Sunday, November 28, 2010

Martin Truther

The Red Pill Guide to the Top 20 Secrets of our Times

This guide is the result of over ten years of research I've done in my own process of “waking up” to hidden truths. The topics are generally considered taboo. While my curiosity compelled me to go forward, it was difficult work and I hope this guide will make “waking up” easier for you and other readers. As Newton put it, “ If I have seen further [than others] it is only by standing on the shoulders of giants.” Many whose work I cite below gave their lifetimes and even their lives to gift us this information. I hope they will not always be as unsung in their heroism as they presently are.

The real world today bears little to no resemblance to the world we've been told about by mainstream media and conventional education. Most of us inhabit an illusion-world-- working, eating, breathing, and going through the motions of modern life as if sleep-walking. We interact within a consensus-reality “dream” that, in fact, has never existed and we're unsure what to do when our somnambulant limbs bump into the hard actual reality we can't even see. It's time for us all to WAKE UP to our actual reality, before we sleep walk off the roof and it's too late.

Our situation is dire and it's vitally important that we now re-examine our current world-views in light of new information, long suppressed, that is available to all of us, thanks to the radically equalizing medium of the internet. New legislation is already targeting internet freedoms and net neutrality, so please study the following issues now, while it is still possible.


Saturday, November 27, 2010

Friday, November 19, 2010

Warren Buffett

The op-ed N.Y. Times piece he shoud of wrote:

DEAR Uncle Sam (Sucker),

I was about to send you a thank you note for bailing out the economy . . . but then some nice men dressed in Ninja outfits came in and shot me full of truth serum. That led me to make one more set of edits to my letter thanking you for saving the economy.

It also helped me recall some things I seemed to have forgotten in my other public pronunciations about the bailouts.

I suddenly recalled who it was who allowed the banks to run wild in the first place: You. Your behavior before, during and after the crisis was the epitome of a corrupt and irresponsible government. You rewarded incompetency, created moral hazard, punished the prudent, and engaged in the single biggest transfer of wealth from the citizenry of the United States to the Wall Street insiders who created the mess in the first place.


Before I get to the bailouts, I have to remind you that in:

• 1999, you passed the Financial Services Modernization Act. This repealed Glass-Steagall, the law that had successfully kept main street banking safely separated from Wall Street for seven decades. Even the 1987 market crash had no impact on Main Street credit availability, thanks to Glass-Steagall.

• 1997-2010, you allowed the Credit Rating Agencies to change their business model, from Investor pays to Underwriter pays — a business structure known as Payola. This change effectively allowed banks to purchase their AAA ratings, and was ignored by the SEC and other regulators.

• 2000, you passed the Commodities Futures Modernization Act. It allowed the shadow banking industry to develop without any oversight by the Commodity Futures Trading Commission, the SEC, or the state insurance regulators. This led to rampant creation of credit-default swaps, CDOs, and other financial weapons of mass destruction — and the demise of AIG.

• 2001-04, the Fed, under Alan Greenspan, irresponsibly dropped fund rates to 1%. This set off an inflationary spiral in housing, commodities, and in most assets priced in dollars or credit.

• 1999-07, the Federal Reserve failed to use its supervisory and regulatory authority over banks, mortgage underwriters and other lenders, who abandoned such standards as employment history, income, down payments, credit rating, assets, property loan-to-value ratio and debt-servicing ability.

• 2004, the SEC waived its leverage rules, allowing the 5 biggest Wall Street firms to go from 12 to 1 to 20, 30 and even 40 to 1. Ironically, this rule was called the Bear Stearns exemption.

These actions and rule changes were requested by the banking industry. Rather than behave as adult supervision, you indulged the reckless kiddies, looking the other way as they acted out. You were the grand enabler of the finance sector’s misbehavior. Hence, you helped create the mess by allowing the banking sector to run roughshod over decades of successful constraints. (Kudos again on that).

There were voices warning about the upcoming crisis, but you managed to turn a deaf ear to them: Warnings about subprime lending, problems with securitization, against the false claim that residential real estate never went down in value, or that the models forecasting VAR were wildly understating risk. An economy driven by growth dependent upon credit fueled consumption was unsustainable, and yet you encouraged that reckless credit consumption. The compensation schemes for Wall Street were hilariously short term (ignored by you); the crony capitalism of Boards of Directors that undercut market discipline was similarly ignored. You encouraged the hollowing out of the US economy, allowing it to become increasingly “Financialized” at the expense of industry and manufacturing. What was once a small but important part of the economy became dominant, yet unproductive, with your blessing.

Bottom line: You were at a loss for understanding the many factors that led to the crisis in the first place.

When the crisis struck, you did not seem to understand the role you should play. Instead of stepping up to halt the financialization, to unwind it, you gave away the shop. You failed to extract concessions from firms on the verge of bankruptcy. Your negotiating skills were embarrassing. In the face of meltdown, you panicked.

You could have undone the decades of radical deregulation at that moment. You could have fired the incompetent management, wiped out the shareholders who invested in insolvent companies, gave the creditors and bond holders a major haircut for their foolish lending. Instead, you rewarded them for their gross incompetence.

The solutions you ran with were ad hoc, poorly thought out, improvised. You crossed legal boundaries, putting the Fed in the position of vio0lating its charter and exceeding its mandates. You created a Moral Hazard, the impact of which may not be felt until decades in the future.

Very few of your senior elected and appointed officials understood what was going on.

Rather than offer an intelligent response to the crisis, you delivered brute force: Trillions of dollars were thrown at the problem, papering over its symptoms but not its underlying causes.

Well, Uncle Sam, you delivered a motherload of cash. Considering the dollar sums involved, your actions were remarkably ineffective. What was left over afterwards was a wildly over-leveraged consumer whose credit limits had been reached; State and municipal budgets were heavily dependent upon that excess consumer spending, creating huge budget holes because of it. Net net: The resultant economy was in the worst recession since the Great Depression.

As a student of the Great Depression, Ben Bernanke should have had the best grasp – but his bailout of Bear Stearns revealed him to be just another banker, intent on saving the banks – banking system be damned. To give you a clue of exactly how lost Hank Paulson was, he spent his time praying, and creating documents that exempt himself personally for liability. He’s from Goldman, so we know that “team first” ain’t exactly his style. Tim Geithner, who did such a stupendous job overseeing the banks in the first place, was n way over his head. And while I never voted for George W. Bush, I give him great credit for hiding under the bed and pretty much staying out of everyone else’s way. I would call him clueless, but that wouldn’t be fair to the legions of clueless around the world.

Sheila Bair grasped the gravity of the situation earliest, and put numerous failed banks through the insolvency process. If we were smart, we would have allowed her to work her way through the entire finance sector, effecting a GM-like prepackaged bankruptcy for Citigroup, Bank of America, Merrill Lynch, Morgan Stanley, AIG, etc. It would have been painful as hell, but we would be much better off had we allowed her to tear the band aid off quickly. Instead, we are suffering through a death of a 1000 cuts, Japanese style.

I would be remiss if I failed to mention my personal positions in this: I made a killing in Goldman Sachs and GE. My investments in Wells Fargo would have been a disaster if not for you. Don’t even get me started with me being the largest shareholder in Moody’s – that was some clusterf#@k. And considering all of the counter-parties that Berkshire Hathaway has, we risked being just another insolvent investment firm along with everyone else had nothing been done.

So I must say thanks to you, Uncle Sam, and your aides. In this extraordinary emergency, you came through for me — and my world looks far different than if you had not.

Your grateful but wide-eyed nephew,



For many years, I’ve been a fan of Warren Buffett’s long term approach to value investing. Understanding the value of a company, regardless of its momentary stock price, is a great long term investing strategy.

But it pains me whenever I read commentary from Buffett that glosses over reality or is somehow self-serving. His OpEd in the NYT today – Pretty Good for Government Work – paints an artificially rosy picture of the Bailout, ignores the negatives, and omits his own financial interest in government actions.

What might he have written if Sir Warren was dosed with some sodium pentothal before he sat down to pen that “Thank you” letter? It might have gone something like this.)


Interest Rates Go Up!

“Inflation has long been the weapon of choice in sovereign defaults on domestic debt and, where possible, on international debt.”

By Peter T Treadway, PhD
Historical Analytics LLC

US and Chinese interest rates going up at the same time? Can things get worse?

As I have been arguing for the past two years in The Dismal Optimist, the dollar- based international monetary system is broken. That has now become the accepted view, in governments and in the markets, as the system has become progressively more broken. Investors, now face unprecedented volatility and uncertainty.

The markets in the last few days have experienced a rise in US and Chinese interest rates. Considering that low rates have been baked into asset prices globally, this is big.

Let’s start with the US.

It’s Our Currency, Your Problem

The above heading of course is a perennial favorite quote, courtesy of Nixon’s Treasury Secretary, John Connolly. Helicopter Ben Bernanke, in the Connolly tradition, has launched QE2 with the assumption that the US could do what it damn pleased regarding monetary policy and the world would put up with it. Ordinary countries might experience higher interest rates and currency collapses if they engaged in irresponsible money printing. Their currency, their problem. The US doesn’t have to worry about such trivia.

But this time we got a hint things might be different in the future. As President Obama discovered at the recent G 20 Meeting, Bernanke’s QE2 has evoked global outrage. And not only that. US longer term Treasury rates, if only momentarily, moved up.

Once upon a time in the good old pre-1914 days when gold underpinned both national and international monetary systems, central banks had only two tasks related to what today would be called monetary policy. The first was to buy and sell gold at an unchangeable fixed rate against their national currency and the second was to nudge short term interest rates up or down so as to encourage or discourage capital flows so as to maintain their country’s gold exchange rate. Actually in that blissful time the US didn’t even have a central bank. (The run on US gold in the Panic of 1893 was in part caused by fears that silver would partly replace gold in the US and the US would leave the gold standard) Central banks at that time were privately owned and profit making. The tasks of promoting full employment, softening the impact of deflationary bubbles, targeting inflation rates, or even targeting money supply, were not their problems. It was only after 1914, when the vast killing machines of an interminable war required endless financing, did the central banks morph into their current dual roles of national monetary central planner and agent of monetary debasement.

The world is well aware of two things: One, the US has borrowed in its own currency. Two, it is headed towards fiscal insolvency. Distinctions between US international and domestic sovereign debt are meaningless. The US will never default via non-payment of principal or interest. It can always print more dollars. If the US defaults, it will be via inflation.

I have been of the view that the Fed would not move up US interest rates in the next 12 months because the US consumer was mired in a massive real estate focused debt deflation. This is still my view. I have assumed the Fed could get away with this for at least another year and that its inflationary money printing would first hit outside the United States and in the global commodity markets.

This recent move-up in US Treasury rates may indeed just be a blip. In the last two years we have experienced occasional backups in US Treasury rates. Like summer thunderstorms, they’ve gone away. But in my opinion the back-up in US rates is an early warning even if reversed for now. The US, unlike Japan (the other low interest rate major debt deflation country) is dependent on foreign buyers to buy its debt. Bernanke has thrown sand in the eyes of the markets and world political leaders. He may discover that the Fed doesn’t quite control US long term Treasury rates the way he thought it did. As I write this, some are even speculating that Bernanke will have to curtail his QE2 plans.

Investors have to face this fact: With the Fed printing high powered money with wild abandon and with the US fiscal situation (including the states) continuing to worsen, sooner or later US longer term interest rates will trend upward.

For investors this is a nightmare. Zero to low US Treasury rates have been baked into asset prices around the world. Bond yields have come down. Investors, earning next to nothing in short term instruments, have been forced to reach for risk. In Asia, that has meant buying real estate. If US rates trend upwards, asset valuations will require recalculation – downwards. The Bernanke bubbles will deflate.

Economists and policy makers around the world expect a wall of QE2 money to hit global asset markets. That certainly has been my expectation. Perhaps this is too simple. Markets have a way of fooling us when “everybody” expects something. Prices get bid up in advance, money flees the oncoming wall, governments react with sometimes very stupid measures.

For example, capital controls are now becoming acceptable. Governments will not hesitate to interfere with markets when they feel threatened. Remember the ill-fated interest equalization tax instituted by President Kennedy in July1963 in response to brewing US balance of payments problems. The following quote from Wikipedia is worth noting:

“Interest Equalization Tax was a domestic tax measure implemented by U.S. President John F Kennedy in July 1963. It was meant to make it less profitable for U.S. investors to invest abroad by taxing the interest on foreign securities.”

Think about this. The Bernanke Fed has already made it less profitable for US investors to invest in domestic fixed income securities with its policy of near zero short rates and quantitative easing. Why not screw US investors on their international investments?

Meanwhile Back in the Middle Kingdom

In the last week China has announced a number of measures including increased reserve requirements on banks and higher bank deposit rates. All of this in response to an ever higher rate of consumer price inflation. More measures are expected including price controls on food (ugh!). All this occurring at the same time the world is in an uproar about QE2 and Ireland has become a global problem. The Chinese stock market—and to a lesser extent all of Asia — as a result has suffered a sharp drop.

Along with many others, I have been expecting a ratcheting upward in Chinese inflation. All this comes back to the Chinese exchange rate policy of undervaluing the renminbi. Keeping the renminbi below what the market would require has forced the Chinese to buy dollars, thereby increasing Chinese bank reserves and domestic money supply. All part of the broken international monetary system.

The last Dismal Optimist reviewed what I consider the mercantilist and misguided features of the East Asian Economic Model, a version of which China espouses. It should be clear now to the authorities in Beijing that the current policies have their cost in terms of increased inflation and consumer unhappiness.

I believe China has reached a crossroads, perhaps as momentous as that faced by Deng Xiaoping in the early 1980s when he successfully reoriented his nation towards a more market oriented approach. The East Asian Economic Model of an undervalued exchange rate, overreliance on investment and exports, significant tariff and non-tariff barriers and massive accumulation of definitely risky US dollar reserves is on its last legs.

Japan with its sclerotic political system has been unable to find a way out of the dead end into which the East Asian Model eventually leads. Japan was lucky. It started thirty five years before China when a robust US economy could suck in Japanese exports. China, at this point with a much lower standard of living than Japan, doesn’t have the luxury of wallowing in Japanese indecision and paralysis, especially with a much weakened US now an unreliable engine of global growth. The bull case for Chinese stocks – and indeed for Hong Kong, Taiwan, Singapore and Korea – assumes that China will make the tough decisions and move away from this Model. That is my view but the next few years could be bumpy as China, to use Deng’s famous expression, makes its way across the river and “feels the stones.”


Sunday, November 14, 2010

The New Economic Cycly

Chart above: By Gordon T. Long

I thought I had figured out what to write about today, because I saw a long line of articles the past few days that all basically have the same theme: US banks that are doing so bad, nationalization must once again be seriously considered. But then I read Professor Morgan Kelly's great, and greatly alarming, article in the Irish Times today:

If you thought the Irish bank bailout was bad, wait until the mortgage defaults hit home

Sad news just in from Our Lady of the Eurozone Hospital: After a sudden worsening in her condition, the Irish Patient, formerly known as the Irish Republic, has been moved into intensive care and put on artificial ventilation. While a hospital spokesman, Jean-Claude Trichet, tried to sound upbeat, there is no prospect that the Patient will recover. [..]

With the Irish Patient now clinically dead, her grieving European relatives face the melancholy task of deciding when to remove her from life support, and how to deal with the extraordinary debts she ran up in the last months of her life. [..]

Ireland faced a painful choice between imposing a resolution on banks that were too big to save or becoming insolvent, and, for whatever reason, chose the latter. Sovereign nations get to make policy choices, and we are no longer a sovereign nation in any meaningful sense of that term. From here on, for better or worse, we can only rely on the kindness of strangers.

Yeah, the European problems will yet come back to bite us all. Ireland is gone as an independent nation in all but ceremonial terms. Greece is not far behind, with Portugal snapping at its heels. Think the US dollar is going to plunge? Think again.

Still, that didn't make as today's theme either, even though I know we have many Irish readers, and Stoneleigh received a great welcome there this summer; we’ll get to talk about Ireland - and Europe- again soon.

It's just that I read an article Ashvin Pandurangi, our by now greatly valued roving reporter, sent me, entitled "Plutocracy Now". Ashvin writes about that first notion I was pondering: the nationalization of US banks, though for him it’s not about Bank of America, but the Fed. He concludes it can't be done, not even an audit will be achieved. And I think that goes for Wall Street banks as well. We can't nationalize the banks, because they have long since "bankalized the nation".

Not that I don't find the efforts and arguments interesting. I just don't think the authors necessarily place sufficient emphasis on the amount and level of political clout and power the financial industry has accumulated over the past few decades. Or indeed the past 100 years for that matter. Seeing them celebrate the birth of the Fed, and do so on Jekyll Island to boot, it makes me think the US is surely as far gone as Ireland is; it's just that fewer people seem to realize it, but that's not too comforting, is it?

Ashvin Pandurangi closes with a very insightful statement, one that every American should take to heart, and many Europeans too:

The reality is that there is only one way back to a true democratic system now, and this path will require nothing less of us than the courage of our forefathers.

Here are some of the articles I was reading:

James K. Galbraith at Common Dreams:

Obama's Problem Simply Defined: It Was The Banks

[..] .. one cannot defend the actions of Team Obama on taking office. Law, policy and politics all pointed in one direction: turn the systemically dangerous banks over to Sheila Bair and the Federal Deposit Insurance Corporation. Insure the depositors, replace the management, fire the lobbyists, audit the books, prosecute the frauds, and restructure and downsize the institutions. The financial system would have been cleaned up. And the big bankers would have been beaten as a political force.

Team Obama did none of these things. Instead they announced "stress tests," plainly designed so as to obscure the banks' true condition. They pressured the Federal Accounting Standards Board to permit the banks to ignore the market value of their toxic assets. Management stayed in place. They prosecuted no one. The Fed cut the cost of funds to zero. The President justified all this by repeating, many times, that the goal of policy was "to get credit flowing again."

The banks threw a party. Reported profits soared, as did bonuses. With free funds, the banks could make money with no risk, by lending back to the Treasury. They could boom the stock market. They could make a mint on proprietary trading.

Will Henley at Global Financial Strategy:

Battered Obama took part in a 'cover up', says ex-regulator Bill Black

In a last campaign pitch to voters, US President Barack Obama justified his response to the Great Recession by contrasting it to "S&L", a 1980s and early 1990s crisis which saw nearly 800 savings and loans institutions go bust amid a disastrous commercial real estate bubble.

Yet for Bill Black - a former Federal Home Loan Bank Board litigation director who as deputy director of the National Commission on Financial Institution Reform, Recovery and Enforcement contributed to a major 1993 report on S&L - it's an analogy which sticks in the throat.

"It's a terrible comparison," says Black. In his reasoning, Obama noted that while George Bush Senior's efforts to stabilise the financial system cost two and a half per cent of gross domestic product (or $125m), his own administration's actions have cost as little as one per cent.

"In the savings and loans crisis, for 2.5 per cent of GDP we actually resolved the problem," Black guffaws. "In this case, they have resolved none of the problems."[..]

While stopping short of asking for a Stalinist purge of executives, he is adamant that it was a mistake for the regulators to not launch more investigations. Without such action, he says there is a danger that white collar criminals may turn into recidivists.

"If they have already destroyed their institutions then they are likely to continue as crooks."

Ellen Brown at Truthout:

ForeclosureGate Could Force Bank Nationalization

For two years, politicians have danced around the nationalization issue, but ForeclosureGate may be the last straw. The megabanks are too big to fail, but they aren't too big to reorganize as federal institutions serving the public interest.[..]

For our newly-elected Congress, the only alternative may be to start budgeting for TARP II.

Jonathan Weil for Bloomberg:

Bank of America Edges Closer to Tipping Point

You wouldn’t know there’s anything wrong with Bank of America by an initial look at its balance sheet. The company showed common shareholder equity, or book value, of $212.4 billion as of Sept. 30. And its regulatory capital ratios have risen steadily throughout the year.

Judging by its shrinking stock price, though, investors are acting as if Bank of America is near a tipping point. Its market capitalization stands at $115.6 billion, or 54 percent of book value. That’s the second-lowest price-to-book ratio among the 24 companies in the KBW Bank Index, and well below the 76 percent ratio the company was at in October 2008 when it landed its first round of TARP dough.

Put another way, the market is saying there’s a $96.8 billion hole in Bank of America’s balance sheet.

And again, pitbulls William K. Black and L. Randall Wray in the Huffington Post:

Let's Set the Record Straight on Bank of America, Part 2: Eliminating Foreclosure Fraud

Out of [..] millions of fraudulent mortgages, Bank of America claims to have modified 700,000; of these, 85,000 are under HAMP. Still, the Treasury says that the bank has another 375,000 mortgages that already meet HAMP terms.[..]

Treasury could be wrong about the mortgages; Bank of America may be refusing to modify mortgages for homeowners who appear to qualify for the HAMP terms because it knows the data Treasury relied upon is false. Their unusually low rate of HAMP modifications could be the result of the extraordinarily high rate of mortgage fraud at Countrywide.

Bank of America has admitted that HAMP's "implicit" purpose is to help the banks that made the fraudulent loans -- not the borrowers. That goal was the same goal underlying the decision to extort FASB to gimmick the accounting rules -- delaying loss recognition.

Bank of America expects to receive billions of dollars for its participation in HAMP. The top three banks (JPMorgan Chase and Wells Fargo being the others) will share $17 billion because HAMP pays servicers, investors and lenders for restructuring. These top 3 banks service $5.4 trillion in mortgages, or half of all outstanding home mortgage loans. Yet, as Phyllis Caldwell, Treasury's housing rescue chief has testified, there is no proof that these banks have any legal title to the loans they are modifying and foreclosing.

It’ll take a whole lot more than attempts at regulation or legislation. The only "representatives of the people" [sic] who have any say are those in the bankers' pockets. The nation has been bankalized, something we've only figured out after it was too late. That means the road to taking over the banks is closed; we’ll be pumping money into them for quite a while to come.

Wednesday, November 10, 2010

Bye Bye Dollar

To Hell Through QE

By Andy Xie

The world seems full of smoke ahead of a world currency war. The weapon of choice is quantitative easing (QE). If you print a trillion, I’ll print a trillion. No change in exchange rate after a trillion? Let’s do it again, QE2. If you listen to people like Geithner, the end of the world is quite near. Rich people everywhere, not just the Chinese, are buying gold for peace of mind. When the currency values vanish in a QE melee, the rich at least have the gold to stay rich.

If you listen to American pundits, politicians or government officials, it’s all China’s fault. China is far from perfect – its currency policy certainly isn’t – but it is not the cause for the world’s ills. The US is by far the biggest source of uncertainty and the initiator of the QE war. Its elite created the biggest financial bubble since 1929, even removing regulations designed to prevent it, and left the US economy in a shambles after it burst. The same people want to find a quick cure to hold onto their power. Unfortunately, there isn’t one.

The US has cut interest rates to zero and run up budget deficits to 10% of GDP. It’s shock-and-awe Kenyesian policy. But, after a few quarters of strong growth, the economy is turning down again. Unemployment remains close to 10% (and would be much higher, close to Spain’s 20%, if the data included the underemployed and those who have stopped looking for work). The stimulus has failed.

How should one interpret the result? If you were Paul Krugman, you would say it wasn’t enough. Of course, if 20% of GDP in budget deficit and another round of QE still doesn’t work, he would say again it’s not enough. You can never prove Krugman wrong.

The second interpretation is that it takes time for the economy to heal. No economy has recovered quickly after so big a bubble – during such a prolonged and massive bubble, resources become so misallocated that it takes a long time for reallocation, particularly in the labor market.

The third interpretation is that it’s China’s fault. Yes, China’s exports to the US rose sharply during its stimulus-inspired pickup, i.e., the stimulus partly went to China. But, whose fault is that? Apple makes all its iPhones in China because it costs them under USD 20 each, even after recent massive wage increases for Chinese workers. Apple’s gross margin is 30 times the processing cost that goes to China. Maybe Apple is an extreme example but the fact is that China’s exports to the US are American goods that retail for 3-4 times of the factory-gate prices. American companies want to make their goods in China to satisfy the stimulus inspired demand.

People like Geithner would argue that China should raise its currency to force American companies to move production back to the US. I suppose that that is how the whole RMB appreciation idea may work. But, at what exchange rate would the American companies want to do it? American wages are ten times China’s. Should China increase its currency value ten times?

Of course, the American pundits wouldn’t put it that way. They would talk about China’s trade or current account surplus and the rising Forex reserves, the prima facie evidence of currency manipulation. I do not want to deny that the rising forex reserves are a problem that China must tackle, but it is a separate issue from the US economy. The solution isn’t RMB appreciation either.

Everybody knows China has a massive savings rate of around half of GDP. It’s a simple equation that the current account surplus is equal to savings minus investment. If current account surplus is a problem, it is either insufficient investment or excessive frugality. China’s investment is over 40% of GDP. Even casual observers would find China’s investment too much. Are Chinese people too frugal? The household income is probably under 40% of GDP, so how could they be the source of the gigantic savings?

The problem is China’s political economy. The government sector raises money through taxes, fees, monopoly franchises, and high property prices. Property sales were 14% of GDP. If the price is normalized, i.e., halved, the household sector would have 7% more of GDP. The household savings rate is roughly one third. This would boost domestic demand by nearly 5%, wiping away the whole current account surplus.

The current account surplus is half of the forex reserve story. The other half is hot money and overseas Chinese are the main source of this. Chinese property and the dollar are their most important foreign assets. As the dollar weakens, they have poured money into China, especially into the property market. Hedge funds and other speculators have also poured money in through buying offshore Chinese assets.

I think China’s currency is overvalued. China’s money supply has exploded in the past decade, rising from RMB 12 to 70 trillion. Every currency has experienced depreciation after a pronged bout of money growth. China’s industry has risen tremendously to justify part of the growth. However, a massive amount is in the overvalued property market. When it normalizes, the money flows out and the currency depreciation pressure happens. We should see this within two years.

What is right isn’t important for now. What is politically expedient is. Americans want a quick cure for their country’s economic difficulties and want to devalue the dollar to achieve it. If it could force China to increase its currency value, then the Yen, Euro, and all the others would go up in tandem. The US, one fourth of the global economy, could export its way out of its problem.

But the others won’t follow this program. China cannot move up its currency value too much or it would trigger hot money outflow, collapsing its property market and the banking system along with it. China is between a rock and a hard place. It is trying to achieve a soft landing of its property market by incremental tightening steps while the currency appreciation expectation keeps the hot money from leaving. This combination may support a multiyear gradual adjustment, giving the banking system time to raise capital.

Japan isn’t in a position to appreciate the yen much. Its industries have lost competitiveness to Germany and even the US. Its industries haven’t had a global hit product for years. Germany and the US auto industries are gaining over Japan’s. It’s hard to see how the yen could rise significantly. The Bank of Japan is vulnerable to political pressure. It doesn’t have a good track record. If it allows the yen to destroy Toyota, Honda, etc., it’s hard to see how it could remain independent. Hence, it will resort to QE to hold down the yen.

The euro is surging by default. The European Central Bank seems to still be talking like Budensbank. But, it can’t sustain its position through the next sovereign debt crisis. When the euro is high, some euro-zone economy, though not Germany or France, will get into a crisis mode. It may join the QE crowd too.

The UK doesn’t need to be persuaded to embrace QE. It is like a big Hong Kong, all about stir-frying stocks and properties. When the bubble bursts, it doesn’t have much else to do – devaluing the currency seems the only way out.

Korea is small but always tries to join the big leagues. It is big in the automobile, electronics, and petrochemical sectors. Its government does not need convincing to watch over the exchange rate. Recently, it has been ‘investigating’ financial institutions for undesirable practices in the currency market.

It seems that nobody wants to appreciate. Most major economies will do something to keep their currencies down. That is checkmate for the US. Without the devaluation benefit on rising exports, QE just leads to inflation, first through rising oil prices. The American people are suffering from declining housing prices and high unemployment. If the gasoline price doubles, the country may not be stable. How would the elite react? Probably more of the same.

The world is heading towards high inflation and political instability. It’s only a matter of time before there is another global crisis. The first sign would be a collapsing treasury market. The Fed is controlling the yield curve through its QE program. But, it is irrational for other investors to play this game. The only reason to stay in is that the Fed won’t let the market fall. But, the underlying value is evaporating with rising money supply and the inflationary consequences. When all the investors realize this, they will run for the exits and the Fed won’t be able to stop the stampede. If it prints enough money to take over the whole market, the people with freshly minted dollars would surely want to convert their money into other assets. The dollar would collapse too.

The world seems on course for another crisis in 2012. The same people who caused the last crisis are still in charge. They’ll get us into another. Iceland is sending its former prime minister to court for causing the banking crisis. A worse fate awaits the people who are causing the next crisis.


Originally published November 5, 2010 in China International Business

Sunday, November 7, 2010


This is worth 2 hours of you time:

And this one is worth two hours too:

Saturday, November 6, 2010

Pragmatic Capitalist


The country has spoken and they are not happy with the Obama economy. And rightfully so. It has been a remarkable disappointment thus far. President Obama’s biggest mistakes were often highlighted by me in real time:

• He should have chosen to bailout Main Street over Wall Street.

• He never should have appointed Geithner or Summers. They were merely attempts to rehash the Clinton economic team and unfortunately, due to his ignorance of the economic environment, President Obama had no idea that these men played a significant role in causing the crisis.

• He absolutely never should have reappointed Ben Bernanke. Mr. Bernanke has rehashed all of Alan Greenspan’s “flawed” policies and has chosen to focus on the banking sector at every twist and turn of this crisis.

• He should have saved his health care plan for term two and focused on helping Americans get the jobs they so badly needed.

• He should have dropped the hammer on Wall Street with harsh regulation. We have become a nation by the banks and for the banks and the de-regulation of the 90′s is largely to blame. We need to end the financialization of this country and get back to 3-6-3 banking as opposed to relying on our bankers to generate economic growth while also mis-allocating resources.

• He has had every opportunity to become the champion of Main Street. Instead, he appears no different than his many predecessors who have been slaves to bank lobbyists.

This election is largely a referendum on the Obama economy. Unfortunately, I am concerned that the change is not necessarily any better. Specifically, I am most concerned about a return to the ways that got us into this mess in the first place:

• I am concerned that we are moving back towards a belief that business is efficient and rational and therefore does not need to be regulated.

• I am concerned that gridlock will lead to severe budget constraints. Like it or not, we are in a balance sheet recession. And when you’re in a balance sheet recession someone must run a surplus or economic growth will decline. That is simply an accounting identity. With the private sector paying down debt they are unlikely to pick up the economic slack. Therefore, without continued government spending or tax cuts we risk a high probability of sinking back into negative growth and possibly worse.

• While I am not a fan of unemployment benefits we are likely to see 3.5MM people lose their unemployment benefits in January as republicans block passage of any extensions. In a balance sheet recession this will put an unnecessary strain on the economy. The government should temporarily hire the qualified of these 3.5MM people and incentivize them to be productive as opposed to paying them to do nothing. The country can certainly afford it and it would put people to work at a time of high private sector unemployment.

We have a very serious state funding crisis that is now almost guaranteed to get worse as spending is reduced. Meredith Whitney believes the state funding crisis is the next shoe to drop and is being overlooked:

“The level of complacency around this issue is alarming. Most assume, as last week’s Buttonwood panel did, that the federal government will simply come to the rescue of the states without appreciating the immensity of the cumulative state-budget gaps. I expect multiple municipal defaults to trigger indiscriminate selling, which will prompt a federal response. Solutions attempted in piecemeal fashion, as we’ve seen thus far, would amount to constantly putting out recurring fires.

Rather than waiting for more federal intervention, states need to make their own hard decisions and not kick the can down the road. How will taxpayers from fiscally conservative states like Texas or Nebraska feel about bailing out threadbare Illinois or California? Let’s hope we never have to find out.”

This country is not bankrupt. We are not the European Union. We are not Argentina. We are not Zimbabwe. We most certainly are not Greece. As the monopoly supplier of currency in a floating exchange rate system we can always afford to spend in our own currency. Unfortunately, the new Congress is likely to move us closer towards austerity and that is an unnecessary hurdle at a time when the country least needs it. It’s difficult to see what we accomplished tonight. And we may have potentially taken a huge step backwards. Tonight’s outcome has 1937 written all over it. Let’s hope our political leaders prove smarter than that.

Written by: The Pragmatic Capitalist is the founder and CEO of an investment partnership. Prior to establishing his own business, TPC was a Merrill Lynch Financial Advisor. TPC is a Georgetown University alumnus, growing up in the DC area and now living in Southern California. In addition to regular commentary by TPC the website is a collaborative work from several different Wall Street experts.

Wednesday, November 3, 2010

Keynesian Confusion

by Michael E. Lewitt

“At the present moment people are unusually expectant of a more fundamental diagnosis; more particularly eager to receive it; eager to try it out, if it should be even plausible. But apart from this contemporary mood, the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the word is ruled by little else. ractical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slave of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”

John Maynard Keynes (1936)

Ironically, John Maynard Keynes himself remains by far the most influential of the defunct economists from whom the madmen in authority are distilling their frenzy today. Economists occupy a world in which their theoretical musings have enormous real world consequences. Unlike their colleagues in the hard sciences, however, economists do not have the luxury of testing out their theories before inflicting them on the rest of us. The Keynesian experiment being run by governments and central banks over the past two years is a case in point.

Keynesian policies are inflicting untold damage on the U.S. and global economies today. Things did not have to be this way; Keynes did not have to be misread. His antidote for slow economic growth and high unemployment – massive doses of government spending – was appropriate in midst of the 2007-08 financial crisis, just as it was sensible during the 1930s global depression that Keynes was experiencing while he was writing The General Theory. In end of world scenarios, government spending is the last resort. But once the economy stabilizes – even at a diminished rate of growth – Keynesian medicine will cripple the patient if it is not withdrawn and replaced with a healthy fiscal regimen. Unfortunately, policymakers – in particular the current and past Chairmen of the Federal Reserve – have shown themselves to be either unwilling or incapable of making the transition from crisis management to post-crisis management of monetary policy. As a result, today’s Federal Reserve is missing the second great lesson of Keynes’ work, the “paradox of thrift.”

The most extended discussion of the paradox of thrift occurs in Chapter 23 of The General Theory, which is actually part of a series of chapters contained in Book IV entitled “Short Notes Suggested by the General Theory.” The discussion of the paradox of thrift in this chapter is primarily devoted to a historical survey of the idea and is relatively disjointed. Keynes’ clearest description of the concept comes much earlier in The General Theory when he writes the following:

“The reconciliation of the identity between saving and investment with the apparent ‘free-will’ of the individual to save what he chooses irrespective of what he or others may be investing, essentially depends on saving being, like spending, a two-sided affair. For although the amount of his own saving is unlikely to have any significant influence on his own income, the reactions of the amount of his consumption on the incomes of others makes it impossible for all individuals simultaneously to save any given sums. Every such attempt to save more by reducing consumption will so affect incomes that the attempt necessarily defeats itself. It is, of course, just as impossible for the community as a whole to save less than the amount of current investment, since the attempt to do so will necessarily raise incomes to a level at which the sums which individuals choose to save add up to a figure exactly equal to the amount of investment.”

In order for the fallacy of thrift to slow economic growth, the capital that consumers and businesses are saving would normally have to be available to recirculate in the economy through loans or investments. This recirculation is precisely what is not happening today, or at least not nearly at the rate necessary to lift growth to a level that would create significant job growth. And this is the Keynesian lesson that fiscal and monetary policymakers appear to have forgotten as they have forged their post-crisis strategy – rather than indiscriminately easing monetary conditions, it is necessary to create an environment in which savings-conscious consumers and corporations are willing to allow their funds to recirculate.

The reason that the current recovery is below par is that the economy is experiencing a massive paradox of thrift. A combination of factors has led individual economic actors – both consumers and corporations – to believe that it is in their best individual interest to save rather to spend, to repay debt rather than borrow. The result has been an increase in the personal savings rate from slightly negative to approximately 6-7 percent, and a significant improvement in corporate balance sheets (corporations are now sitting on approximately $1 trillion of cash). This has improved the financial condition of these individual economic actors, but deprived the broader economy of consumption and investment spending.

Unwise economic policy choices have led to the current situation. Consumers are saving instead of spending because the value of their homes has declined significantly, which is a result of the pro-cyclical monetary policy and lack of regulation that contributed to the housing debacle. Businesses are limiting their hiring and expansion plans due to the increasing regulatory burden being placed on them by the government, by fears of impending tax increases, and by the general anti-business tone coming out of Washington D.C. Investors are fleeing the stock market because regulators don’t have the guts to stand up to Wall Street and address dangerous practices such as the repeal of the uptick rule, naked CDS on systemically important institutions (which allows speculators to mount bear raids on companies such as BP plc), and flash and algorithmic trading. The combination of all of these policy failures has led to a massive crisis of confidence in the American model of capitalism, which has become as badly corrupted as the Japanese model that is responsible for Japan’s decades of deflation and economic paralysis. And our current politics offers little prospect for change.

This is the landscape investors are facing as we enter one of the most important weeks in American politics and markets in a long time. HCM is devoting so much time to a discussion of policy and politics because these are the forces that are driving financial markets today. The performance of individual companies is far less important than macroeconomic factors in determining investment performance. The United States is on the verge of two important events that will affect not only its own immediate future but the future of the global economy: the November 2 mid-term elections, and the November 3 meeting of the Federal Reserve’s Open Market Committee. The mid-term elections are expected to produce a significant shift in power in the U.S. Congress, with Republicans expected to regain control of the House of Representatives, move into an unassailable blocking position in the Senate, and make major gains at the state level as well. The financial markets have been treating these two early November dates as early Christmas presents, but the post-holiday hangover may be brutal. Financial markets should be careful what they wish for on November 2 and 3. Despite likely short-term market gains, they may ultimately be staring at coal in their stockings.

The Mid-Term Elections

The mid-term elections promise a big victory for the Republicans, a party whose brand was so severely devalued a mere two years ago that the media was already writing about President Obama’s second term agenda. But a Republican resurrection is hardly likely to improve economic or social conditions; the Republicans’ rigid anti-tax, anti-regulatory agenda has inflicted great damage on this country. The repudiation of Congress that will occur on November 3 should be considered bi-partisan – both parties have been abject failures. The political process has become deeply corrupted and dysfunctional. Returning the party to power that presided over 8 years of budget profligacy and regulatory malpractice between 2000 and 2008 is hardly a great accomplishment; it merely promises to temper the worst anti-business and anti-growth policies of the Obama administration and its Congressional minions. Many believe that political gridlock will ensue, although we would not be surprised to see progress made on several policy fronts such as a compromise on taxes and perhaps some marginal budget cuts (not entitlement reform unfortunately). Those promoting a Republican victory argue that at least things won’t get worse for the economy if the Obama agenda is stopped in its tracks, but the economy will get worse if America’s ill-advised fiscal and tax policies remain in place.

After the election, HCM expects a dangerous outbreak of populism that will most likely take the form of protectionist economic measures primarily aimed at China. If this occurs, it will not be good for the financial markets. There are already rising pressures in Congress to take action against China, and we will have to see if these sentiments will fade after the election. Our expectation is that they will not. The demagogic danger is a real one and it is growing. With more than one in eight Americans on food stamps, new revelations about mortgage foreclosure abuses, and the appearance on the scene of politicians of the ilk of New York gubernatorial candidate Carl Paladino, Delaware Senatorial candidate Christine O’Donnell, and Ohio Congressional candidate Rich Lott, who used to spend his spare time engaging in Nazi reenactments (with his son!) and was actually endorsed by future House Speaker John Boehner, it is a small leap to protectionist legislation aimed at China and other countries that can be scapegoated for America’s own failures. The way to combat China’s currency policy is not through punitive measures but through policies that improve America’s competitive economic position, a concept that is unlikely to gain currency in today’s devalued marketplace of ideas. Instead, bad ideas are likely to gain ascendancy and provide political cover for American politicians trying to avoid making the tough choices needed to right the American economy. We may not need our politicians to be nuclear scientists, but this country isn’t going to served by electing outright idiots either.


One day after the mid-term elections, the Open Market Committee is expected to announce the details of its plan to engage in a second round of quantitative easing (QE2) pursuant to which the central bank will intervene directly in the financial markets to purchase as much as US$1 trillion of Treasury securities. The stated purpose of QE2 is to prevent inflation from dropping below the Federal Reserve’s target of 2 percent, which is somehow supposed to stimulate economic growth. This ignores the fact that record low interest rates over the past two years have failed to do precisely that. Nonetheless, all of the Fed’s jawboning about its plans has had a significant impact on the financial markets. The Dow Jones Industrial Average is up about 12% since Fed Chairman Ben Bernanke began hinting that further quantitative easing was coming two months ago. Inflation expectations have shifted sharply upward, with a recent 5-year TIPs auction resulting in a negative real yield of -0.55 percent (see Graph 1 below). On the other hand, the yield on 10-year and 30-year Treasuries has increased by about 30 and 40 basis points, respectively, since the Fed announced its intentions. Markets are heeding the history lesson that monetary policy plays a key role in shaping post-crisis economies; the problem thus far is that the markets aren’t doing what the Fed wants them to do. If the Fed does not play small ball with QE2, however, we would expect rates to drop back down in the near term. We doubt, however, that reducing already low rates is going to stimulate much of anything other than more frustration on the part of savers.

HCM has a hard time making a case that inflation is either a serious or imminent threat despite the signals coming from the market. Hedge fund star John Paulson recently told investors that he believes that inflation will rise to the double-digits by 2012, a forecast we find excessive in degree and timing although not ultimately in direction (calling for higher inflation in the future is an easy call; the tough call is deciding when inflation will hit). There is still too much excess capacity in too many areas of the economy – finance, real estate, housing – to create significant near-term inflationary pressures. The type of inflation Mr. Paulson is predicting really speaks to a different type of scenario that would involve a collapse of the U.S. dollar and with it the U.S. economy, which would be consistent with reports that Mr. Paulson holds 80 percent of his considerable personal assets in gold. HCM is a strong believer in gold and even a stronger believer in a dollar collapse and continuing U.S. economic weakness barring a 180 degree change in policy, but we don’t see it happening as quickly as Mr. Paulson.

Opinion among the Fed governors concerning the wisdom and prospects for quantitative easing is hardly uniform. For example, during an October 19 speech before the New York Association for Business Economics, Richard W. Fisher, the president of the Federal Reserve Bank of Dallas admitted that “n my darkest moments, I have begun to wonder if the monetary accommodation we have already engineered might even be working in the wrong places.” St. Louis Federal Reserve Bank President James Hoenig has been a consistent dissenter from recent Fed decisions and in HCM’s opinion is the lone voice of reason in a sea of Keynesian insanity. Despite these doubts, the central bank is intent on mounting another feckless attack on the powerful deleveraging trends at work in the post-crisis world.

In a twist that must have amused the Fed’s harshest critics, it was reported that the Fed surveyed government bond dealers and investors about their expectations of the initial size of any new program of debt purchases and the time period over which it would be completed. It also asked firms how often they expected the program to be reevaluated by the Fed and to estimate its ultimate size. Coming less than a week before the Open Market Committee, this request is consistent with the tradition of the Fed cow-towing to the financial markets. Former Chairman Alan Greenspan used to rely on the wisdom of the stock market, and declared to the world that it was a “conundrum” when interest rates did not respond to Fed policy moves in accordance with his ideology. Ben Bernanke’s Fed doesn’t even wait for the markets to opine – it asks the markets in advance about their expectations, presumably so the central bank will not disappoint them and see them drop (God forbid!). That’s one way to avoid conundrums, but it is no way to manage monetary policy. The markets are counting on a $1 trillion program of quantitative easing over a reasonably short period of time; anything less could cause a sell-off in equities. The markets, as usual, are only focusing on the short-term and ignoring the long-term risks created by ill-advised monetary policies. QE2 may sustain the markets for a brief period of time, but sooner rather than later the markets are going to have to pay the piper for the mountains of debt and extended period of artificially low interest rates that this policy has promulgated.

As I have written in El Mundo and spoken about at the recent Value Investing Congress in New York, QE2 is not only unlikely to work but is certain to contribute to future financial instability. The financial system is already sitting on US$1 trillion of excess reserves. The reason that these reserves are not being used to grow the economy through capital spending or to create jobs is not that interest rates are too high. Rather, reserves are going unutilized because of a profound lack of confidence on the part of economic actors bred by anti-growth policies promoted by the Obama administration (particularly healthcare reform) and the threat of significantly higher taxes (as much as US$6 trillion over the next 10 years if current plans aren’t altered. ) QE2 will do nothing to address these factors suppressing demand for funds. QE2 is a monetary policy tool being used to address a problem that has nothing to do with monetary policy. As such, it is misguided and is unlikely to work. What it will do, however, is further swell the Federal Reserve’s balance sheet and lower the value of the dollar, neither of which will contribute to the long-term strength of the American or global economy.

But QE2 doesn’t only fail to aim at the right target (employment); it doesn’t really aim at anything at all. Instead, QE2 basically sprays money indiscriminately into the economy instead of targeting money at productive activities. Current fiscal and tax policy promotes peculation at the expense of productive growth; examples include the lax rules governing derivatives trading and leveraged buyouts, activities that add nothing to the productive capacity of the economy. Without fiscal and tax policy changes designed to promote productive growth, the excess reserves created by QE2 will end up in the hands of speculators in the financial industry. This will increase systemic leverage and exacerbate existing overcapacity in unproductive areas such as finance and real estate. QE2 without fiscal and tax policy changes is simply a continuation of the boom-and-bust regime that has dominated global financial markets for the past three decades.

The Stock of the Fed is Dropping Quickly

The once Teflon reputation of the Federal Reserve has taken a beating since the financial crisis, but its management of the post-crisis environment has lifted criticism of the central bank to a new and perhaps unprecedented level. Previously, the most strident attacks came from the likes of Congressman Ron Paul and other libertarians; today they are coming from respected market figures such as Morgan Stanley economist Stephen Roach, PIMCO’s Bill Gross, and Jeremy Grantham.

Readers of this publication are well aware that HCM has long admired the work of Morgan Stanley’s Stephen Roach. Mr. Roach is one of the more intellectually honest and outspoken central bank critics on the scene today. On October 12, he addressed the World Knowledge Forum in Seoul, South Korea and delivered one of the harshest public critiques of the Federal Reserve that has been made in many years. The primary thesis of the speech was that policy makers have failed to learn from the policy errors made by Japan. He writes that “it is now debatable as to whether there was ever a clear understanding of the true Lessons of Japan and what they might imply for macro policy management in the modern world.” This is important because “n the aftermath of the Crisis of 2009-09 – and the Great Recession it spawned – a legacy of post-crisis debt and deleveraging is now increasingly global in scope.” The correct lesson of what has happened to Japan over the past two decades is not that Japanese authorities moved with insufficient speed and aggression to deal with credit and asset bubbles. The correct lesson is that such bubbles must be identified earlier and avoided in the first place.

Mr. Roach rightly criticized the Federal Reserve for failing to spot obvious bubbles in advance (the Internet Bubble, Housing Bubble, and Corporate Bond Bubble are three obvious examples). But even worse, he said, is that the Federal Reserve Chairman was leading the intellectual charge supporting the case that these were not bubbles.

“One of the most disturbing features about each of these episodes is that the Chairman of the Federal Reserve – steeped in his ideological convictions that markets always know best – led the charge in denying that they were bubbles. He argued that the NASDAQ bubble was well supported by the productivity renaissance of the New Economy. Housing bubbles could only be local – never national. And the unprecedented tightening of credit spreads was an outgrowth of stunning advances in financial innovation.”

As someone who was fortunate enough to warn in this publication (and elsewhere) of each of these bubbles in advance, HCM welcomes Mr. Roach’s willingness to speak out about the failure of so-called leading economists to miss such obvious imbalances. These imbalances are what cause the types of market crashes that wipe out years of investment performance in the blink of an eye, or create the opportunity to profit from selling short. Moreover, these bubbles are not that difficult to identify if one is willing to look at the facts with an objective eye and not be corrupted by the madness of crowds. As I wrote in The Death of Capital:

“there are clear indicia of when asset prices are rising at unsustainable levels….Any significant departure from long-term valuation trends should capture the concern and attention of central bankers and trigger a response. But the types of deviations from the norm that occurred in the decade preceding the crisis of 2008 were far more than mere departures from long-term trends; they were obvious bubbles that required no special economic knowledge to identify. Stock prices traded at a multiple of 351x earnings on the NASDAQ Stock Exchange at their peak on March 10, 2000; the average price/earnings multiple at previous market peaks had been no higher than 20 before that. The risk premium (known as spread) on Credit Suisse’s High Yield Index reached 271 basis points over Treasuries on May 31, 2007, a record level that exceeded the historical average of 570 to 580 basis points by over 50 percent.”

Unfortunately, we are again heading into dangerous territory as a result of the Federal Reserve’s ill-advised zero interest rate policy, which is being exacerbated by an irrational fear of disinflation that is leading to its truly hare-brained scheme to engage in QE2. You can be sure we will do our best (as we have in the past) to sound the warning when markets get out of hand again. It is only a matter of when, not if, this occurs.

Mr. Roach also criticizes the Federal Reserve for failing to take into account the fact that financial bubbles have a devastating effect on the real economy. “A key lesson from Japan,” he said, “is for the authorities to be especially mindful of the lethal interplay between asset and credit bubbles and related distortions in the real economy. That lesson was totally lost on the Federal Reserve over the past decade.” In the post-crisis environment, monetary policy is being guided by deflation fears fed by Japan’s experience that lead to policies that are likely to exacerbate those very same deflationary risks. Mr. Roach warns: “[t]hat could very well be the single greatest flaw of a narrow and mechanistic inflation-targeting policy rule – a framework that does not allow for the unintended consequences of low nominal interest rates in spurring a steady string of asset and credit bubbles that could well compound deflationary risks over time.” In other words, the Fed’s narrow mandate (or its narrow interpretation of its mandate) is leading it to adopt policies that are exacerbating the very risks it is seeking to mitigate.

Mr. Roach’s solution is to add to the central bank’s mandate a requirement to maintain “financial stability.” Such a requirement would provide monetary authorities “with the political cover to attack asset and credit bubbles before they had dangerously destabilizing impacts on markets and wealth- and credit-dependent economies.” He believes such a change is necessary because we have had “a Federal Reserve that was swayed more by ideology than discipline, and debased by politically-motivated fiscal authorities who have become fixated on short-term stimulus while ignoring longer-term considerations. In this environment, we can no longer count on the promises of policy makers to act in accordance with the lessons they have learned from Japan or from the Great Crisis of 2008-09.” HCM would slightly modify Mr. Roach’s last statement. Policymakers have simply failed to learn the right lessons from the 2008-09 crisis. As we argued above, rather than learning from Keynes that a debt crisis should be solved with more debt, the authorities should have better understood how the paradox of thrift would operate in a post-crisis environment and developed policies to deal with that phenomenon.

Bill Gross was also harshly critical of Federal Reserve policy in his most recent Investment Outlook. In so many words, he accused the U.S. government of running a massive Ponzi scheme, although he softened this comment by noting that public debt always has Ponzilike characteristics. But the Ponzi scheme currently being run by the U.S. government is unprecedented in size and scope. Mr. Gross argued that:

“with growth in doubt, it seems that the Fed has taken Charles Ponzi one step further. Instead of simply paying for maturing debt with receipts from financial sector creditors – banks, insurance companies, surplus reserve nations and investment managers, to name the most significant – the Fed has joined the party itself. Rather than orchestrating the game from on high, it has jumped into the pond with the other swimmers. One and one-half trillion in checks were written in 2009, and trillions more lie ahead. The Fed, in effect, is telling the markets not to worry about our fiscal deficits, it will be the buyer of first and perhaps last resort. There is no need – as with Charles Ponzi – to find an increasing amount of future gullible, they will just write the checks themselves. I ask you: Has there ever been a Ponzi scheme so brazen?”

PIMCO is a huge holder of Treasury and other types of securities that are likely to benefit in the short run from QE2, but Mr. Gross correctly frets about the inevitable inflationary consequences of this policy. Inflation, of course, could decimate PIMCO’s long bond positions when it begins to rear its ugly head (although we assume he is hedged), so Mr. Gross is not only making a principled argument but also to some degree talking his book (which is his right).

Jeremy Grantham, in a Quarterly Letter entitled “Night of the Living Fed,” makes the compelling argument that debt doesn’t correlate with long-term growth rates. Debt, he writes, “is the paper world. It is, in an important sense, not the real world.” He continues:

“In the real world, growth depends on real factors: the quality and quantity of education, worth ethic, population profile, the quality and quantity of existing plant and equipment, business organization, the quality of public leadership (especially from the Fed in the U.S.), and the quality (not quantity) of existing regulations and the degree of enforcement. If you really want to worry about growth, you should be concerned about sliding education standards and an aging population. All of the real power of debt is negative: it can gum up the works in a liquidity/solvency crisis and freeze the economy for quite a while.”

Mr. Grantham has long been a critic of Alan Greenspan, Ben Bernanke and the Federal Reserve, but he could hardly contain himself in his last quarterly letter. He provides a great deal of fodder for the growing intellectual case against the pro-cyclical path that monetary policy has taken under its two most recent Chairmen.

Market Recommendations

We still expect the stock and bond markets to maintain their strength through the end of the year, particularly in the aftermath of a Republican victory in the mid-term elections and the announcement of QE2. Our short-term oriented readers should act accordingly. The corporate credit markets are paying absolutely no attention to company quality; anything with a decent coupon is trading up. The risk trade is clearly on.

Readers with a long-term focus should continue to accumulate gold and limit their investments in the credit area to bank loans (through mutual funds), BB/BBB corporate bonds, and stocks that have lower-than-market p/e ratios and pay dividends. We would avoid Treasuries at all costs. Lending to our government at 2.6 percent for 10 years is a great way to become a millionaire – if you’re already a billionaire. Sooner or later, everything being earned on the upside of this liquidity-induced rally will be given back in spades – the only question is when.

Monday, November 1, 2010

Thw Dismal Optimist

The International Monetary System is Broken

BY Peter T Treadway, PhD
Historical Analytics LLC
October 31, 2010

Deficiencies in the international monetary system are a root cause – if not the root cause – of the volatility and bubbles that have afflicted the post-Bretton Woods global economy. Political decisions often dominate what should be an economic process. Unlike under the classic gold standard, there seems to be no automatic market force that can eliminate the American trade deficit or the phenomenon of East Asian countries piling up American dollars.

In a recent Dismal Optimist, I argued because the dollar was the center of the current international monetary system, that unlike China or Japan the United States could not intervene in the currency markets to lower the value of its currency. Were the United States to do so, it would unleash total chaos on the international monetary system. In fact, in an Oct 4 article in the Financial Times, respected Brookings economist Fred Bergsten advocated that indeed the United States do just that type of intervention. Bergsten gave this hypothetical US action the grandiloquent appellation “countervailing currency intervention.”

I believe Bergsten’s recommendation is reckless and fraught with danger. But on second thought maybe it doesn’t matter. For the United States, there is more than one way to skin a monetary cat. QE2 to be precise will do just fine. QE2 is a grandiloquent abbreviation for the Fed recklessly printing money. There is no finer way for a country to depreciate its currency than by printing an endless supply of it. No need for countervailing currency intervention and completely consistent with the US policy of advocating a stronger dollar while acting to weaken the dollar. Quantitative easing by the US is equally reckless and fraught with danger.

The recent G 20 meeting exposed one of the weaknesses of the current system. Major international monetary decisions are usually political in nature. Governments have many weapons at their disposal. Markets either do not always succeed in forcing rational solutions to imbalances or they take time to do so. Governments set exchange rates maybe not forever but they last for periods that can be long enough. Adjustments by surplus and deficit countries often do not happen automatically and remain uncorrected for long periods of time. Countries will pursue their own self interest and “argue their own book”. Adjustments generally aren’t made voluntarily. The result of the G 20 meetings was a vague unenforceable resolution about excessive trade imbalances and competitive devaluations. A complete waste of time.

The East Asian Miracle /Train Wreck?

The biggest question mark for the global economy is what will happen with the Chinese economy in the next year. Forecasting the US and European economies is child’s play compared with forecasting that of China. For the optimists, China is the world economy’s growth engine since not much can be expected from the US or Europe. According to the pessimists, China and therefore the world economy are headed for trouble.

I frequently travel between Hong Kong and New York. Fifteen hour plane trips have some advantages. On my last trip I had time to read In the Jaws of the Dragon by Eamon Fingleton. Fingleton is not a consensus thinker. He puts forth (disapprovingly) what he terms the East Asian Economic Model, first followed by Japan in its WW II puppet state in Manchuria, then in post-War Japan itself, then Taiwan and Korea and now China. The East Asian model is according to Fingleton responsible for the success of the East Asian economies. The East Asian Model is at its core an ultra-mercantalist , statist strategy that is hollowing out the American manufacturing industry. Americans, seduced in part by low interest rates and cheap imports and imbued with the belief that the market will conquer all, have happily allowed this to happen.

Fingleton exaggerates from time to time and holds some debatable political views. But I believe his East Asian model – which is really a synthesis of ideas put forth by many others — describes economic reality well enough. The Model is an economic strategy that has the following key points:

1. A labyrinthine system of trade barriers.

2. An artificially undervalued currency.

3. An industrial policy that focuses on developing so-called pillar industries and uses export subsidies and other unfair tactics to give them an unfair advantage in world markets.

4. Systematic pressure on foreign companies to transfer their most advanced production technologies.

5. A systematic bias in favor of savings and against consumption.

An interesting conclusion can be derived this model. If China has erected significant tariff and non-tariff barriers, then it will also be true that a revaluation of the renminbi will have a limited effect on Chinese imports. It won’t matter what the price is of US exports to China if they are not allowed in at any price. The giant trade imbalances with the US will persist. The international monetary system will remain in disequilibrium. And Chinese consumers will get a raw deal. This is a world in which market signals are ignored.

Spending time in Hong Kong as I do, I have come to regard the city as a special mirror on what is happening in China. As I have written before, I have been struck by the ever-increasing numbers of Mainlanders who descend on the city to buy all kinds of luxury goods. Hong Kong is rapidly turning into a giant upscale mall. (Similarly Mainlanders head for Macau as gambling is flat out prohibited in China.) Why can’t the Mainlanders load up on Louis Vuittons and Pradas in China? One reason might be the gradual appreciation of the renminbi against the US dollar-pegged Hong Kong dollar. That makes everything in renminbi cheap in Hong Kong (including stocks and condos.) But a second reason might be that unlike in China there are no barriers – - tariff or non-tariff- – on consumer imports into Hong Kong.

Short seller Jim Chanos continues to hold to his view that the Chinese economy is about to suffer a serious slowdown. His argument is that China has poured excess funds into useless capital projects and real estate construction at the expense of its consumers. His presentations are peppered with tales of grandiose white elephants such as the new city of Ordos in Inner Mongolia and the New South China Mall in Guangdong. Both are apparently empty of people. Chanos and company are really predicting that the East Asian Model as far as it is practiced by China will hit the wall. According to this viewpoint, China has deviated too much from what a market directed economy would dictate. Stagnant Japan could be China’s future.

In my opinion, too much pessimism may not be warranted. Historically, China over thousands of years has fluctuated between periods of weakness and disorder and periods of external strength and internal prosperity. China at the moment is in the upswing part of its historical cycle. Western pessimists overlook one thing: the strong work habits and discipline of the East Asian populations and their national obsession to achieve material prosperity. These qualities continue to make East Asia an important long term investment destination. These qualities may overcome a plethora of economic policy sins. Or postpone the day of reckoning long enough to keep the shorts from making much money. We’ll see. As Lord Keynes famously said, “markets can remain irrational longer than you can remain solvent.”

Inasmuch as the East Asian Economic Model describes reality, the countries that have employed it need to ask whether it will work for them in the future. Don’t expect East Asian leaders to nobly act on behalf of the United States. But more consumer spending, more imports, and revalued exchange rates are what their future prosperity requires. They certainly don’t need a protectionist trade war with the United States, a continued pile up of dollar reserves or more domestic inflation. Unlike the paralyzed political class in Japan, the ever pragmatic Chinese leadership may yet make the necessary adjustments. Unfortunately the situation is complicated by the fact that, whereas Japan, South Korea and Taiwan have been allies of the United States, China is a geopolitical rival.

Investing in an Unstable World Economy

“It’s not easy” is the short answer. Markets can turn on a dime. A “buy stocks now” approach because the Fed is embarking on QE2 may be too simplistic and frankly is a little scary. Today’s smart investment can become tomorrow’s disaster when the value of a currency changes dramatically. If the US flips from quasi-deflation to significant inflation investors had better be prepared to do a quick rebalancing of their portfolios. If China exhibits a major slowdown in 2011 and the US and Europe limp along in near or renewed recession, investors face grim choices.

One investment that should be considered is gold. Currencies have lost their ability to be a reliable store of value. Gold is an alternative currency. It is a currency whose supply is not threatened by Bernanke-directed massive sudden increases.

OK gold doesn’t go up in a straight line. So-called experts have been forecasting a correction as gold has risen. And gold is subject to confiscatory actions by governments who do not relish giving up their monopoly to issue and debase their own currency. No doubt the coming US elections will have a major effect on the gold price. Unfortunately I don’t know what that effect will be and neither does anybody else.

I have argued in past Dismal Optimists that while the US may appear to be tottering on the brink of a debt deflation, the surplus countries of the world notably in Asia and the Middle East have inflation problems. All those reserves created in buying dollars are one factor. They aren’t all sterilized. Non US money supplies are rising. Add to this are pressures on natural resources and agricultural products coming from all those new emerging market consumers. This is a second area where investors should put their money while keeping their fingers crossed that any China slowdown will be a gradual one. Bernanke’s Quantitative Easing may not do much near term for US internal demand and real estate prices but they are adding to inflation around the world.

Longer term investors have to assume the gradual abandonment of the East Asian Model, i.e, stronger Asian currencies, more imports, more consumer spending. The big global export oriented US companies—especially those in the technology area– should be well positioned as this happens. So will consumer oriented companies in East Asia. Hopefully significant abandonment will occur in the next two years and not ten years from now.


Peter T Treadway also serves as Chief Economist, CT RISKS, Hong Kong
pttreadway -at-
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