance of the Dow. I'm going to start the clock now, even though I bought DDM a few days ago. I'm going to say you can pick up DDM at its current price of $26.93, you can get 370 shares. (More if you're on margin, but let's keep it straight.)

I don't believe the bear market is over. I think the Dow will still fall to the 1000 range or below. (In a previous post, I called for 400). The reality is that the stock market has been on an outrageous tear for 27 years. That kind of growth is not corrected by an 18-month bear market, even one of this severity.

Once this rally has tapped out, I'll call for taking the opposite side, with an ETF called DXD, which moves double the inverse of the Dow.

PermaRenter: "Full Commanding Denial"

2009-04-29T08:00:00.000-07:00

I liked this comment that I found on patrick.net, written by PermaRenter:

Full Commanding Denial

If central casting called for a poised, straight-talking, and capable-seeming president, it would be hard to come up with someone better than the Barack Obama who walked and talked around the White House grounds with Steve Croft on “60-Minutes” Sunday night. He may perfectly represent the majority who elected him, though, because he also appears to be in full commanding denial of the realities overtaking our American experience.

Those realities include the fact that we can’t possibly return to the easy credit and no money down “consumer” economy no matter how many nominal dollars get shoveled into the fiery furnaces of banks too-big-to-fail. As Treasury Secretary Geithner’s underling, Stephanie Cutter, said last week, “Our singular focus is on increasing lending to support economic recovery. Everything we do to stabilize the financial system is done with that goal in mind.”

Lending on the scale that became normal over the last decade is for sure the one thing that we will not recover. We turn around in 2009 to find ourselves a much poorer nation than we thought we were a year ago, especially among that broad range of formerly middle-class wage-earners who lived so luxuriously until yesterday. The public can’t process this reality and the president, for all his relaxed charm, is either not ready to articulate it, or can’t process it himself.

Everything that we’re doing right now is engineered to avoid reality, to sustain the unsustainable, to recover the unrecoverable, when the mandate of reality compels us to face our losses in order to move on to the next chapter of a collective American life. The next chapter would be a society that runs on a much more local and modest scale, centered on essential activities like growing food, requiring harder physical work, and focused attention — in other words, the opposite of a society lost in abstractions, long-range daisy chains of off-loaded responsibility, and incessant pleasure-seeking.

In retreat from this reality, we’ve set in motion two forces that are pretty certain to bring us to grief. The first proceeds from the fateful FMOC [sic.] decision last week at the Federal Reserve Bank to begin buying massive amounts of our own treasury bonds and bills. This is predicated on the idea that the mechanisms of wealth production — even of illusory wealth, such as the fortunes created by trading securitized unpayable debt — can keep chugging along, spinning off limitless additional suburban villas, chain stores, car trips, and deep-fried snacks. It would be sententious to explain how this destroys currencies, but wherever “monetizing debt” has been tried before in history, that is the outcome. The result would be ruinous at every level and would lead straight to the second terrible force: social upheaval brought on by the conversion of economic problems into political turbulence.

Those two forces are underway right now, in fact, since the overt monetizing of last week was preceded by the shoveling of bail-outs, which tacitly guaranteed a collapse of credibility in US debt instruments. I’m not in favor of violence and anarchy, but after the AIG bonus affair, it’s hard to imagine that we are not one more corporate misdeed away from a rocket-propelled-grenade, or something like that, being fired into a glass office tower somewhere — and then the “first-broken-window” rule of social disintegration comes into play. Meanwhile, I stick to my time-table of six-to-eighteen months before the reckless creation of new money-for-nothing filters through the system, overcomes even compressive mass bankruptcy, and starts expressing itself in the sinking value of dollars and the revved up velocity of their circulation in pursuit of tangible commodities.

We’re already seeing the first twinges of that in the up-creep of oil prices, busting through the $50-a-barrel barrier last week. Since scarcity tends to express itself in gross volatility, it’s easy to imagine oil prices rising swiftly beyond the $147-per-barrel record level of last year. As that occurs, the most basic premises of everyday life in the USA will be called into question. If you think car sales have been bad lately, with oil in the $35-a-barrel range most of the winter, just wait. The newly-minted unemployed will be marooned in their subdivisions. They will not be buying GMC Yukons on 48-month installment contracts, let alone X-boxes on their Visa cards. They might be very very hungry, though. All bets are off as to how these social classes may organize themselves to alleviate their hunger (and express their anger about it).

Given all this, it’s kind of hard to believe that the savvy, thoughtful Mr. Obama is going along with such a disastrous program as the one his “team” is rolling out. Perhaps his ease and confidence masks a tragically conventional world-view, an incapacity to imagine “change” outside a very narrow range of possibility. I must say I doubt this is the case. I think, he is going along, for the moment, with a consensus of wishes to prop up life as we know it at all costs. This consensus emanates from the top down and the bottom up. The millions of “Joe-the-Plumber(s)” out there don’t want to rethink the terms of existence anymore than the lords of Goldman Sachs. I also think that circumstances will force Mr. Obama’s hand before long — specifically that a moment will arrive when he goes on TV and tells the American public that things have changed way beyond the scope of what they even imagined when they pulled the levers last fall and voted for an uncharted future.

Capable observers are calling, meanwhile, for a robust bear market rally moving through Spring, on technical grounds that have little to do with the greater forces roistering in the background. Reality is a cruel mistress. If the stock market rally rolls out as predicted, it will surely fake-out the mainstream media. They’ll conclude wishfully and foolishly that something like “recovery” is underway. They may even interpret rising oil prices as a “positive sign” that the great groaning enterprise of the something-for-nothing economy is back “on track.”

They’ll be shocked sometime after Memorial Day when it all comes off the rails again. We have a lot to sort out and very little time to get on with job. Notice, I haven’t even mentioned the potential for mischief and instability coming out of the rest of the world — enough black swans to blot out the sun. Want some concrete advice? For those of you sitting on US Treasury bonds and bills, now would be a good time to get out.

Wow. After that summary of our woes, check out my Reasons for Economic Optimism - coming tomorrow!

Real Estate: The New "Don't Ask, Don't Tell"

2009-04-28T08:15:00.000-07:00

According to an article in the New York Times, New Yorkers are dealing with falling real estate values the old fashioned way: denial.

Let's not forget that falling real estate prices are good. Yeah, let me say that again: falling real estate prices are good.

Falling real estate prices remind us that homes are not investment goods, they are consumption goods. That will help us make smart investments in actual businesses that produce actual stuff. Homes don't produce anything, you see, so there's no good economic reason why the price of homes ought to go up faster than the rate of inflation. Does your car go up in value each year?

Falling home prices make real estate affordable again, for those who want to own. Owning vs renting is always multi-dimensional question, having as much to do with your preferences for responsibility and maintenance as it does with your propensity to move and the tax advantages of the mortgage interest deduction. The point is, not everyone is or should be a homeowner, and that's a good thing. When home prices reach a reasonable and affordable level (the median home price should be about 3 times the median income, maybe as high as 4 or 5 for a big city) then those who want to own don't have to use the mortgage equivalent of financial derivatives to afford housing.

Did the Oil Boom Cause the Recession?

2009-04-28T08:12:00.000-07:00

There are several recent papers which make the argument that without the oil price boom of 2007-08, there wouldn't have been a recession. James Hamilton says "I don't quite believe the conclusion myself."

These papers make some interesting points, and there certainly is a connection between rising expenditures on gas and falling consumer spending. That said, I don't find it persuasive that rising oil prices "caused" the recession. The primary cause of the recession is the bursting of the artificially induced credit bubble. What caused that bubble was the rapid expansion of the money supply, which is always the ultimate cause of bubbles. There is only one way that stocks can outpace overall productivity growth over a long period, there's only one way that any asset can become outrageously overvalued without coming under pressure from short sellers and that is money creation.

Repo Fee

2009-04-27T13:48:00.000-07:00

The Treasury reports that as of Friday, a new fee will be levied on participants in the Repo market of 3%. This is an interesting development; it's pretty unusual for the government to place any kind of punitive fee on any financial market. Why are they doing it?

A "repo" or "sale and repurchase agreement" is a kind of fixed rate short-term lending that uses debt or equity as collateral. A common form of debt to use is US Treasury debt.

An example of a repo transaction would go like this. Say I'm a bank with $10 mil in Treasury debt, and say I'd like to make an investment, but I also want to keep the Treasuries on my balance sheet. I can use a repo to sell the Treasuries to another bank, agreeing to repurchase the Treasuries some time later, for a set amount. Let's say I agree to repurchase the debt 100 days later for $10,0136,986.30. (This would imply that the yearly rate is 5%) I pay $136,986.30 to the lender for giving up my illiquid Treasury debt but knowing I could buy it back later at a fixed price. Why would I do it? Perhaps I have an idea in mind for an investment which would have a higher yield, but I need money to do it, not Treasury debt. Why not simply sell the Treasuries in the bond market and buy them back later? If I did that, there would be no entry in my balance sheet, and say I need to keep the Treasuries on my balance sheet because they are my reserves, and I must keep a certain ratio of reserves to deposits.

Repos are in fact commonly used by banks to have their cake and eat it, too. Banks can lend their reserves at a proft (thereby reducing their reserve ratio, which banks always want to do) and they can keep the Treasuries on their books as if they own the Treasuries, when in fact the bank no longer owns the Treasuries (at least for the term of the repo). The implied interest rate on repos (called the "repo rate") is usually a bit below the federal funds rate, currently at zero.

The unusual thing that began to happen on a large scale during the credit crunch of the fall of 2008 is that many of the buyers of repos (the lenders) did not return the Treasury debt on time. In fact, the total of all the late repos added up to $5 tril (there's a good discussion on the Naked Capitalism blog). There's no real penalty for this, but one question we might ask is: why?

Are the lenders unable to come up with the Treasuries? What did they do with them? Could they have done a repo on the Treasuries they just bought?

The Treasury will place a fee of 3% on the late repos. Because rates are so low, this will probably push the repo rate into negative territory. (Hey, just what Greg Mankiw wanted!) So if the repo rate is negative 3%, the math on my $10 mil repo changes. I now buy back my $10 mil in Treasury debt for only$ 9,917,808.72. Wow, free money! I get to make my investment (hope that works out) and I get to make an easy profit of over $82 grand!

Will the negative repo rate spur banks to make more repos, and hence to make more loans? Perhaps that's the goal of this policy change. My guess is that there will be unforeseen consequences. Who will rush to take the money-losing side of the repo? If there is no counterparty, then the repo market could be diminished, which may have the effect of raising reserve ratios, further contracting the money supply. Most economists these days are against a contraction in the money supply during a recession, especially "The Great Recession".

The End of Bling

2009-04-27T08:00:00.000-07:00

Time Magazine calls it the new frugality on its cover for this week. I call it the end of bling. Bling is shiny stuff, conspicuous consumption; it symbolizes the fast times and easy living of the boom years, but also the artificiality and denial.

Time reports that

Among people earning less than $50,000 a year — roughly half of U.S. households — 34% have not gone to the doctor because of the cost, 31% have been out of work at some point, and 13% have been hungry. At the same time, 4 in 10 people earning more than $100,000 say they are buying more store brands, 36% are using coupons more, and 39% have postponed or canceled a vacation to save money.

These kind of facts are often reported as though they are bad news. The real question is, does increased consumption make people happier? It's good news that we're slowing down our consumption, because it'll help us focus on the things that truly matter. And our bling years were pretty hard on the environment. When I think of bling, I think of a big Escalade or Hummer with massive chrome rims. That image hardly makes me think we have much of a future. But now that the recession has dulled our appetite for bling, I think we have a much better chance of facing the challenges we must face.

Great New Proposal by Kotlikoff and Leamer

2009-04-24T10:15:00.000-07:00

Professors Kotlikoff and Leamer offer a bold yet simple way to reform the banking sector in their article in Forbes entitled A Banking System We Can Trust.

This is the most important proposal I have yet seen in the mainstream press to reform the financial system. Unlike the other plans I've seen, it would actually work, for it would end the fractional reserve banking system, while preserving the function of banks, which is to serve as a conduit for savings to flow to investment. Kotlikoff and Leamer call it "Limited Purpose Banking".

Everyone who is concerned about the financial crisis should read this article. I hope that policymakers and my fellow economists take heed.

There is one further step I'd suggest to protect the financial stability of the banking sector: tie the value of the dollar to a commodity. In an earlier post, I outlined a plan to do this. A commodity basis is necessary for the dollar to serve its function in the long term, which is to provide a stable store of value to facilitate trade and investment. Because the Federal government seems to run on deficit spending, it has tended to escape the discipline that commodity money imposes. But an escape from that discipline is only found in inflating the money supply, which cannot work in the long term.

The Cash System

2009-04-24T08:00:00.000-07:00

The way banks have over-leveraged themselves, it is wise to consider minimizing your exposure to the banking system. Just as you would be unwise to put all your assets in one investment, consider diversifying outside of banks. Hold some cash for transactions, instead of relying on credit or debit cards for everything. Hold some savings in gold. (A good way to do that is to use an "online gold" bank, of which I think the best is Goldmoney.com.)

Instead of taking out cash when needed, consider the reverse. Keep a minimum amount in the bank, hold basically all your money for transactions in cash, and put money into the bank to pay bills.

There is some evidence that using the cash system will help in the budgeting process. It gives you a good idea of how much money you have at any given time, and it imposes a psychological discipline on spending, called the denomination effect. Basically, you're more reluctant to break a $100 bill than you are to break a twenty.

Obama: China Is Not Manipulating the Yuan

2009-04-23T08:00:00.000-07:00

The Obama Administration has backed off from labeling China a currency manipulator.

All this back-and-forth on whether or not China's currency, the Renminbi, or Yuan (RMB) is being manipulated or not really starts to beg the question of what currency manipulation actually means. In a world of fiat currencies, it doesn't mean very much.

China is well aware that in order to defend the value of the RMB against the dollar and other major currencies, it must maintain a foreign exchange reserve, mostly composed of dollars, since the dollar is the reserve currency of the world. However, with China's foreign exchange reserve at around $2 tril, it is impossible for currency speculators to attack the RMB, as George Soros did with the British Pound back in 1992, when he broke the bank of England.

So China can credibly defend the RMB. But what is the intrinsic value of the RMB? Well, there is none. Fiat currencies do not have an intrinsic value, which is what makes their movements so unpredictable relative to each other. The charge that China is a currency manipulator is not only vacuous, but it serves no real purpose other than stirring up anti-China sentiment. Perhaps that is a useful tool for politicians who trade in fear and want to create a new enemy. It's good that the Obama Administration has not taken further steps down that path.

Footnote: Paul Krugman has written an interesting piece recently arguing that China's steps to move away from the US dollar are signs of weakness rather than strength.

Interesting Article on Piracy

2009-04-23T07:50:00.001-07:00

Johann Hari has written a very interesting article on the recent piracy in Somalia. Writing for The Independent, the articles is titled You Are Being Lied To About Pirates. I don't know enough about the issues to comment, but I do recognize a persuasive, provocative argument when I see one. That makes it worth considering.

The Wall Street Journal tends to take the other side of this issue, arguing for harsh international penalties on piracy. Here's a piece arguing for convoys to protect ships, for example. Another piece refers to this as a struggle of civilization vs. barbarism.

It certainly seems like some kind of desperate situation has arisen to make people take the kind of risks involved in piracy. While we deplore violence and lawlessness, we'd be wise to consider why it arises.

Karl Case on Real Estate (and Banking)

2009-04-23T07:01:00.000-07:00

On 3/31/09, me and a few dozen of my economics professor colleagues tuned in to a webcast by Karl Case, co-creator of the Case-Shiller Home Price Index. He told an interesting story of how the housing market came to be constructed, how home prices became collateral for all kinds of other assets, and how the smartest statisticians on earth could have been wrong about default rates on subprime mortgages, since they were deceived by a 30-year long real estate boom. I liked his story of the real estate bubble, though I think he missed the primary cause, the only logical reason why housing could become hideously overvalued: money creation.

I questioned him on the connection between fractional reserve banking and the housing bubble. His response showed how little he had thought about banking. "There's no need to destroy the entire credit system and bring lending to a halt," he replied.

I understand that response, for I thought much the same a few years ago, before I began to research the issue. Banks are a major conduit through which savings become investment. It is an economic necessity that such a conduit exists, but it is far from the only one. When corporations issue stocks or bonds, for example, savings become investment. (Assuming the corporation uses the money it raises for investment and not some other purpose.)

If we insist that banks are honest and do not permit them to engage in fraud, it does not mean that there will be no credit system and no lending. It simply means that lending will be done on a basis that is absolutely solid and does not involve the fraud and instability of the fractional reserve system.

The great American economist Irving Fisher showed this quite clearly in his 1935 book 100% Money. Murray Rothbard argues for the same thing in his article The Case for the 100% Gold Dollar. A full reserve system would not destroy banking, nor would it end credit. Banks would be restricted to lending only from bonds they would issue specifically for the purpose of investment. People who bought such bonds would know that they are taking a risk, sacrificing liquidity for a return. No lending from demand deposits (checking and savings accounts) would take place.

Full reserve banking would not end credit, it would simply make the credit system rational, functional, and morally sound.

Econ Quiz from the NY Times

2009-04-22T12:28:00.000-07:00

This quiz is a sample of some Advanced Placement economics questions. Unfortunately, what the quiz purports to do, tell you whether you're a classical, Keynesian, or monetarist, it doesn't do. It just tells you how many questions you got right.

Inflation Coming Soon

2009-04-21T08:41:00.000-07:00

Wow. Greg Mankiw has written an unusually provocative argument in favor of inflation, even outright monetary destruction. Addressing the problem that the Fed can only push rates to zero, (and if that doesn't stimulate lending, what will?) he writes:

Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.
That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10.

I am shocked by how reckless his proposal is. Unbelievable. The way out of the financial collapse is to basically render useless one-tenth our money. (As Mankiw no doubt realizes, in practical terms this wouldn't work, since the overwhelming portion of the money supply is not attached to paper notes. Only about $800 bil of the money supply is paper currency, while M3, the broad measure of the money supply, is nearly $15 tril)

Imagine if stimulating the economy were as easy as Mankiw suggests. If destroying 10% of our money is this good, why not destroy 50%? Why not simply build immense fires and burn all our paper Federal Reserve notes that we call money? What a fantastic stimulus that would be.

Destroying money through inflation will not cause a stimulus of any kind, it will cause chaos. Inflation introduces distortions into the economy. Businesses cannot easily calculate future returns; inflation transfers money from worker to employer, from saver to borrower, from the poor who tend to be far away from the money-generating mechanism, to the wealthy and well-connected, who tend to be nearer to the source, and hence can spend their income before prices rise.

Because Greg Mankiw is a towering figure in the economics establishment (professor at Harvard, chair of the Council of Economic Advisors under Bush, influential blogger and textbook author), and because this interesting article appears in the NY Times, (where it is immediately heralded by Paul Krugman) I suggest that Mankiw is striking a chord that will resonate with the central banking and political establishment, which no doubt sees the logic of inflation.

Though the CPI indicates that deflation has been our recent history, that will not last under a determined attempt to produce inflation. Remember, the Fed can print money and drop it from Helicopters. The Fed can write the US government a check for a trillion dollars. (The Fed can even write me a check for a trillion dollars, but I'm afraid I will not stop blogging.) If the Fed wants inflation, the Fed will get inflation. Mankiw simply says what needs to be said to ease the way toward that inflation.

By the way, it is completely wrong to say that inflation will stimulate bank lending. Banks are extremely reluctant to lend under inflationary conditions, unless interest rates are fully flexible, indexed to inflation and all other relevant conditions. Does that sound familiar? That is what an adjustable rate mortgage is all about. But even if rates are fully adjustable, there are two additional problems:

1) what if raising the rate high enough to cover the bank and ensure that the loan is profitable destroys the borrower?

2) how many borrowers are willing to borrow with such uncertain costs of borrowing?

If inflation was such a reliable way to stimulate bank lending, Zimbabwe would've become the world's banker, instead of the world's most recent example of the failure of central banking.

Within a year, we'll see double-digit inflation rates.

Nice Graphic on Unemployment by County

2009-04-20T20:24:00.000-07:00

Check out Slate for a nice animated graphic on unemployment by county in the US.

The graph shows something that apparently Paul Krugman has forgotten: the real estate bubble actually did cause important economic distortions, which are now manifesting in real job losses.

Krugman argues that the real estate bubble isn't what's behind job losses now; I agree insofar as the real estate bubble is an intermediate rather than primary cause. The primary cause is the explosion of money created by the fractional reserve banking system, overseen by the Federal Reserve and the Federal government.

How Long Will the Stock Market Rally Last?

2009-04-17T12:30:00.000-07:00

Here's where I go out on a limb. My feeling is that the rally will take the Dow to 8300 or so, before the market returns to its downward course. How long will that take?

On the one hand, the rally that began after the March 9th low has only been around 5 weeks, but already it has wrought a powerful change in sentiment. There is big money on the sidelines hoping to recoup some losses. Some have no doubt been tempted to get back in.

On the other hand, it feels as though the rally has already begun to cool. Yes, the last few days have shown gains, but it feels like the winds are changing. Perhaps we'll see the market move sideways for a while, as it did today, ending flat (+5.90 or 0.07%).

The recession is just beginning. How will the market respond to further bad news? Has the market discounted all the bad news? Has the market already looked ahead?

I don't think so. The conventional wisdom is that the recession will last the year. My own view is that we are in for a 5 to 10 year recession.

An interesting possibility is how the market may respond to the inflation that is coming soon, once the deflationary pressures have abated. Will stocks leap ahead, encouraging investors that the bear market is over, a rally that is stimulated by inflation, not real underlying growth? That is a distinct possibility.

Did Mark-to-market Accounting Destroy the Economy?

2009-04-16T10:00:00.000-07:00

Mark-to-market accounting basically means that assets will be valued according to what the market price of the asset at the time. This is a commonsense practice. What is your house worth, what is your car worth, what is your time worth? The answer is the same for all: it is worth what the market will bear.

Frank Holmes argues that this simple and commonsense practice (recently suspended by the Financial Accounting Standards Board, here is the original guideline) says yes, in a recent article on the Kitco website. Unlike most analysts on this issue, he provides some data. Holmes argues that the FASB accounting rule (implemented at the beginning of 2008) caused a vicious cycle: the rule caused banks to write down losses that were at that point unrealized, which then caused them to be under-capitalized, causing them to then restrict lending.

Here's his chart (in $bil):

What makes Holmes' argument spurious is that the very time when the graph begins its sharp descent corresponds with the end of the peak performance of the stock market (the Dow hit its record in Oct 2007, with a long downward slide since). (To be fair, Holmes notes this when he says credit market became 'impaired', meaning they were on the way down, but because of rigidity in some derivatives markets, supply and demand did not clear.)

It simply does not matter whether banks 'realize' their losses or not. As long as the market value of the asset is below what they paid for it, there is a loss. If a person buys a 1000 shares of a stock at $10 a share and that stock falls to $7, that person has lost $3,000. If he sells, the loss is realized. If he decides to keep the stock, he has a paper loss, or an unrealized loss. Perhaps he decides he doesn't want to take the loss, and hopes the market improves taking the stock back to $10, or even above. Fine, but that doesn't change the fact that the asset is worth $7,000 today. No amount of wishful thinking will change that, and this is why the suspension of mark-to-market accounting will do nothing to solve the financial crisis.

In fact, the FASB rule did not cause banks to restrict lending. It simply revealed how short banks are. That information was readily available well before FAS 157 (the mark-to-market rule) took effect. Federal reserve data shows that bank reserves had fallen to well below 1% of deposits. That only works during the boom years; when markets began to flag, and then seriously head downward, banks pulled back their lending because they saw banks failing, being taken over by the FDIC, and those that were still left standing panicked, beginning a mad rush for deposits that took bank reserves to about 12% (as of 4/8/09, reserves $861 bil, deposits of $7,361 bil). Eric deCarbonnel has a nice article on bank reserves steadily moving to basically zero.

It was the over-use of leverage that created the conditions for the financial collapse, and the main culprit is the fractional reserve banking system. Don't blame honest accounting for the collapse.

Did the Gold Standard Cause the Great Depression?

2009-04-03T08:00:00.000-07:00

(I'll be out of town until 4/12, so I won't be blogging. Can you live without me?)

A fascinating 1997 paper by Barry Eichengreen and Peter Temin argues that the gold standard caused the Great Depression. (Well, at least that the gold standard 'mentalite' was part of a set of factors that caused the Depression.) Eichengreen (UC Berkeley) and Temin (MIT) are top-notch economists; each has published a slew of articles on economic history. They represent the mainstream orthodox neoclassical-Keynesian synthesis on this point.

In this view, which is really more Keynesian than classical, sound money tends to tie the hands of government during a recession. Sound money is 'inelastic', you see, and cannot be made to do what government officials want it to do. The government often wants the impossible: lots of spending, while at the same time cutting taxes.

Eichengreen and Temin's paper is good to read alongside Murray Rothbard's America's Great Depression. (Freely available in its entirety at the previous link). Rothbard essentially argues the opposite: it was the rapid expansion of bank credit during the 1920s which caused the inevitable contraction in the money supply as banks rushed to cover; the government's response in the form of stimulus made things far worse by lengthening the time of adjustment.

FASB Suspends Mark-to-market Accounting Rules

2009-04-02T08:30:00.000-07:00

And the market loves it! The Dow is up 270 points as I write this. (Here's a link to a WSJ article on this development.)

Well, we should have known that with the steady drumbeat of analysis (examples here, here, and here) blaming the financial crisis on mark-to-market accounting that this would eventually happen.

Unbelievable. It is absolutely absurd to blame the financial crisis on mark-to-market accounting. What causes banks to suddenly realize that they have solvency problems is that they are insolvent every single day of every year; it's only that a dip in asset prices causes them to worry about it for the first time. Modern banks run on the fractional reserve system. During a credit boom, market competition pushes banks to decrease their reserve ratios, for this is key to higher profits. The Fed tends to look the other way as banks move assets around to avoid mandatory reserve requirements (either 10% or 3% depending on the size of the bank.) According to Fed data, aggregate bank reserves fell to 0.74% of bank deposits, showing that banks are adept at getting around mandated reserve ratios. (Reserves have exploded since the fall of 2008, showing the fear that has struck the banks.)

Allowing corporations more flexibility to value their assets (i.e. facilitating wishful thinking or outright deception) will not make this crisis go away, it will prolong it. The crisis will be over when markets clear. That requires accurate information, not opacity.

Krugman vs. Austrian View of Booms and Busts

2009-04-02T08:00:00.000-07:00

Robert Murphy has an interesting blog post on the Austrian economic explanation for booms and busts. Austrian economics is based on the writings of Carl Menger, Ludwig von Mises, Friedrich Hayek, and Murray Rothbard.

This post is a critique of a recent post by Paul Krugman, who seems to intentionally misunderstand the views of other schools of thought in economics. Is it so difficult to understand each perspective and give it a fair hearing before attempting to refute it?

It seems this crisis may offer an opportunity to test which of the predictions from these schools of thought end up being more accurate: the Keynesian view, as seen in Paul Krugman's writings, or the Austrian view. For example, Krugman writes:

Just a quick note on the new, pessimistic CBO budget projections:
1. These projections have no bearing on the case for a large stimulus now — none. Adding, say, another $600 billion to stimulus spending would, on net, add around $400 billion to debt a decade from now (net is less than gross because the stimulus expands GDP, which leads to higher revenues that partly offset the initial outlay.)

This is a testable hypothesis. We shall see if it is the case that spending another $600 bil actually results in an addition of (only) $400 bil in debt in a decade.

Just to be fair, let me throw in my own prediction: this crisis will be a severe test of the Keynesian faith in monetary and fiscal stimulus, for neither one is capable of solving the problem. All indications point to an inflationary recession and stagnation, much like the Japanese experience of the 1990s. Of course, Japan did not have the world's reserve currency. We do, and we're tempted to use that power to inflate away our massive debts. I predict we will do so, like Roosevelt did in 1933 when he essentially defaulted on US debt by suspending the gold standard and devaluing the dollar by 41%.

Rather than saying, along with Krugman, that debt doesn't matter, we ought to be recognizing that expanding the Federal debt burden to finance an economic stimulus is exactly the wrong direction. We ought to trim spending and cut taxes, and get out of the way of the inevitable economic adjustment to equilibrium.

Amariglio vs. DeLong

2009-04-01T08:00:00.000-07:00

Looking for an amusing diversion from the financial collapse?

Have a look at Brad DeLong's blog post from 2007 attempting to take David Ruccio and Jack Amariglio to task over the definition of postmodernism and its legacy. Did he even read their book Postmodern Moments in Modern Economics before attempting to teach them the meaning of the term 'postmodern'?

The amusing part is Amariglio's response. I have not seen such an erudite and proper public spanking in some time. It reminds me of Jim Cramer's recent treatment on the Daily Show. DeLong had nothing to say in response, because it is evident that he has only the most cursory exposure to the ideas he is attempting to discuss.

Robert Reich: "Double the Stimulus"

2009-03-31T08:00:00.000-07:00

I like Robert Reich. He has a wonderful style of writing, at once assertive in his rhetoric and reasonable in his tone. In a recent blog post, (3/13/09) he calls for a new stimulus of roughly equal size to the last stimulus of $787 billion.

That is interesting. The President of the European Union, Czech PM Mirek Topolanek has just made headlines by calling the stimulus the way to hell. Topolanek argues that to ramp up spending during a recession is the wrong move. He's going against the grain, and since his center-right party just lost a vote of no confidence, he probably won't have much influence. It does seem like an unusually provocative statement.

Double the stimulus or road to hell?

In Marxian terms, this recession is all about what is called 'unproductive' economic activity, meaning labor which is not designed to produce value (i.e. activities which directly transform raw materials with labor in order to produce something which meets a human need). Unproductive activity is important, yet it does not directly produce an economic surplus (that amount which is produced which is greater than the needs of the direct producer). Over the last 60 years, the US economy has dramatically increased its unproductive activity, shown nicely in Measuring the Wealth of Nations, by Anwar Shaikh and E. Ahmet Tonak.

The activities of the Federal government, though important, are unproductive in the sense that they are not intended to produce a surplus. That means that government must be funded from a portion of the total surplus produced in the US. Since the crisis facing US capitalism is a crisis of unproductive activity, it cannot be solved by increasing the amount of unproductive activity.

In the years to come, we will see a return to productive economic activity: agriculture and manufacturing will once again dominate the US economy.

Fed "Quarterbacking"

2009-03-30T08:00:00.000-07:00

If you want something that will turn you against the study of monetary economics forever, read a series of experts debating what the Fed should've done and how what they did affected the economy. For example, The Wall Street Journal's recent symposium, Did Alan Greenspan Cause the Housing Bubble?

What a tiresome parade of simplistic reasoning and confusion, with the exception of Judy Shelton's piece, "Loose Money and the Derivative Bubble." (She has another great article published on 2/11 called Capitalism Needs a Sound-Money Foundation. (Ms. Shelton is the author of Money Meltdown, which I confess I have not yet read.)

To blame the Chair of the Fed for supposedly disastrous Fed policies is "quarterbacking", as in, how might have that game played out if the quarterback had acted differently? A speculative exercise at best, quarterbacking ignores the interconnected nature of events, supposing that we could go back in time and change one thing, leaving all other things unchanged.

The other problem with Fed quarterbacking is that the Fed is in an impossible position. The Fed's stated mission is to maintain price stability, full employment, and financial stability. Each of these is a sham. Price stability? The Fed issues a fiat currency, and has recently increased the number of Federal Reserve Notes (aka dollars) by several trillion (most of it in electronic form). The Fed is the primary engine of inflation, not price stability.

That the Fed can use wise monetary stimulus to ensure full employment is Keynesian dogma, and it's more or less true during the credit-fueled boom. But when that boom ends, as it must, the Fed becomes ineffective, for the contraction in bank lending tends to counteract the Fed's lowering of the interbank lending rate. This is where we are now, and the Fed's efforts to re-inflate the bubble are likely to create inflation, which will surely interfere with the economic adjustments necessary to begin recovery.

As for financial stability, the Fed presides over a fractional reserve banking system, which is inherently unstable. Like building on a river delta, a flood will periodically come and wash out the banking system, causing banking failures and bank runs, which the system cannot endure.

The housing bubble isn't Alan Greenspan's fault. But it is the fault of the Fed system, which generates credit bubbles which must inevitably pop. Greenspan should've known better. He has long advocated the gold standard. But he just did what everyone wanted him to do: he spiked the punch so we could all get drunk at a decades-long party. Now we're sobering up and cursing the man who sold us the drinks we demanded.

"No reputable economic forecaster is predicting a depression"

2009-03-27T09:17:00.000-07:00

Says Edward Leamer, Director of the UCLA Anderson Forecast, on Marketplace. He sees no depression in the near future:

We've frightened consumers to the point where they imagine there is a good prospect of a Great Depression. That certainly is not the prospect. No reputable forecaster is producing anything like a Great Depression. So it's still OK if you spend a little bit. You do not have to put all your money into a mattress.

Dr. Leamer also sees the economy in a "healing cycle" by the second half of 2009, without "significant growth", but with fewer of the "large negatives" we've seen so far.

We shall see. I do not think that the errors and excesses of the boom years will be corrected by then. My guess is that the inflationary recession will continue for a period of years rather than quarters, particularly since government policy seems driven to prevent markets from reaching equilibrium, and the Fed is producing monumental amounts of new money, much of it secretively, off its balance sheet. Estimates of Fed off-balance sheet money creation are in the trillions of dollars.

Here are a few analyses of the magnitude of these Fed activities: ritholtz.com/blog, nowandfutures.com (this site also has a reconstruction of M3, the broad monetary aggregate that was discontinued by the Fed in 2006.)

Webcast with Karl Case "The Economy and the Housing Crisis"

2009-03-26T20:36:00.000-07:00

I got an invitation from Pearson, one of the textbook publishers that is always trying to sell me their texts, to participate in a live webcast with Karl E. Case, Professor of Economics at Wellesley College and founding partner of the real estate research firm Fiserv Case Shiller Weiss, which produces the S&P Case Shiller Index. The Case Shiller Index is, in my view, the best of the real estate indices.

If you want to check it out, it's March 31st, 12-1 EST.

Go to: www2.eventsvc.com/pearson

They want you to register first.

I'm interested because Karl Case has said housing has hit bottom, and I'd like to know his reasons. There will be a Q&A after the talk, so I'll report back on it.

Outrage Over AIG Bonuses

2009-03-26T08:26:00.000-07:00

It's been interesting to watch the back-and-forth over the $165 mil in bonuses to the AIG execs and financial wunderkinds in the division that wrecked the company.

On the one side, AIG is like, well, we're still in business, so it's business as usual. The "performance" part of the bonuses was based on a Panglossian assessment of the profitability of the credit default swaps. (Jack Adamo of Forbes has a nice article on this.)

It sure makes the government look bad to be completely behind the curve on this. Congress knew about the bonuses for months, but only acts once the public gets upset.

Is AIG stock a candidate for a short sell? I'd say so. The stock more than tripled in price recently, going from a low of $0.35 to a high of $1.28 today. The short interest is currently 5.9%.

A former student sent me a note asking about AIG - is it a good idea to invest in it, since it seems like the government is behind it, so it can't fail, right? I said it was extremely speculative, since AIG is sitting on God-knows-how-much in liabilities, but in the short term, I expect the stock to rally to $1, making it a good play if you have the stomach for the risk.

At this point, I expect the rally to take the Dow to 8300 before resuming its downward course, and I expect AIG will be punished by the market soon.

And yes, I try to only list my good calls...

Should We Cap Interest Rates?

2009-03-24T14:32:00.000-07:00

A new article in Harper's Magazine (subscriber only, but here is an interview where he gives the main points) by Thomas Geoghegan offers an interesting solution to the problem of financial collapse: cap interest rates.

His argument is provocative: by deregulating interest rates, we encouraged the massive growth of the financial sector, for the simple reason that capital can obtain much higher rates of return through lending consumers money at high interest rates than it can get in, say, manufacturing. Securitization separated the lender from the owner of the debt, which created an incentive for lenders to engage in misleading practices and really sell the idea of debt to consumers. The average working family got killed by higher and higher interest rates.

He's right about so much of this that I find it frustrating that he arrives at the conclusion of capping interest rates.

Yes, the growth of the financial sector was because of higher profit rates; yes, securitization separates lender from owner of debt, creating some bad incentives; and yes, the average household is getting killed by high interest rates. But to cap interest rates would simply mean that much of the lending to consumers would simply dry up or be driven underground at much higher interest rates. (The classic deal with a loan shark is "a point a week", or 52% yearly interest.)

High adjustable-rate interest is simply the market's response to inflation. Eliminate the inflation, and you will eliminate high interest rates. Indeed, the sooner the market correctly prices the asset-backed securities that are based on debt, the better, because that will be the day when this scheme is finally buried once and for all.

To get the government involved in this process would be a mistake. Government-based pricing does not tend to produce good outcomes, it tends to produce shortages and surpluses.

The Architect of the Obama Stimulus Plan

2009-03-23T07:34:00.001-07:00

Professor Bob Pollin, one of my old professors from the University of Massachusetts Amherst wrote an influential article in The Nation called How To End the Recession which had a big impact on the Obama Administration.

I have a lot of respect for Professor Pollin. He is the co-founder of the Political Economy Research Institute and a long-time advocate for working Americans. He is the author of Contours of Descent, a good book about the US economy during the 1990s. (Click here for a review I wrote of the book). Nonetheless I must differ with him that a stimulus of the kind and magnitude he offers will end the recession. (In the article, he calls for a stimulus of $300 bil, so that has been enthusiastically exceeded by the Obama Administration)

The recession will continue until all the disastrous business blunders that accumulated during the distortions of the boom years have been purged.

During a credit-fueled boom like the one we've just observed, the economy accumulates investment mistakes, due to the patterns that emerge that look sustainable but are not. For example, due to the easing of lending standards, the rate of homeownership rose from about 65% to nearly 70%. Millions more people owned homes than before. That incredible rise in real estate buying and selling fueled a boom in home construction. It is now abundantly clear that many of the new homeowners should not have purchased their homes. They did not have the income to purchase the home they did at that price.

All the economic activity that grew up around booming home prices now must be directed toward other ends. The number of realtors, which increased 50% (thanks to the Political Calculations blog for a nice analysis) from 2001 to 2006, must return to historical levels. Home construction must fall. Home prices must fall until they reach a level of historical affordability.

The reality is that an economic stimulus of $300 bil such as what Professor Pollin proposed, or the more ambitious version that the Obama Administration created will not encourage the kind of restructuring to which I refer above. Instead it will slow down the necessary adjustment, and add inflationary pressure to the mix.

A Prediction for the Dow

2009-03-22T20:01:00.000-07:00

In the spring of 2006, my father and I predicted a financial crisis would hit the US. (We assumed that this crisis would be driven by dollar depreciation, which has not yet occurred). We continue to feel strongly that the dimensions of the coming crisis are still not grasped by most Americans. In January 2008, I predicted the Dow would fall to 7000. Given what has now occurred, our concerns were mild. Yes, an estimated $60 tril of paper wealth has been destroyed globally, but there is much more to come.
Over the next five or ten years, the US will sink into a deep recession. Unemployment will rise dramatically as the restructuring of the American economy proceeds. We see the Dow falling to 400. Yes, four hundred.
Given the endless parade of bad news and bearish forecasts for the economy, it may seem that the worst has already happened, and there is nowhere to go but up. Indeed, some analysts (for example here and here) have called a market bottom. The US consumer is not spending, unemployment is rising, the highest officeholders in the land call it the worst situation since the Great Depression... you might say, how many other shoes are there waiting to drop (or be thrown)?
What has not yet occurred is a serious threat to the dollar's status as the world's reserve currency. That threat will come, for the world cannot continue to finance American profligacy. When the eventual flight from the dollar occurs, it will cause much worse damage even than the unbelievable carnage in asset prices (click here for a chart of the Dow over the last year) we've already seen.

Stewart vs. Cramer: Short Selling Backlash

2009-03-17T18:44:00.000-07:00

[Written for the Borsen-Kurier]
Judging from the cable news cycle, the most important story of the last week in the US was a face-off between Jon Stewart, comedian and host of The Daily Show (you can watch the show here), Comedy Central’s fake news network, and Jim Cramer, a former hedge fund trader and host of CNBC’s Mad Money. How did it happen that arguably the most serious journalist in the US, virtually the only interviewer who is willing to ask truly tough questions, is a comic specializing in, as he puts it, “fart jokes”?
Stewart played a clip from the end of 2006, which showed Cramer being interviewed and revealing some of his secrets of short selling: “You want to spread rumors about the company,” he said, “it’s against the rules, but the SEC won’t find out.” After the clip, Stewart says: “I want the Jim Cramer on CNBC to protect me from that Jim Cramer.” Cramer squirmed and capitulated, trying to make it seem that he’s doing everything he can to prevent the kind of abuses he’s just been shown to be adept at, and promising to do a better job as a financial reporter. “That would be great,” said Stewart, pressing on, “but this is about more than you.” It’s about the network, the show, the whole focus on short-term gain at the expense of the little guy, about gaming the system, about the average investor “capitalizing your adventure”.
He’s right, of course, in that financial markets can function like a poker game. As Warren Buffett put it, if you’ve been playing poker for half an hour and you don’t know who the sucker is, it’s you. Shows like Mad Money are designed to draw in more suckers, who then make amateurish blunders, which the pros exploit.
What should be done?
It doesn’t seem to make much sense to try to ban rumor-mongering. But should we ban or try to restrict short-selling? Has short-selling caused the financial meltdown? Short-selling is the practice of borrowing shares, selling them, then waiting for a lower price, which allows the investor to buy back the shares, and return them to the lender, pocketing the difference. The practice of short-selling is having its 400th anniversary this year, and it remains controversial, because it puts the investor in the position of hoping for a decline, and for the last 400 years, short sellers have been blamed for causing markets to fall.
But such a position is untenable. Though it is true that every short sale begins with selling, and each act of selling exerts downward pressure on a stock, the number of short sellers in a market tends to be small, and short sellers tend to be professional (or at least experienced) traders.
Because markets tend to price in available information, rumors cannot bring prices down for long. If a stock is undervalued by the market, its price will eventually rise, just as overvalued stocks will fall. Short sellers do a valuable service by putting pressure on overvalued stocks. Either the shorts are correct, and the stock falls back to a lower value, or the shorts are wrong, in which case they lose money. There is no more effective discipline for traders than losing money. Blaming short-sellers for falling stock prices is like blaming a vulture for the death of a zebra. A vulture is incapable of killing a zebra, but the vulture obviously benefits from the zebra’s death; the rest of the ecosystem benefits from the vulture stripping the carcass.
Short selling did not cause the US stock market to fall. The stock market fell because it had reached a monumentally overvalued condition. To restrict short selling not only locks the barn after the horse is gone, it discourages traders from taking positions which correct overvalued prices.

Weakness = Strength? Lasting Prosperity Cannot Occur Through Currency Depreciation

2009-03-16T18:14:00.000-07:00

[Written for the Borsen-Kurier]
Perhaps the most under-reported story in the US is one that hints at the future of the dollar: China plans a technical change in the way international transactions are made by its multinational corporations, allowing these transactions to be settled in its own currency, the Yuan, rather than in dollars, Euros, or another ‘hard’ currency. Though the move does not affect the exchange rate between the Yuan and the US dollar, it is a move that undermines the dollar’s reserve currency status; No doubt China would like to put the Yuan in the dollar’s place.
These days a curious idea seems to hold sway: that a country can get economic growth by destroying its own money. Currency Depreciation Can Spur Boom In Exports, Lead to Economic Recovery, reads the subtitle of a recent Wall Street Journal article, which cites the US in 1933 and the Asian tigers (and Russia) during the 1990s. All of these economies supposedly reached prosperity through reducing the value of their currencies.
The US accuses China of holding the Yuan ‘artificially low’, giving Chinese products an unfair advantage in the US market. As the US dollar weakens against the Euro, and the unwinding of the Yen carry trade causes the Yen to strengthen, Europe and Japan can no longer count on exports to the US to produce growth.
Each country wants their currency to be both strong and weak at the same time, as weakness helps exports, while strength leads to increases in foreign investment and the ability to issue bonds at attractive rates.
Since we live in a world of fiat money, where the value of a currency depends on little more than the resolve of central banks to defend it using their foreign exchange reserves coupled with their reticence (or lack thereof) to create more money, weakening a currency against the US dollar simply requires the rate of money creation be greater than the rate of growth of the US money supply.
Clearly, the entire world cannot employ this strategy. There must be some anchor. That anchor, of course, has been the US dollar for the last 60 years. But now the US wants to play the same game; but how can the world’s reserve currency survive a regime of massive indebtedness? As the dollar fades, some of the benefit of a reserve currency may also be lost: the anchor that helped world trade flourish during the eras of Bretton Woods I (1945-1971) and what some have called ‘Bretton Woods II’ (1971-present) will be lost. Will the distrustful beggar-thy-neighbor trade policies of an earlier era return? It seems likely that there will be a period of chaos which will disrupt global trade until a suitable substitute is found. There is one choice for a medium to conduct international settlement that is widely seen as ‘the gold standard’, which is… uh… the gold standard.

What Caused the Housing Crash?

2009-02-16T18:07:00.000-08:00

“Problems started at the household level, with poorly-designed mortgage products”, claims Elizabeth Warren, professor of law and member of the newly-formed Financial Products Safety Commission. According to this view, the US housing bubble, where prices of homes increased 125% from 2000 to 2006, was the result of shoddy products sold to an unsuspecting public. Like the general claim of ‘predatory lending’ such a view assumes that people need a government agency to protect them from making bad decisions.
The fall in home prices, which began in 2006 and continues, has so far wiped out perhaps $10 trillion in value. If only there had been some government agency providing oversight, all of this may have been averted, Warren suggests. But there was. It’s called the Federal Reserve. But the Fed did nothing to avert the housing bubble—in fact, former Fed Chair Alan Greenspan made public statements urging people to buy homes with adjustable rate mortgages. What a spectacle: the nation’s foremost economist urging people to commit financial hari-kari.
Sure, there were ‘toxic mortgages’, to use a recently-coined term which seems to have caught on. Mortgage brokers aggressively sold them to people. People were encouraged to lie about their income and assets and they did so eagerly, to get their piece of the American dream: their own home. Fraud and deception proliferate in an atmosphere of denial. Home prices will always go up; you’ll be able to re-finance later at low rates, an army of mortgage brokers said.
But to say the current crisis is the result of bad mortgages is to employ a circular logic. Why did these mortgage products spread and gain dominance? Why did they displace the traditional banker’s strategy of lending conservatively to qualified borrowers? The reason is that the creation of toxic mortgages is the result of the same force that produced the rapid growth in hedge funds, credit-default swaps and other financial derivatives, and massive increases in trading volumes: money creation. Money created out of thin air always creates inflation. But when the price being inflated is a home, it seems to cause a special kind of madness that does not result from the inflation of other prices, like food, gasoline, or medical care.
Money creation is itself the product of two forces: the fractional reserve banking system, and the desire of the government to run large, continuing deficits, which are partly financed by slowly depreciating the currency through inflation. The change in bank policy which made toxic mortgages possible was a relatively new practice of moving money into new categories (such as repos, Eurodollars, collateralized debt obligations, and others) which allowed banks to circumvent the Fed’s required reserve ratio (which ranges from 10% for larger banks to 3% for smaller ones). As the result of this shell game, the actual reserve ratio in US banks fell to an incredible 0.74% at its trough—that’s $0.74 for each $100 deposited (this ratio has since risen, as banks are now in panic mode).
The Fed, which, after all keeps the statistics on bank deposits and lending, certainly must have known, but opted to look the other way. The rewards to financial ‘innovation’ of this kind were great, and the riskier banks bought those who employed more traditional strategies. Mortgage lending became so profitable that banks specialized in it, eschewing deposits altogether, instead obtaining funding by selling the mortgages as securities and making more loans, always more loans.
Given that the housing bubble was caused by money creation, it would be simply silly to think that some commission assigned to prevent bad mortgage products will have an impact. The solution to future asset bubbles is clear: abolish fractional reserve banking.

What Caused the Stock Market Crash of 2008-2009?

2009-01-22T17:45:00.000-08:00

[Written for the Borsen-Kurier]
What caused the US stock market to spectacularly crash in 2008 is intimately connected to what caused the market to boom from 1980 to 2007. In broad terms, the long market boom, which took the Dow from 875 to over 14,000 at its peak in the fall of 2007, was the result of two interconnected forces: money creation and redistribution.
Economically, the great puzzle to solve is not why the market crashed, but why it performed so far above the rate of economic growth for so long. Why should the stock market, which is composed of nothing more than a broad section of corporations, on average perform any better than the overall rate of economic growth, upon which it surely rests?
Consider the following graph of the stock market and M3, the Federal Reserve’s broadest measure of money creation (M3 was discontinued in 2006, but the series is kept up by several different private economists). Notice that the performance of the stock market (as measured by the Dow) is far above the rate of productivity growth or the rate of real economic growth.

The fractional reserve nature of most modern banking systems means that money creation takes place in a decentralized manner; during this period, much of that money found its way into financial markets, in the form of leveraged buyouts, stock buybacks, and the effects of increasing leverage on the part of investment banks and the explosive growth of the highly-leveraged hedge fund industry. Much of this borrowing went to purchase equities, bidding up prices dramatically.
At the same time, the shifting balance of power between labor and capital made it possible for corporations to hold down wage growth, resulting in an unprecedented 20 year period of falling real wages in the US. This caused corporate profits to increase, along with share prices, as stockholders re-evaluated the new distribution of income between labor and capital.
The problem, of course, is that neither of these forces are sustainable. The share of income going to labor can fall, allowing the share that goes to profits to rise, but labor’s share cannot fall far without producing resistance. In the US, that resistance was weak, in part because of a new innovation: leverage for consumers. Unfortunately, the new kinds of consumer credit that were invented and eagerly used by US consumers were rarely used for any kind of investment, so debts mounted without an increase in income to pay them back.
As for money creation, it must eventually lead to inflation. No one can truly create wealth out of thin air, so when money is created far in excess of economic growth it must cause rising prices somewhere. If it causes rising consumer prices, we notice it and demand a solution, but if it causes rising stock prices, we celebrate it. But the money is not real, and the prices cannot last. At this point, it seems likely that the Dow will fall to 5500, which would give the Dow a traditional bear market dividend yield of 6%. Given the extent of money creation thus far, a strong possibility is that the Dow shows strong growth, perhaps rising above 10,000, or even above its record heights. While this may reassure investors, such an outcome would simply be the first manifestation of inflation that will not be confined to financial markets this time around.

Economic Stimulus and the Banking Sector

2009-01-21T17:38:00.000-08:00

The incoming Obama administration has been steadily increasing the size of the proposed economic stimulus, which now stands at $850 billion. Thus far, much of the debate has centered around the question of how big a stimulus ought to be, and what should be the mix of tax cuts versus government spending. This week, discussion has centered on what kind of spending would be desirable, and while the proposal of ‘green tech’ and repairing infrastructure is appealing, the criticism has been raised that since 97% of construction workers are male, and most are white, infrastructure projects leave out many of the most vulnerable poor, among them women and minorities.
The size of the stimulus will no doubt continue to grow as economic conditions worsen, particularly in the job market, where job losses appear to be accelerating, with 524,000 jobs lost last month. As for the overall effect of the stimulus package, Macroeconomic Advisers estimates that the Obama stimulus will increase GDP growth by 3.2%, and reduce unemployment by 1.7% by creating 3.3 million jobs.
Given the sudden reluctance of consumers to spend, it seems likely that the $275 billion portion of the stimulus package that is tax cuts will effectively disappear into savings or toward paying off household debt. But if lenders receive payment, they can make new loans, right?
I wonder. So far lending has fallen by $133 billion since October 2008, which means the money supply is contracting just as the stimulus is put in place, perhaps by as much as $1.33 trillion, assuming a money multiplier of 10. The big question is if banks continue to reduce their lending. It seems likely that banks will have reduced demand for loans without the mergers and acquisitions boom, and with de-leveraging occurring on all sides. If lending falls by another $100 billion in 2009, it means another $1 trillion decrease in the money supply, which would easily swamp the stimulus. This is one of the great weaknesses of the fractional reserve system: it tends to destroy money at exactly the wrong moment.
Think of the classical quantity theory of money: MV = PQ. The money supply is falling, and it seems likely that the velocity of money is also falling, as consumers spend less and save more. (It’s hard to measure the velocity of money directly, and it is typically inferred by measurements of the other variables.) This leads to falling prices and economic output. The adjustment process shouldn’t take long, if left alone: a year or two at most to purge failed ideas and business models, to de-leverage and move toward saving.
But of course it is hardly being left alone. Instead an ocean of money is being created and borrowed, all to prevent the natural adjustment of the economy back to a sustainable course. This adjustment cannot be prevented, though it may be delayed, it may be drawn out. The casualty of all this will be the US dollar, which is in its last days of being the world’s reserve currency.

Solving the US Banking Crisis

2008-11-30T17:35:00.000-08:00

[Written for the Borsen-Kurier]

Most efforts proposed these days go exactly the wrong direction: back toward unsustainable economic activity like debt-funded consumer spending, home buying, and government spending, or away from the transparency that markets need to reach equilibrium (for example, the recent proposal at the G-20 meeting that accounting standards be ‘temporarily’ loosened—as if we could escape our problems through denial).

Here is an economic plan that would work immediately; it would stabilize the banking sector instantly, preventing the crisis in the stock market from reducing business investment in the real economy, thus preventing a major contraction of GDP.

The catch? It will involve some short-term economic pain.

The reason that banks are fragile is that they have only a fraction of their deposits on hand at any given time. Because banks are currently scrambling to increase their reserves, they have restricted lending by $100 bil from October 29th to November 19th. Granted, this is a small decrease when the total volume of loans is over $7,000 bil, but any decrease in lending tends to be pro-cyclical, resulting in the contraction of the money supply at precisely the wrong time. In theory, a money multiplier of 10 would imply that a $100 bil restriction in lending would lead to money destruction of $1,000 bil. Additionally, because of decreased consumption and investment spending, there is a falling velocity of money, meaning fewer transactions per week. This exacerbates the effect of a contraction in the money supply. As of November 28th, 2008, the total money supply (M2) was $7,854 bil. Bank reserves have skyrocketed from $44 bil in August to $652 bil in October, while bank deposits have stayed constant at about $7,000 bil.

Here’s the plan, in two parts.

Part 1: the total cash and coin in the US is less than $800 bil. Print an additional $7,000 bil, and give it to banks in exact proportion to their deposits. Then make sure that bank reserves always equal bank deposits, creating a 100% reserve system. This would cause no net change in the money supply, for we’d simply have printed money to back up bank deposits, money that was already in use. We’d merely replace checkbook-money with paper money. No problem so far. There would be no inflationary pressure, and the cost would be minimal - the cost of printing and distributing the money.

Part 2: Define the dollar as a portion of gold. This is where the sacrifice begins, for it involves a substantial devaluation of the dollar. The US holds 8.133 bil grams of gold, and the IMF has another 3.217 bil grams; if we divide the total money supply M2 by the total US and IMF gold reserves, we get about $700 per gram, meaning a dollar is worth 1/700th of a gram. Now the tough part: we keep this ratio in good times and bad, at all times allowing anyone to trade $700 for a gram of gold. Since the current market price of gold is about $26 per gram, this plan would entail that the dollar must fall to 3.7% of its current value. (The drop would probably be less severe, as this plan would pull gold out of private gold stocks and into service as money).

The sacrifice would begin when all imported goods immediately rise in price dramatically (an imported good that costs $1 may rise to $25). International trade flows would change as markets reach equilibrium. This would certainly cause some dislocation. But we’d skip the lasting pain of a sequel to the Great Depression because the main damage to the economy would be avoided. The money supply would not contract due to banks rational fear of collapsing during the financial crisis. Banks would be on a solid basis, and they could immediately begin lending (from savings accounts only; these would have to be set aside specifically for investment purposes, and would no longer be available on demand).

Sacrifices would continue as the US could no longer maintain a current account deficit without draining US gold reserves. The federal government would not be able to borrow billions or trillions to finance deficit spending. The depreciation of the dollar would mean foreign bond holders would immediately lose money, and large-scale selling of bonds would ensue. While it is unfortunate to break the trust of those who bought US bonds, it is simply unavoidable. The US has too much debt to pay it back. The US government will repudiate its debt, either simply and honestly, as in this plan, or covertly, through inflation.

Without access to deficit spending, cuts in government spending will add to the economic contraction, but the plan will prevent future pain, for the current strategy of massive money creation and fiscal deficits will surely devalue the dollar, without the benefit of ever leading to a sound medium of exchange.

The financial crisis is first and foremost a debt-deflation crisis, which was produced by banks’ wanton money creation during the expansion of the 1990s and early 2000s (an expansion supervised by the Federal Reserve). If we give the market a medium of exchange that can be trusted to hold its value, the extraordinary ingenuity and entrepreneurship that is America’s greatest asset will be unleashed, and we will soon be enjoying prosperous times again.

Inflation-Deflation Seesaw

2008-11-22T17:32:00.000-08:00

[A piece for the Austrian paper Borsen-Kurier]
The big news from America is President Obama: a truly great man has been elected president, and he did it in spite of his race and unusual name. It is a great moment for America. President-elect Obama faces a global economy that is more tightly interlinked than ever before, and so trends that emerge in the US (and elsewhere) have global ramifications.
The US Producer Price Index has been falling for 3 straight months: down 2.8% in October, 0.4% in September, and 0.9% in August. The PPI doesn’t reflect the plummeting asset prices in financial markets (the Dow is down 40%) and real estate (down 20% nationwide, according to the Case Shiller index). There is considerable downward pressure on nearly every asset class worldwide, and it seems likely that commodity deflation will continue for at least several more months.
Of course, the central banks of the world are working overtime to combat deflation; the Federal Reserve and the Treasury have borrowed or created nearly $3 trillion out of thin air this year alone. As that new money is absorbed and digested by markets, it will eventually cause inflation. Certainly the announcements of the G-20 meeting, with its statement that the world should work together to re-inflate sagging markets, is also inflationary.
By the current rules of the game, no country that relies on exports to fuel its growth can afford an appreciating currency against the dollar, for the strengthening of the currency would hurt sales in the US and every other country that maintains a dollar peg, which includes some pretty big markets, as well as some high growth markets, such as China. This means that when the US creates dollars, other countries rush to weaken their currencies. With a worldwide crash in equities, countries are not exactly reluctant to create money and funnel it into financial markets, but at some point, this will catch up with commodities again, and we’ll see a resumption of global commodity inflation, which is likely to accelerate.
The US bond market is currently pricing in low inflation over the long term. Indeed, for a time the inflation protected Treasury bonds (TIPS) had a higher yield than the nominal 10-year Treasury bond, meaning that the bond market predicts deflation. But what will happen when the money creation returns to markets in the form of inflation? Bond yields will have to rise, to compensate for inflation, leading to broad-based increases in interest rates across the economy; even though the Federal funds rate is likely to be low, I bet we’ll see high interbank lending rates, with the consequence of rising rates for consumer credit, and rising rates for corporate bonds as well.
There is no easy way out of this, but President-elect Obama has already done one good thing: reminded America that there will be sacrifices ahead. I think we can make sacrifices, if there is an understanding that it’s for a good reason, and it will help to eventually restore solid economic growth.