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New round of financial crisis hit rather suddenly and bonds join stocks in decline.
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fivecentnickel.com
I just ran across an interesting article that talks about a lawsuit against Wal-Mart over their 401(k) investment selections. The suit claims that Wal-Mart harmed their employees by offering high-cost retail funds instead of the cheaper institutional funds for which they surely qualify, and by only offering actively-managed (and thus costly) fund options rather than choosing a company such as Vanguard that offers low-cost index funds. Overall, the suit claims that if the Wal-Mart 401(k) had been invested in Vanguard funds, it would have been worth an additional $140 million over the six year period under consideration.
This is an interesting case. While I'm not a big fan of lawsuits of this nature, the lack of affordable investment options in many 401(k) plans is a real issue that needs to be dealt with.
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The Mess That Greenspan Made
The hits keep-a-comin' for former Fed Chairman Alan Greenspan. In today's installment at Bloomberg (hat tip CB), Jonathan Weil turns back the clock to 1963 when the Ayn Rand devotee was formulating his view of the world.
Ironically, this view of things might have described the current condition much better had he not been head of the world's most important central bank for 18 years.
Greenspan's '63 Essay Foretold Subprime Inaction: Jonathan WeilOnce again, had he not been Fed Chairman for almost two decades, helping to transform the world's greatest economy into a country full of leveraged speculators, willing to take risks with borrowed money that they wouldn't have dreamed of years earlier, his 1963 views might be a lot more relevant today.
Why did Alan Greenspan fail to act while the roots of the subprime-mortgage crisis spread? Here's one possible explanation: The Ayn Rand disciple held fast to his unwavering laissez-faire beliefs.Yesterday's New York Times carried a front-page article chronicling the many warnings the former Federal Reserve chairman received about aggressive subprime lenders luring unsuspecting customers into crazy mortgages they never could afford. "Where was Washington?" the newspaper asked. And where was Alan?
...
I believe the best answer can be found in an August 1963 article called "The Assault on Integrity" that Greenspan, then 37, wrote for Rand's monthly journal, "The Objectivist." Judging by how he rebuffed Gramlich and others, it looks like he followed his old instincts as the subprime mess festered.Agent of Consumers
"Protection of the consumer against 'dishonest and unscrupulous business practices' has become a cardinal ingredient of welfare statism," Greenspan began his essay, which Rand included in her 1967 book, "Capitalism: The Unknown Ideal.""Left to their own devices, it is alleged, businessmen would attempt to sell unsafe food and drugs, fraudulent securities, and shoddy buildings. Thus, it is argued, the Pure Food and Drug Administration, the Securities and Exchange Commission, and the numerous building regulatory agencies are indispensible if the consumer is to be protected from the 'greed' of the businessman.
"But it is precisely the 'greed' of the businessman or, more appropriately, his profit-seeking, which is the unexcelled protector of the consumer.
"What collectivists refuse to recognize is that it is in the self-interest of every businessman to have a reputation for honest dealings and a quality product."
...
"Protection of the consumer by regulation is thus illusory," he said. "Rather than isolating the consumer from the dishonest businessman, it is gradually destroying the only reliable protection the consumer has: competition for reputation."While the consumer is thus endangered, the major victim of 'protective' regulation is the producer: the businessman."
The largely unregulated subprime-lending industry, of course, didn't turn out this way. Countless mortgage brokers and lenders didn't care about their reputations. Wall Street banks, which packaged and pitched the loans as AAA securities, didn't care about theirs either. There were quick killings to be had.
Four decades later, Greenspan's argument seems almost childlike in its idealism. Yet, judging by his inaction, it looks like he never stopped believing.
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The US government's Energy Information Administration (EIA) concluded in its most recent monthly Short Term Energy Outlook report that US oil demand is expected to decline by 190,000 barrels per day (b/d) this year. That is mainly owing to the deepening economic recession. <
Chinese consumption, the EIA says, far from exploding, is expected to increase this year by only 400,000 barrels a day. That is hardly the "surging oil demand" blamed on China in the media. Last year, China imported 3.2 million barrels per day, and its estimated usage was around 7 million b/d total. The US, by contrast, consumes around 20.7 million b/d. <
That means the key oil-consuming nation, the US, is experiencing a significant drop in demand. China, which consumes only a third of the oil the US does, will see a minor rise in import demand compared with the total daily world oil output of some 84 million barrels, less than half of one percent of total demand.
OPEC has its 2008 global oil demand growth forecast unchanged at 1.2 million barrels per day (mm bpd), as slowing economic growth in the industrialized world is offset by slightly growing consumption in developing nations. OPEC predicts that global oil demand in 2008 will average 87 million bpd, largely unchanged from its previous estimate. Demand from China, the Middle East, India and Latin America is forecast to be stronger, but the European Union and North American demand will be lower. <
So the world's largest oil consumer faces a sharp decline in consumption, a decline that will worsen as the housing and related economic effects of the US securitization crisis in finance de-leverages. The price in normal open or transparent markets should presumably be falling not rising. No supply crisis justifies the way the world's oil is being priced today.
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In response to the collapse of the credit and speculation boom, the Fed has set a deliberate re-inflationary objective in order to reverse falling asset prices. It has aggressively resumed its expansionary monetary policy since August 2007, cutting the federal funds rate from 5.25% to 2% with a consequent faster expansion of money supply, resulting in a rapidly depreciating dollar and disrupting stability in commodity markets, propelling oil prices from US$65 to $135 per barrel. <
A depreciating dollar and rising oil prices have gone hand-in-hand. Oil prices are quoted in dollars; a falling dollar results in an increasing dollar price for oil. Given a falling dollar, oil producers and others with surplus dollars are reluctant to store their wealth in dollars but instead are diversifying into other currencies, largely the euro and the yen, again putting further pressure on the dollar and again driving up oil prices; or in some cases producers cut back output as they are reluctant to hold more dollars. <
The reluctance of oil producers to expand oil output is best illustrated by Saudi Arabia's recent lukewarm response to US pressure for increased oil production. As inflationary expectations have become firmly rooted, oil and food producers know they can generate more revenues by restraining supply. This vicious circle is all but obvious to anyone whose head is above water. Yet, it has somehow seems to have escaped the Fed's radar in Washington. <
In large part because of the Fed's actions above and more specifically because of low or negative real interest rates, a falling dollar, economic uncertainty and volatility, investors and speculators have exacerbated market conditions. With low or negative real interest rates and a depreciating dollar, investors have been reluctant to accumulate dollar-denominated assets. <
Commodities, especially oil, have afforded them a good hedge. Speculators, understanding fully the weaknesses of the Fed's current policy and its imminent consequences on oil and natural gas markets, have seen an opportunity to profit from the prevailing policy stance. This added demand of investors and speculators has also fueled the oil market, but to what extent nobody can tell for sure. <
Mystery of missing output
In most markets, rising prices can be expected to encourage more output or supplies, albeit sometimes with a lag. Why has this not happened in the oil and natural gas markets? First and foremost, oil is not a commodity such as shoes. It takes anywhere from about three to 10 years to develop an oil field and bring the oil to market, depending on the location and other characteristics of the field. <Second, given low oil prices from the mid-1980s until the late 1990s, there was little incentive to develop new fields. As a result the level of excess capacity to produce oil has been low. So when markets are tight, as they are today, there is little additional production that can come on line quickly. Making matters worse, the small excess capacity that exists today, on the order of 500,000-1,000,000 barrels per day (mbd) and in the range of 1% of daily global consumption of about 87 mbd, is all in members of the Organization of Petroleum Exporting Countries (largely in Saudi Arabia). <
But the real issue that seems to have escaped all these oil analysts is the overriding reason why additions to oil supplies (and the capacity to produce more oil) have been so small in recent years? This can be laid at the door of the White House; the George W Bush administration and its predecessors have caused the current supply shortage through their policy stance towards the Persian Gulf region and especially towards Iran and Iraq.
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By Peter D. Schiff
It's unfortunate that the U.S. Supreme Court, in its ruling last week that U.S. currency is unfair to the blind, did not make the next logical step and declare it unfair to everyone who buys gasoline.
In their search for explanations as to why oil has surged past $130 per barrel, Washington, Wall Street and the financial media are as clueless as cavemen after a freak summer snowstorm. Despite the head-scratching, the blame game is nevertheless in full force.
Speculators and big oil companies are being trotted out as scapegoats, and increased margin requirements and taxes on windfall profits and futures trading have been mentioned as appropriate sanctions. It should be clear that this is pure farce, and that no one understands what is actually happening.
The reality is that after years of reckless consumption and dollar debasement, Americans are now being priced out of the very markets over which they formerly held unchallenged title. As more affluent foreigners consume more of the resources and products they previously exported to us, Americans are being forced to cut back. The rising dollar-based price of gasoline is simply an illustration of this global trend.
Poorly concealed behind contrived government statistics, the signs of America's falling standard of living are everywhere; all one has to do is look. We are unloading our SUVs for less-desirable compacts, and are paying more to fly on crowded planes (where we pay to check luggage and dine only on what we bring onboard). We now buy our lattes from McDonald's Corp. (MCD) or not at all, and we increasingly forego dining out, trips to the mall and vacations - just so we can scrape together enough to fill our gas tanks and kitchen pantries, pay taxes and insurance, or make credit card, mortgage or car payments.
The collective belt tightening is simply the down payment on the U.S. government's massive bailout of Wall Street investment banks and mortgage lenders. As the U.S. Federal Reserve creates money to buy bad mortgages and other shaky securities held by banks and brokerage firms, the value of the savings and wages of everyone on Main Street will continue to fall. As a result, the costs of products previously taken for granted have begun to bite.
The various housing bills and stimulus packages now passing through Congress will add significantly to the staggering final price tag. In the end, the "free lunch" currently being dished out by Washington will be the most expensive meal ever served. The cost will be borne by ordinary Americans citizens every time they open their wallets. And $4 gasoline is just the beginning.
For all the talk of increased global demand, few seem to understand from where it actually comes. The surge in global demand is both a function of the increased purchasing power of foreign currencies and the fact that foreigners are choosing to spend more of their incomes themselves.
In other words, former Fed Chairman Alan Greenspan's famous "global savings glut" is turning into a global consumption binge, with Americans unable to crash the party. This trend will only get worse as the dollar-denominated price of just about everything that is either imported, or capable of being exported, goes through the roof.
We can look for scapegoats all we want, but the simple fact is Americans are going to have to get used to a much lower standard of living. Those who have been putting all the food on our tables are finally pulling up chairs and are serving themselves.
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Vladimir Masch has offered some radical solutions to the problems of globalization. In terms of the U.S., here is how he describes the problem:The US is currently in a precarious position, one of the most dangerous in its history. In addition to geopolitical threats, we face a severe economic shock. The enormous wealth of this country is transferred abroad at a high and accelerating rate. To finance our voracious consumption, we borrow from potential adversaries. We lose important industries and millions of middle-class jobs. With the industrial base being destroyed, our security is compromised. The country has lost every important economic weapon that can be used in thorny geopolitical situations, which will prevail in this century.At the heart of the problem is the problem of trade, a problem that few economists have addressed. Instead, we have a "relentless propaganda" machine, headed by economists on both the right and on the left--Krugman and Mankiw are examples--that globalization as practiced will bring benefits to all. Free Trade is the mantra. And here are the results.In 2006, its current account deficit will probably reach about $900B, or almost 7% of GDP, with its rise accelerating. In just one year, the deficit exceeded more than twice our expense on the Iraq war for four years. The notorious "bridge to nowhere" costs $222 million; in foreign trade, we lose that amount every two and a half hours. In 6 to 8 years, just our return payments on foreign holdings on US securities may reach half a trillion dollars a year. A large part of that debt is borrowed from China, our potential adversary; it holds now more than one trillion dollars of currency reserves, predominantly in the US debt securities, and expects to double that amount in four years. This is an ever-growing mortgage on our country, and the situation is unsustainable. Even President Bush, a religious devotee of free trade, says so.The just completed draft of the Horizon Project, which is intended to be a Marshall type Plan for America and has been authored by eleven eminent CEOs and policy
innovators, comes to basically the same conclusions. The Horizon Project talks about "a hollowing out of American productive and services capacity," about "the US international trade position … being in free fall," about "many U.S. multinational corporations which … seem tempted to off shore almost everything but consumption." Consequently, "The traditional U.S. trade surplus in agricultural products is nearing zero, in high-technology products it has turned negative, and in trade services it is small and declining as a proportion of total trade." Moreover, it considers emigration of such industries as chip manufacturing to China, Taiwan and South Korea as "very unwise," as these areas are threatened by potential geopolitical disturbance in the region that might "greatly diminish U.S. armed forces operations and effectiveness."The present relatively low rates of inflation and unemployment and satisfactory rates of growth were bought at an enormous price of transferring our wealth and labor force abroad.Vladimir addresses the so-called law of "comparative advantage", which assumes that every country will specialize in what it does best. While theoretically, the law seems elegant and incontrovertible, it ignores important externalities such as adjustment costs--re-training, etc.Outsource everything--full speed ahead. Damn the costs. And, if the money has flowed abroad or into CEO and corporate coffers, who is to pick up the tab? How are we to adjust? How do we pay for re-training? And in what?
We are not talking here about a few people; we are talking about millions of people and uncountable industries. And then, of course, we have to wait--painfully--while wages equalize...if they ever do. And what has been the result: Enormous polarity in the distribution of wealth. So many problems; so little thought has been given to them.
No economist gave any thought to wage disparity; it simply became tucked into the law of comparative advantage.
No economist ever gave thought to labor rights as essential for sound trade. Again, labor rights became a mere externality--an uncomfortable side issue that deflates the bottom line.
Should the WTO have insisted that China protect labor rights prior to WTO entry? Of course it should have.
Right wingers love to tell us how much better off the poor peasant is in his sweat shop. Does the right winger care about sweatshop labor conditions? Of course not. Meanwhile, the rich get richer. And meanwhile, the U.S. is headed down the tubes.
And while we are at it, let me suggest another difficulty: Specialization has its own difficulties, as I pointed out in this piece: Local or Global .
Specialization puts any country at risk, especially in key commodities. And if big players with deep pockets can quickly shift money to exploit the problems, what then? According to one wag, 60% of the cost of oil is a result of one such shift. (While I do not agree with this figure, many here apparently do. And if they do, what say they then about free trade?)
Vladimir has described the problem, at least for the U.S. And what is his answer: Trade balances must be controlled. He suggests the following:
Interesting, but I think unworkable.
- Congress sets annual limits (upper bounds) on the overall U.S. trade deficit in consumer goods and undesirable capital goods (oil and gas excluded)
- The President of the U.S. allocates the allowed deficit for each of our trading counterparts-countries or groups of countries
- A country may exceed the limit if its government pays the U.S. Treasury a stipulated percentage (up to the full amount) of the excess deficit, also approved for each country by the President of the U.S. These payments may be capped
- To raise the money for excess deficit payments, our trading counterparts may either use export taxes and export certificate auctions or pay from their currency reserves
Imagine telling China that it must compensate us for its trade surplus! And what do we say to poor Mexico? Or to Canada? Send us our monthly check, please.
My own solution is three-fold and it is based on the following--over 60% of China's exports are from foreign companies inside of China. Unless we address that uncomfortable fact--almost 80% in IT--, our goose is cooked.
- Insist that all countries protect labor rights. No more fast track trade deals that are merely grease for our companies to find cheap labor.
- Reform the WTO or withdraw from it. The WTO should immediately start a process whereby all WTO countries move towards an acceptable standard for the protection of labor. Better late then never.
- Tax goods that U.S. companies make with cheap overseas labor. Put a price on outsourcing and offshoring. Hey, Intel and Apple, no more free rides. Hey, Walmart, your prices are going up. Time to compete fairly.
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As someone who in not an economist, but who has to make investment decisions based in part on understanding what is going with oil, I have been devoting some effort to this issue. Particularly after Krugmann's essay claiming supply and demand is the only possible explanation, I tried hard to understand if he was right because my bias is to think he isn't.
Since I don't have the theoretical expertise, after a while, due to my science training perhaps, it occured to me to use the data. smart huh?
So... if the price of oil is purely reflective of supply and demand, then it necessarily follows that when the price of oil dropped precipitously immediately prior to the 2006 election, a drop that was a bigger delta than across the entire 2001 recession period, (in a matter of weeks, not years), it follows that this must have been entirely due to supply and demand. uh, no. No way, sorry not buying it. The idea that supply in 2001 was tighter than in 2006, or that demand in 2006 with the economy booming, was less than than demand at the bottom of a recession, and that moreove this change happened in a couple of weeks, instead of a couple of years is... absurd.
It is in fact, beyond absurd, it is manipulative to even propose it. That price drop in 2006 clearly demonstrated that oil prices are affected by things other than supply and demand. You may choose to believe that it was a nefarious manipulation of price or that it was a surprise consequence of Goldman Sachs for some reason choosing to make a change, but you cannot argue that supply and demand together swung by that amount in that short of a period of time with little or no macro cause, or consequence interestingly enough.
The whole thing is absurd, and for any economist to devote more than one word of theorizing about why it isn't a consequence of the financial market structure, is for them to be engaged in foolish sophistry, at best or outright duplicity at worst
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A reader pointed me to a great post at Institutional Risk Analytics, which consists of an interview with Richard Alford, an economist in the Federal Reserve Bank of New York's foreign department during the heady years of the Plaza Accord and active FX intervention by the Group of Seven who now works as an expert in macroeconomic trends.
I'm particularly keen about Alford's views because he picks up on themes that are important yet sorely neglected. One is that the US formulates its monetary (indeed its broader economic policies) as if the nation was an independent actor. The role of the trade sector and our dependence on boatloads of foreign inflows to fund our trade deficits is missing from the official calculus (note this is also one of my pet peeves in most analyses of the Great Depression: the role of the breakdown of the financial flows among Germany, which had to pay reparations to England, which had to repay war loans from the US, which in turn was lending money to Germany to pay its reparations, is generally omitted). Alford says the Fed in fighting deflation has misread the US situation. He also warns our trading partners don't believe we will drive the dollar to the level required to get US consumption back in line (he has an intriguing view of why other countries won't be so keen to step into the reserve currency role).
Alford, with his focus on the trade/international funds flows component, highlights another aspect too often neglected: our unsustainable level of consumption and what bringing it down might entail. He is blunt in saying that the Fed did damage by defining the problem incorrectly and implementing wrongheaded measures. It's a compelling, sobering analysis.
From Institutional Risk Analytics:
The IRA: Dick, in your latest missive you say that the Fed has misread inflation for deflation, and that former Fed Chairman Alan Greenspan and now Ben Bernanke are fighting the wrong battles. There is clearly a lot of new inflation in the system due to energy prices, but you rarely hear anyone talking about monetary policy as a secular source of inflation.Alford: One of the interesting aspects of economic policy in the US is a belief that we exist independent of the rest of the world. In the minds of many policy makers, the US is the focus and the rest of world economy is just a stable background. To open the model up to external factors, market imperfections, and quasi-floating exchange rates would increase the complexity of the model and limit the number of policy prescriptions that could be made, so most US economists pretend that the rest of the world does not exist, is stable, or that the dollar will quickly adjust so as to maintain US external balances. It has only been in the past few years that the trade deficit has moved to a level that is clearly unsustainable. The US economic model is yet to catch up with reality.
The IRA: But don't you argue that because no other nation wants to be a reserve currency this allows the US to play this game without limit?
Alford: A lot of people thought that the game would end when foreign investors no longer wanted to hold dollars. All of a sudden China and Japan or OPEC would just say "no mas." But the problem with that view is that in most cases the reason to accumulate dollar reserves still exists. China, among others, still wants to grow through exports. They'll let the exchange rate appreciate until it really affects their growth, but no more. In addition, it is useful to remember that for a currency to function as a reserve currency, non-residents must hold large net claims denominated in that currency. This can only happen if the country of issue runs a large current deficit. I do not see any policymaker in the EU or Japan permitting large current account deficits. The dollar still may be the only game in town. But the other part of the equation, what people often forget, is that Americans must also be willing to hold more debt. At some point - and I think we are here now - Americans are not going to want their debt to income ratio to go up any more. They will stop borrowing and this whole game is going to come to an end. If Americans can't or won't borrow, they can't spend and the US economy goes into recession.
The IRA: Not only a recession, but a lowering of overall expectations, don't you think?
Alford: The primary effect is going to be that aggregate demand growth, especially consumption, is going to fall. We'll be at a point where the Fed can lean on monetary policy, but like Japan, these policy moves will do absolutely nothing. I can see a rather long period where the US underperforms trend growth by a significant amount.
The IRA: But going back to the point about the insular US mentality, isn't it obvious that once debt and other sources of new "bubble" financing are exhausted that we must see a downward adjustment in consumption?
Alford: If you look at the difference between gross domestic purchases and potential output, by US consumers, businesses, and government -- all are above potential output. The only time in recent memory when the difference between these two measures started to narrow was in 2001 when we were in a recession. One of the things we need to consider is that that US may need to see consumption drop significantly before we can achieve a sustainable position, for example vis a vis the dollar. That is going to be painful. I think private consumption must drop because a fall in investment will further limit income and job growth. I do not believe government expenditures are about to contract nor do I believe that the US has "decoupled" from the rest of the world. If we slow our growth rate and our consumption falls, then the rest of the world will slow as well.
The IRA: Correct. So if, for example, you take the worst case scenario of our friend Nouriel Roubini for US consumption, such a retreat by American consumers could ripple throughout the global economy, possibly causing an absolute decline in trade and financial flows.
Alford: Part of the issue is that where the US does have exchange rate flexibility, it is where we least need it. We certainly are competitive with the EU, but there are parts of the world where we are not competitive, where the exchange rate is not moving or not moving quickly enough. But we've past the point where prices alone- namely exchange rates - could adjust the system. Now we see income starting to adjust.
The IRA: Americans certainly are feeling the adjustment, especially in view of energy prices. Given what you see on the trade and economic front, how would you characterize Fed monetary policy?
Alford: Fed policy has been inappropriate to say the least. If you listen to Chairman Bernanke, he and the members of the Board of Governors are responding to the prospect of deflation in the US - a deflation which he describes as the result of a shortfall in aggregate demand.
The IRA: Thus the Bush stimulus package.
Alford: Yes. My view is that the demand side is fine. Remember, US domestic purchases are still running around 105-106% of potential domestic output. The problem is not the level of demand but rather the composition of demand. Americans are buying too many imported goods and the world is not buying enough of our exports. So we have a growing wedge growing between gross domestic purchases, which is what the Fed really controls, and net aggregate demand, which is defined as gross domestic purchases less the trade deficit. Given the inability or unwillingness of the US to correct the trade imbalance, the Fed has run expansionary monetary policy almost continuously, generating higher levels of domestic purchases so as to keep net aggregate demand near potential output. The Fed did this using low interest rates, which generated asset bubbles, large increases in consumer debt and sharp declines in savings, and also a larger trade deficit. What has been totally missing is any policy aimed correcting the external imbalance. We are relying on the tools of counter-cyclical domestic demand management to address problems caused by a structural external supply shift.
The IRA: All in the name of maintaining the nominal appearance of growth. So what measure does the Fed use to gauge its policy actions? Is the Fed's measure the dollar or what Americans have come to expect in terms of income levels?
Alford: The Fed is living in a Taylor rule world. Given the Taylor rule framework and the deflationary impact of globalization, the policy goal has been to generate sufficient levels of demand to support full employment. It is important to note that the Taylor rule framework implicitly attaches zero cost to growing external imbalances or financial instability. They are trying to get net aggregate demand to equal potential economic output. That would be fine if we did not have a net trade sector or at least had a stable net trade sector. But globalization has occurred and we've had a flood of imports which have depressed prices in tradable goods. Fed Governor Don Kohn gave a speech recently that said imported deflation knocked 50-100 basis points off measured per annum inflation. At the same time, rising imports have hurt American workers. From the US is an island, Taylor rule perspective, such a result is consistent with a shortfall in aggregate demand and requires expansionary policy. But today the underlying problem is not deficient US demand, but a structural external increase in supply (globalization). Given the inability of the dollar to serve as an adjustment mechanism, we are consuming too many imports, but instead of US policmakers addressing this global development, we created a number of unsustainable domestic imbalances to keep employment at politically acceptable levels. Higher levels of debt and asset bubbles have been the result of policy responses to external imbalances.
The IRA: Your description of the macro economic situation makes us think of the deteriorating credit quality of the American consumer. The higher debt levels and reliance upon speculative binges to manufacture the appearance of economic vitality at the national level ultimately manifest as higher default rates for individual consumers. Your scenario for the US adjustment process makes us feel even more bearish about US bank asset quality, if that is possible.
Alford: It seems that while the regulators and the Congress abhor (some might say abet -- editor) leverage and dodgy financial structures, they are also addicted to the asset prices only reached because of leverage and financial engineering. So now it seems that that the authorities will want better capitalized banks to support inflated asset prices previously reached through excessive leverage! We'll see how the great deleveraging plays out.
The IRA: Right, but this is not a particularly credible policy for a central bank to take over the medium to longer term. In the meantime, something had to move - namely the savings rate?
Alford: Yes, something had to move. You had to have net demand rise relative to income, which means that savings had to fall. Since 2000, the demand increases relative to GDP in the US mostly came from the consumer and housing sectors. Now with domestic demand waning, the attention has turned to stimulating foreign demand via a weaker dollar.
The IRA: OK, so what happens when the US consumer reaches the natural limit in the deterioration in their credit quality? When consumer have to become net savers, how much of US aggregate demand disappears from GDP?
Alford: That is a very complex question and one that is best addressed in pieces rather than via a point in time forecast. If the US consumer were to go back to savings rates of the 1996 period, then you are talking about savings going from essentially zero today to approximately 8% of disposable income. Since US GDP is about 70% consumption, that implies a decline in demand of about 5 to 5.5%. That would be a very dramatic effect. I don't think that this type of shift will happen all at once. It would occur over time. A shift back to a higher level of savings by the US consumer implies that the actual growth rate of the US economy will trail potential growth and will not support full employment-unless the trade deficit collapses.
The IRA: Well that's precisely the point, is it not? The US has an aging population that is intent upon drawing down savings in the later years of their lives. This means that the relatively smaller population of younger workers must be saving like crazy to offset the continued dis-saving by the Greatest Ever Generation.
Alford: Young people will have to save like crazy and the public sector will also have to save as well, though recent history is not encouraging in that regard. The Clinton deficit drawdown of the 1990s was a transitory event driven by tax policy and bubble induced stock market capital gains, not the underlying dynamics of the US economy.
The IRA: So how does the Fed's moves to re-liquefy Wall Street and bailout Bear, Stearns (NYSE:BSC), JPMorgan (NYSE:JPM) and the rest of the dealer community figure in the monetary policy equation?
Alford: Lots of people in a position to know have told me that they could not say no to a BSC rescue, that it was OK for the Fed to intervene. We'll it's not OK. This intervention may have been necessary, but it is also very troubling. To say it is OK or doesn't free policymakers from responsibility for their role in promoting the financial excesses that lead to the current dislocations in the world's financial markets. The policies that we followed since 1996 explain how we got to the present juncture, including keeping Fed Funds at 1% for almost a year and then the Fed taking its sweet time raising rates, and doing so in quarter point increments! The Fed's actions provided an incentive for economic agents to lever up and run maturity mismatches. Even households went out and got ARMs while the Fed was keeping rates artificially low! Banks (SIVs) and municipalities (auction rate securities) and corporate were all funding long-term obligations with short-term debt, so it's no big surprise that the economy takes a hit when rates finally rise back to normal. Short-term interest rates were clearly too low for financial stability in the early part of the decade and everyone in the US economy was running grotesque maturity mismatches that have now collapsed.
The IRA: So it was Fed monetary policy that has in fact created a safety and soundness problem in the US?
Alford: Yes. The policy stance was sufficient to generate asset bubbles and misallocations of resources. The regulatory system helped shape the crisis, but isn't a sufficient explanation for the crisis arising. That is a far easier explanation than to say that the regulatory system somehow simultaneously failed in the mortgage industry, the banking industry, municipal finance, etc and that we now require new layers of regulation in every corner of the financial system to correct the imbalances in the system. The Fed's monetary policy, in fact, was a necessary component of the systemic instability. No amount of regulation could prevent market participants from taking advantage of the incentives created by the Fed from 2001 through 2005 via extreme easy money policy. The incentive to run maturity mismatches would still be there and people would find a way to take advantage of it. This is not say that all regulation is futile, but rather that incentives are also important.
The IRA: So Milton Friedman was right when he said that keeping money policy relatively stable helps to avoid other evils.
Alford: The Fed has taken an approach that focuses on apparent price stability to the exclusion of other policy goals. The problem is that while price stability is necessary for long run economic and financial stability, it is not sufficient. When the Fed decided to focus on relative price stability, the US did not have a functional policy regarding the dollar. We did not and still do not have a functional trade policy. We have deficient regulatory policy. So by pursuing this one policy goal, which would be admirable if there other areas were being addressed, the Fed actually contributed to vast problems elsewhere.
The IRA: In fairness to the Fed, aren't they simply trying to make up for a government that is completely dysfunctional in areas like trade and the dollar? The Bush Administration's approach to things like economic policy is to simply have no policy.
Alford: It is incumbent on the Fed to go to the Congress and even the American people and say "we do not have the tools to address globalization." The Fed can clearly ease the transition, but adjusting the Fed funds rate is not an adequate response to the changes that the globalization of trade and investment flows are having on the US economy.
The IRA: Agreed. Why is it that the Fed cannot tell the White House and the Congress that these issues fall outside the realm of monetary policy?
Alford: Under Greenspan, there was this aura at the Fed that said "let's take credit for everything that's good" regarding the economy. The trouble with that position is that politicians and markets then expect the Fed to keep the party going. Fed policy, monetary policy has been vastly oversold. By focusing on short-term inflation and employment, the Fed misses a lot of other factors - like global trade and investment flows, like the decline in household savings as percentage of income, like leverage in the financial markets - which we can now see are rather important. Going back to the early part of the decade, economists within the Fed system apparently saw a world where US prices and incomes were made at home. Now we see that is not the case. In the EU and around the world, currency movements are seen as a constraint on monetary policy, but in the US economists have grown up thinking that the dollar would never be a constraint on policy. I think that the FOMC was probably a little surprised recently when they found that the dollar and commodity markets impinged on their ability to ease.
The IRA: Fine, so let's assume that you are a Fed governor - which we think is a good idea, by the way - what would you do differently?
Alford: Asking what should have been done in 1996 or 2000 is a tough enough question because the imbalances were all smaller, but today by comparison we have serious problems. Politically and economically, there is no painless solution to the imbalances in the US. For US policymakers, it seems that even short-term pain is intolerable. Nobody in Washington wants to bite the bullet and explain the full dimension of the required change to the US electorate, so we muddle. Going back to the early 1990s, US politicians have bought support from the voters by keeping consumption on an ever rising trajectory. For at least 12 years, we've had debt induced increases in consumption and the political class optimized their behavior to maintaining that illusion of rising consumption even as the economic fundamentals worsened.
The IRA: Members of Congress actually believe that endlessly rising home prices are now part of the American Dream.
Alford: Precisely. The US population is not ready to hear that their real levels of income, assets prices and other indicia of national well being may be falling or relatively stagnant for the foreseeable future. This is just politically not acceptable. So our politicians will attempt to maintain the appearance of growth, but not address the underlying causes. Devaluing the dollar alone is not going to correct the issue. World financial markets would destabilize if they perceived that the dollar was about to depreciation enough to restore the US to external balance. They still believe that it will never happen.
The IRA: Never say never. Thanks Dick.
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May 29 2008
Some say the credit crisis is over. Not Tom Attwood, managing director of Intermediate Capital Group (ICG), a firm which makes few waves outside financial circles. Its business is mezzanine finance, specialist high-risk lending to private equity firms. That puts it at the frontline of the financial turmoil and Attwood's bleak assessment of conditions yesterday is worth quoting.
Sub-prime, he says, was merely a catalyst to the bursting of the credit bubble. It was going to happen anyway. "Credit disciplines across almost all markets were bypassed in favour of loan book growth at almost any cost."
So far, so uncontroversial, and Attwood has been singing a similar tune for a while. The key point is that he can't spot the break in the clouds that many bankers claim to see. "What was a liquidity crisis is likely to lead to a credit crisis," he says.
A year or two? Well, yes. ICG assumes there will be a recession in the US, the UK, Spain - the markets most pumped up with credit - and a slowdown elsewhere.
His bottom line is: "There is no sign of a return to liquidity in debt markets as a whole. Raising new funds will become increasingly difficult across the board."
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The Fed announced that Frederic Mishkin will be leaving the central bank effective August 31. The governor's term extended through 2014, but he chose to leave early to return to the Columbia faculty, where he teaches at the business school.
Personally, I think this is a good thing. Mishkin was on the FOMC and a vocal proponent of rate cuts (I'm in complete agreement with Richard Alford that the Fed is looking at the situation incorrectly and pushing the gas pedal too hard). My sense was, both due to his friendship with Bernanke and his forceful style, that his influence was far greater than his single vote.
Comments
Mishkin has been to Bernanke as Bernanke was to Greenspan: he's provided the academic, intellectual justification for the Fed's deflation-fighting experiments.
It will be interesting to see whether the senate will replace Mishkin any time soon. Bernanke all of a sudden looks isolated: even Yellen, a long-time dove, doesn't necessarily buy into the Mishkin academic hocus pocus. The Chairman relies on Kohn like never before, but Kohn is only a recent convert to his line of thinking. One wonders how long the Vice-Chairman will continue to serve as an apologist for rising inflation.
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I've often noted that the financial industry is rife with pathological optimists and clueless wishful thinkers. However, there are a few exceptions. The realists include individuals like Albert Edwards and James Montier, the highly-rated co-heads of strategy at France's Societe Generale, and Merrill Lynch's North American economist, David Rosenberg.
Another individual who is not usually found in the bear camp, but who is nevertheless willing to call it like he sees it when he sees trouble on the horizon, is the billionaire chairman of Berkshire Hathaway. In "Buffett Sees 'Long, Deep' U.S. Recession," Reuters reports that the "sage of Omaha" has a less-than-sanguine outlook nowadays.
The United States is already in a recession and it will be longer as well as deeper than many people expect, U.S. investor Warren Buffett said in an interview published in German magazine Der Spiegel on Saturday.
He said the United States was "already in recession" and added: "Perhaps not in the sense that economists would define it" with two consecutive quarters of negative growth.
"But the people are already feeling the effects," said Buffett, the world's richest man. "It will be deeper and last longer than many think."
But he said that won't stop him from investing in selected companies and said he remained interested in well-managed German family-owned companies.
"If the world were falling apart I'd still invest in companies," he said.
Buffett also renewed his criticism of derivatives trading.
"It's not right that hundreds of thousands of jobs are being eliminated, that entire industrial sectors in the real economy are being wiped out by financial bets even though the sectors are actually in good health."
Buffett complained about the lack of effective controls.
"That's the problem," he said. "You can't steer it, you can't regulate it anymore. You can't get the genie back in the bottle."
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Financial Armageddon
When it comes to the world of business and finance, it sometimes takes tens of thousands of words to explain what is going on. Other times, it might only require a few carefully chosen sentences. In a post entitled "A Bear's Moan" at his New York Times blog, Floyd Norris: Notions on High and Low Finance, the newspaper's chief financial correspondent highlights some brief, though very informative thoughts from a strategist who actually knows what he is talking about.
This has been a frustrating time for bears, who see disaster all around them - except in stock prices.
James Montier, an analyst with Societe Generale in London, has published what may be the ultimate scream of frustration. Entitled "Road to Revulsion," it argues that bubbles end in total investor despair.
Here is the opening paragraph of the report:
"We have seen the heads of virtually all financial institutions stand up over the last few months and claim the worst is behind us. Who would anyone listen to those people? They didn't see the disaster coming, and yet somehow they are qualified to tell us it is alright!
Perhaps I am just unduly skeptical, but this reeks of a conspiracy of optimism. The recession has barely started, let alone reached its nadir. The market moves of late have all the hallmarks of a classic sucker's rally. This isn't discounting the recovery, this is denial! Far from being behind us, the worst may still lie ahead."
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I somehow missed this piece by Robert Nadeau in Scientific American when it came out earlier this year, and I thought it made for good Sunday/holiday reading.
Nadeau's criticisms are admittedly pretty broad and similar observations have been made elsewhere (although Nadeau does add some useful historical detail), and a short piece by a non-expert is always vulnerable to criticism. But that doesn't mean that Nadeau isn't on to something. The propensity of economics to start from abstraction is limiting, yet once certain constructs become codified via textbooks, they become part of the discipline's world view.
For instance, around the time of the release of the IPCC report and the Stern report (which endeavored to assess the economic cost of climate change), there was considerable discussion of how to properly characterize the costs and risks of inaction, and the failure of market-based approaches (Brad De Long had a fine post). There have been some debates within the profession about the neoclassical orthodoxy and heterodox economics (see here and here for examples).
Now if you want to read a fair minded yet in some ways devastating critique, and a well-written, entertaining and informative one at that, you must go immediately to Deidre McCloskey's essay, The Secret Sins of Economics.
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Operation Iraqi Freedom has been a smashing success, and only appalling Wilsonian wimpiness in the US government has prevented the United States from taking full advantage of it. Iraq's known oil reserves have been increased by about 100 billion barrels since the invasion, as competent US oil companies have been free to explore for new oil employing techniques more advanced than the 40-year-old dowsing sticks used by Saddam's oil operation. At today's oil price of $130, less a generous $20 for drilling and extraction, those additional reserves have a value of $11 trillion – approximately 10 times the most alarmist estimate of the cost of the war to date.<
The problem is that the US did not secure itself a proper royalty on the new oil finds (even 10% would have been worthwhile -- $1.1 trillion over the next few decades.) Nor did it ensure, by setting up a privatized oil company and a trust fund for the Iraqi people diverting oil revenues from the Iraqi government, that the new oil finds would be exploited in an efficient manner and the supplies directed properly into the world oil market. Any future invasion of an oil producing country should avoid these two mistakes and thus make itself self-financing.<
The obvious place to invade is Venezuela (even if current estimates of Venezuelan and Saudi reserves are wrong and there is in reality more oil in Saudi Arabia that could be unlocked if ExxonMobil and the boys were given free rein, the Saudis are nominally our allies, so an invasion would be considered unsporting by world opinion.) Since the 1.8 trillion barrels of Venezuelan oil deposits consist largely of the Orinoco tar sands, a Venezuelan oil-related invasion would impose an additional requirement: to keep the environmentalists away, in order that reserves could be exploited with maximum efficiency.<
... ... ...<
In summary, a sharp rise in US and world interest rates is the best way to solve the problem of spiraling energy and commodity prices, which will probably not solve itself. If that doesn't work or is "politically impossible" it's time to prepare the 82nd Airborne for jungle warfare in the Orinoco Basin.
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...To achieve energy independence, the U.S. needs to cut consumption of petroleum from 21 million barrels a day down to 10-11 million barrels a day (MBD), and quickly. The ignorant cheerleaders (many of whom seem to have gained elected office) are always yammering about "endless new sources of energy" but under close examination with basic high-school science, every single "miracle source" turns out to have real-world limitations.
I have covered some of these limitations in the past few months, and will mention just two (again) of the most popular "miracle cures to our need for more energy:" shale oil and coal gasification. Canada and the U.S. have hundreds of years of shale oil, tar-sand oil and King Coal, we are constantly told, yet in a peculiar oversight, nobody seems to mention that turning these hydrocarbons into liquid fuels is horrendously energy-intensive, complex and limited by physical constraints.
The best estimates by those who actually know about moving entire mountains of shale and tar sand, heating it up with vast quantities of natural gas, etc., is that total top production will reach about 2 million barrels a day--about 10% of the oil the U.S. consumes (not to mention Canada's consumption).
Gasifying coal sounds like a neato-peachy-keen "solution to our energy shortage" until you go to a vast Western strip mine and take a look at the infrastructure needed to make a paltry 2 million barrels a day. The notion that we can turn billions of tons of coal (yes, we already burn a billion tons of coal a year, and China burns 2 billion tons) into 20 million barrels of liquid fuels per day is simply absurd.
Like many of you, I think nuclear power technology has advanced (like all other technologies) since the 1960s designs which are in operation today; to dismiss nuclear power out of hand is another form of ignorance, especially when you consider the alternatives, like $300/barrel oil going to $1,000/barrel. (Yes, it could.)
But it will take years to build 100 more nuclear power plants, and they do, after all, only generate electricity, not liquid fuels. And yes, we can move to hybrid vehicles and electric tractors but those lithium-ion batteries are costly to make and replace; as the saying goes, there is no free lunch.
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Drum roll please: here are a few obvious ways to encourage conservation and making the U.S. far more energy-efficient. I know, I know, none of these are politically viable; we'll just have to watch oil go to $300/barrel before Americans will get off their duffs and start dealing with reality. But hey, it's fun to dream:
1. start supporting basic research on efficiency and alternative energy on a much larger scale. Take a look at this chart of Federally-funded research:
Here is the source article in the San Francisco Chronicle: Dan Kammen: Clean energy and America's future.
Yes, the "marketplace" is responding with its own investments but the "low cost" of oil is driving pernicious "incentives" to rely on "cheap" coal and oil. The problem is that when these "cheap" sources of energy become expensive, they will do so very quickly, and the vaunted "marketplace" won't have time to catch up.
Let's also not forget that the vast majority of technological advances can be traced back to government-funded research, work often done in University settings (like, say, nuclear technologies, the Internet, etc.), not "market-based" investment. Even most of the miracle drugs can be traced back to government research, not the pharmaceutical industry.
2. require all electronic/electrical devices to shut off rather than remain in power wasting "standby mode." Something like 5% of the entire U.S. electrical consumption is wasted by millions of transformers and inefficient circuitry in tens of millions of TVs, stereos, computers, etc.
3. mandate another round of serious efficiency improvements in all appliances. The supposedly efficient "market" did absolutely nothing about energy efficiency until the government (yes, the "evil, can't do anything right" government) imposed efficiency standards in the wake of the 1973 and 1979 oil shocks.
4. raise the mileage standards of all vehicles to 40 miles per gallon effective next year. Please don't tell me it's impossible unless you're an engineer with Honda Motor Company, in which case I would ask you to look at your own company's vehicles from 1972.
The ICE (internal combustion engine) I know best, the basic Honda CVCC, has risen from about 85 horsepower to about 120 HP in the past two decades, with a comcomitant decline in mileage (yes, some of that increase in HP is due to technology, but there are still trade-offs) . The current crop of Honda 1800CC engines could be scaled back to 1300CC with a reduction in unnecessary horsepower and a substantial increase in mileage.
And for everyone who whines that their SUV or truck needs 200 HP, recall that a Volkswagen bus (the original hippie SUV, van and truck combined) operated quite well (albeit slowly when ascending steep grades) with a 45 HP engine that was terribly inefficient.
A standard Honda-type engine of 1300CC would very easily generate enough horsepower (when properly geared) to power non-bloated pickups. Larger vehicles would work just fine with "larger" 1800CC engines producing 125+ HP.
The only real trade-off is a loss of acceleration. Autos and trucks have gotten bigger, heavier and faster, all at the expense of efficiency and mileage. Reverse those trends and you will see immediate reductions in transportation consumption, which accounts for 2/3 of U.S. oil consumption.
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5. lower speed limits to 65 MPH and enforce the limit. This is the easiest, most obvious way to boost mileage by 10-20%--lower speeds from 75+ MPH to 65 MPH. We'll all still get there, believe me. Just as an experiment, the last time I drove home from Los Angeles (380 miles) I drove about 65-67 MPH most of the way. I wasn't in a big hurry, thiugh it certainly seemed like everyone else was; most of the vehicles whizzing past were traveling in excess of 80 MPH. (This was at night, by the way.)
The slower pace added about 20 minutes to a 7-hour drive, but is this really the end of the world? Meanwhile, because we keep our 1998 Honda Civic properly tuned and the tires properly inflated--not exactly brain surgery--I got about 42 miles per gallon in a standard ICE production engine with 10-year old technology--more than most hybrid cars which cost much more and require hideously costly batteries.
If Honda cut the engine size and HP down a bit, I could probably get 50 MPG without any reduction in driving pleasure or convenience. And so could everyone else. And I'm 6 foot 2 inches tall, so please don't tell me you need a huge vehicle. (The guy in the video link above is 6 foot 5 inches tall.)
6. close entire streets to vehicles, creating safe, convenient bikelanes. My brother-in-law and I took a pleasant bike ride recently, in honor of his visiting us, and our 40-mile roundtrip (70 KM) ride on marked bike lanes eventually took us onto the shoulder of I-580--a freeway. I am not kidding--the bike lane merged onto the shoulder of a freeway for quite some distance. A single sign marked "share the road" with a bike logo on it denoted that the drivers whizzing past should not think the two bicyclists were insane and should be arrested. Was that part of the ride enjoyable? Do you reckon?
This is in "astoundingly environmental" California.
We all know Americans are too fat for their own good, and riding a bike is, for at least much of the year in most of the country, a convenient way to get about. (You can always put on a rain slicker like people do in other countries.) But it's only pleasant and convenient if roads are closed to cars and trucks. Yes, such closures would impose a burden on vehicles, but the time for wimpy half-measures like bike lanes on freeways and busy 4-lane roads is long past.
7. subsidize bus, train ans subway rides with a $1/gallon tax on gasoline, diesel and jet fuel. To repeat: the time for wimpy half-measures like subways and trains which cost a bloody fortune to ride is long past. If we want to modify behavior to conserve energy, then we have to make it nearly free to ride a bus, train or subway and very dear to drive a car.
Yes, you can argue about commutes and how big the West is and fairness and exurbs and all the rest, but it's really very simple: if it's nearly free to take public transport or carpool, people will do so and find some way to get to the station or pickup point. Ditto for carpools and other huge, practical, behavioral (not technological) efficiency-boosts. Even a 15 MPG SUV becomes efficient when there's six people being transported in it.
8. make building in the distant suburbs/exurbs either impossible or extremely expensive, and make building more low-rise housing in the city and inner ring essentially quick and cost-free to developers, non-profit and for-profit alike. I happen to live in a college town with population densities rivaling Hong Kong (in the south of campus area), yet there are very few buildings over three stories in height. You don't need highrises to increase density, you simply need mid-height buildings (see Paris or equivalent European cities for examples; six-story buildings create a very liveable scale.)
It's a simple idea, encouraging people to live closer to their jobs, and yet we as a nation have created all the wrong incentives: it's been dirt-cheap to build 50 miles from the city but costly and tiresome to obtain permission to tear down an obsolete structure and build a liveable moderate-density building in or near the city.
You can probably add another 8 or 16 or 24 other obvious, non-fancy ideas which would require little real sacrifice. You want sacrifice? How about no light at night? How about cold water baths? How about walking 10 miles to and from school/water/work/market? This is normal life in much of the world; just how awful will it be to have a street without cars? Is that really so unbearable? How about a car which doesn't accelerate like a race car? Is that really such an immense burden that we can't bear to give it up?
Funny, nobody thought life was miserable and awful and wretched and they had to cry themselves to sleep in 1957; have you ever driven an old American pickup truck from that era, a truck with a simple engine and wood slats in the bed? They didn't exactly accelerate like greased lightning, yet somehow (breathlessly, we ask, how? How? It's impossible!) the farmwork and building got done despite a horrible, soul-draining lack of horsepower and acceleration.
Then fine, the world will take it away from us in it's own time--which will be sooner than most of us can possibly imagine.
Extra-special bonus idea: convert all large U.S. Navy ships to nuclear power plants. The U.S. Military uses as much oil as the entire nation of Sweden; surely there are some efficiencies which could lower this stupendous consumption (along with curtailing U.S. involvement in Iraq.)
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Companies are now facing a squeeze. Figures from Britain this week showed that firms had pushed up their output prices by 7.5% over the previous year but this rise, while startling enough, was nowhere near sufficient to compensate them for a 23.3% gain in raw-materials prices, the biggest since 1980.
It will be even more difficult to maintain profit margins when consumers are under pressure. Again, higher oil prices are part of the problem. Goldman Sachs reckons that some $3 trillion of wealth was transferred from oil consumers to oil producers between 2001 and 2007 and the pace of transfer is running at $1.8 trillion a year. In general, producing countries save more, and spend less, than consuming nations. At the same time, of course, falling house prices in America, Britain, Spain and Ireland threaten to make consumers feel the pinch.
Moreover, central banks may be unable to give consumers much help. With British inflation rising faster than expected, the Bank of England may join the European Central Bank, the Bank of Japan and the Federal Reserve in keeping interest rates on hold for the foreseeable future. So far oil has been the "dog that did not bark"; but it may yet give the global economy a nasty bite.
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Keith Bowers wrote:May 18, 2008 19:35
I believe the U.S. economy is decelerating MUCH faster and MUCH more severely than 'statistics' show thus far.High energy costs are causing draconian changes in consumer behavior. Many U.S. farmers ARE NOT planting this spring because of the extreme escalation in fertilizer and fuel prices have not been reflected yet in grain prices on the futures markets.
This dichotomy ensures a LOSS if they do plant--it costs more for fertilizer and fuel (and seed, pesticides, herbicides) , revolving credit for planting supplies is very difficult to get, so they are gonna take a year off.
This weekend, I splurged and drove almost 700 miles round trip to spend 3 days visiting my daughter. U.S. I-81 through Virginia to PA was a major portion of the route. It was absolutely EMPTY of traffic as compared to last year and 'normal times.
I estimate a drop of at least 50% in number of vehicles on the road. I was astonished at the sudden change. Gasoline costs ranged from $3.89 to $4.13, with diesel even higher. I spent some $120 on fuel. Flying was not an option, nor was mass transit. The cold,dark days of pre-oil are upon us NOW.
gwalduck wrote:May 16, 2008 07:53
... For my part, I am concerned that central bankers think they are in control. It's all very well to dampen demand by raising interest rates, but when price rises are caused by fundamental changes in the balance of economic power - in this case from "western" consumers to commodity producers - the only thing that can happen is a fall in the "western" standard of living. Not a bad thing, really, if it reduces waste and economic arrogance along the way. We can't inflate ourselves out of this situation, even if the bankers would let us.
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I keep hearing on CNBC and reading at some blogs that if cars get better mileage that people will drive more by enough to offset the improved mileage.I can see that people could drive more because of the savings. But to argue that reducing mileage by 20%, for example will lead to people increasing their driving by more then 20% seems like a very questionable conclusion. I'm willing to listen to an argument that increasing gas mileage would be partially offset by increased driving, but not that the responses would be more than 100%.
Does anyone have any idea of the original source or research of this belief by so many Republicans, Conservatives and Libertarians?
Is it just another Wall Street Journal editorial page finding that is too good to be true?
Comments
Libertarians want to say that, given increased fuel efficiency, to say 400 miles per tank, people will choose to live further out from city centers, their jobs, and services. If that's true, then it's a wash.
Constraints on the consumption of time make this type of response nonlinear, perhaps highly so. Doubling the efficiency may make it possible to double the driving distance at the same price; but it doesn't address the problem of greatly increased driving time.
Michael Cain | 05.23.08 - 9:49 pm |
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The effect is real but small -- it's called the 'rebound effect' in fuel economy rulemaking speak. The current CAFE notice of proposed rulemaking assumes an elasticity of vehicle-miles traveled with respect to per-mile fuel cost of -0.15. So reducing fuel consumption per mile by 20% would (holding price constant) be expected to increase VMT by about 3%.
Tom Bozzo | Homepage | 05.23.08 - 10:35 pm | #===
My visceral reaction (no hard data) is that these WSJ people are idiots who live in an intellectual vacuum, well apart from the real world. Here in the real world, people are trying to reduce their fuel *expenses*, not be able to drive more for the same cost. Morons.
Idaho_Spud | 05.23.08 - 10:37 pm | #
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I'm not sure that mileage has improved 20%, if that is the figure mentioned. The EPA released a report on "real world" estimates which flat-lines fuel economy (or worse) from the mid-eighties. A chart and link to that report is on my blog thedailychart.blogspot.com Furthermore, for the past 4 months or so traffic volumes have been decreasing, a link to the February Federal Highway Admin Report is also on my blog.
Leo | Homepage | 05.24.08 - 12:22 am | #
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The level of ignorance required to believe this effect dominates is astounding. The largest single contributor to consumption of gas is incomes. Since incomes have risen in real terms, consumption of energy has grown. Period.
Most of the other effects are swamped by income growth. To try to look at consumption without considering income growth is absurd.Greg | 05.24.08 - 4:29 am | #
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The Twelve Steps:1. Stop deluding ourselves. The era of cheap, readily-available oil has ended. Prices may fluctuate, but the underlying trend is up, up, up. We have to get used to using less.
2. Demand that politicians take the issue seriously. Make it an election issue. Don't take 'we've got everything under control' as an answer.
3. Stop building new roads. They're a monumental waste of money, time and effort. They encourage, rather than ease, congestion, and besides, the growth in car travel that's used to justify them isn't going to happen anyway.
4. Divert that money and effort into measures that address the challenges of oil depletion and climate change.
5. Make a major investment in public transport. It needs to be better, faster, more comfortable, more regular, and more predictable. It needs to cater for everyone, not just peak-hour commuters - though they need a better service as well.
6. Make a major investment in broadband internet to allow more people to work from home, and change tax and business practices that discourage working from home. The more car trips we can avoid, the better.
7. Electrify transport where possible. New Zealand is well placed to use renewable electricity for transport. We should be electrifying commuter rail where it is not already electric, using light rail (trams) in cities, and looking at electrification of the main trunk line. On the other end of the scale, electric bikes and scooters can make a big difference in our cities. And electric cars show promise, though there's a lot of questions to be answered yet.
8. Don't use cars unless there's no alternative. Take the bus. Take the train. Switch to a scooter. Walk or cycle – both your wallet and your doctor will thank you.
9. Deal with other aspects of our oil dependence. Agriculture, for example, is highly dependent on oil. We're going to need to change the way we grow and distribute food. Let's get to work on that now, not wait until supermarket shelves start to empty.
10. Stockpile or manufacture vital products currently imported from overseas. When oil runs short, will that still be possible? Let's take stock now and work out what we may need to start stockpiling or making in New Zealand.
11. Think local. Ending our oil addiction isn't just up to central government, though it can play its part. Communities can work together to make themselves more resilient. Join or start a Transition Towns group in your local area.
12. Accept reality. The age of cheap oil is over. It's not coming back. As individuals and as a nation, we have to adapt.
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The Debate Challenge
Before the debunking commences in earnest, I want to reiterate a debate challenge I made to Khosla. Following his essay at The Huffington Post entitled The Big Oil Companies Have Been Ripping Californians Off -- And Not Just at the Pump, I issued a challenge to Khosla to debate his claims. I repeat that challenge here. We can engage in a written debate (so claims can be referenced and verified) hosted at The Oil Drum, or at the venue of his choice. The focus will be on various ethanol claims that he has made. I will show that many of his claims are simply incorrect, and a lot of it is propaganda.
Debunking Selected Claims
Let's focus on some specific claims that Khosla made in his presentation, and see if they hold up to scrutiny. If they don't, then I want to ask why anyone takes his claims seriously, and why we are allowing him to influence energy policy. I want to ask those who encounter him to vigorously challenge him on his exuberant claims (and make sure he knows about the debate challenge). Because if he is wrong, and political leaders are betting that he is correct, we will be throwing good money away and wasting time while we could be going after real solutions.
During the video presentation, at the 3:50 mark Khosla makes the following claim:
Vinod Khosla: Brazil has replaced 40% of their petroleum use with ethanol already.So, is this true? No. As I documented in the article on ethanol that I wrote for Financial Sense:According to BP's recently released "Statistical Review of World Energy 2006", Brazil consumed 664 million barrels of oil in 2005. In 2005, Brazil produced 4.8 billion gallons of ethanol, or 114 million barrels. However, a barrel of ethanol contains approximately 3.5 million BTUs, and a barrel of oil contains approximately 6 million BTUs. Therefore, 114 million barrels of ethanol only displaced 67 million barrels of oil, around 10% of Brazil's oil consumption. In other words, Brazil's energy independence miracle was 10% ethanol and 90% domestic crude oil production.
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According to BP's recently released "Statistical Review of World Energy 2006", Brazil consumed 664 million barrels of oil in 2005. In 2005, Brazil produced 4.8 billion gallons of ethanol, or 114 million barrels. However, a barrel of ethanol contains approximately 3.5 million BTUs, and a barrel of oil contains approximately 6 million BTUs. Therefore, 114 million barrels of ethanol only displaced 67 million barrels of oil, around 10% of Brazil's oil consumption. In other words, Brazil's energy independence miracle was 10% ethanol and 90% domestic crude oil production.
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One of the innumerable problems with Wall Street and the City is that they never do seem to learn from their mistakes....Each generation seems obligated to re-experience the errors of its predecessors. There is little or no 'race memory' that might at least mean that this year's crisis is brand new rather than a tired retread of past embarrassments.
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What makes markets so intriguing today is that equities seem largely immune to a combination of $120+ oil, softening housing markets and a likely collapse in western consumer spending. Arguing that several trillion currently either sheltering in money market funds or rapidly accumulating thanks to petrodollar wealth in sovereign wealth funds will ride in to support stock markets (a.k.a. greater fool theory) only logically goes so far in the face of such sizeable challenges. But some confusing short-term resilience on the part of stock markets does not invalidate the need for caution, it rather reinforces the need for patience.I
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n the face of almost insurmountable doubts (over likely economic slowdown, the impact on consumer confidence of softening residential property prices, the robustness of Asian fundamentals in the face of the ongoing commodity rally, the impact of $130+ oil, and the health of government bond markets given growing doubts over the under-reporting of inflationary pressures) it makes absolute sense to assume ongoing and substantial macro uncertainties....Unfortunately, an especially discredited Wall Street establishment now has peculiarly weak authority in either recommending appropriate strategies or taking advantage of the resultant dislocations in markets.
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most investors are in denial about unpleasant truths:
1. Financial assets are far riskier than the press, the textbooks, and conventional methodologies indicate. The models that the pros use are based on assumptions that are fundamentally flawed. The dangers of the erroneous belief that financial assets are safe is now being revealed.2. The people who control the markets (the intermediaries) have their own, and not the publics', best interest at heart. Due to the proliferation of OTC markets and the value of assets involved, they cannot be dispensed with. And the regulators lack the skill and will to ride herd on them. As Keynes remarked,
When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.We see ample evidence of that problem, yet seem to lack a way out.
So in a way, these gnawing issues do come around to Waldman's point. In times of crisis, people look to leaders for guidance. But in our prevailing doctrine of free markets, there are no leaders, just agents interacting in ways purported to produce virtuous outcomes. And the parties who ought to step into the breach fail to understand the need for that role right now. That is why an old fashioned (and very tall) banker like Volcker is so reassuring. He handled a crisis; he's not afraid to take the reins or say things are bad and changes are needed.We are at the end of a paradigm: large scale OTC markets, lightly regulated players and instruments, dollar as reserve currency, US as the most important global economic actors. Waldman is good here:
People are losing faith in financial assets for good reason. Rather than organizing productive economies, the machinery of finance has recently functioned as an anesthetic, masking the pain while resources were mismanaged and stolen. We need a solid financial system, but confidence cannot be imposed or legislated. It will have to be earned. There has to be a plan.
But Yeats is better:Turning and turning in the widening gyre
The falcon cannot hear the falconer;
Things fall apart; the centre cannot hold;
Mere anarchy is loosed upon the world,
The blood-dimmed tide is loosed, and everywhere
The ceremony of innocence is drowned;
The best lack all conviction, while the worst
Are full of passionate intensity
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Tom Keene's show:Bloomberg Podcasts: DeLong Expects Dollar to Fall Versus Asian Currencies: May 20 (Bloomberg) -- Bradford DeLong, an economics professor at the University of California, Berkeley, talks with Bloomberg's Tom Keene in San Francisco about the outlook for the U.S. dollar versus Asian currencies, Federal Reserve monetary policy and the battle between Democratic U.S. presidential candidates Hillary Clinton and Barack Obama.
http://media.bloomberg.com/bb/avfile/Economics/On_Economy/vKpRex1Ueuy0.mp3
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So just as Bank of America's once touted deal with Countrywide looks like it will turn out to be a slow-motion train wreck, the Bear deal has the potential to be a millstone rather than an asset to JP Morgan.
A further sign that all is not well in former Bear-land is the sudden exodus of two former executives who were given very senior roles at Morgan.
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A run on central banks?When I see what commodity prices are doing, I don't think "low interest rates" or "skyrocketing demand". I think about a loss of confidence.
There is that old saw about gold, that it is the only money that is no one's liability. Wheat is no one's liability, and neither is corn. Oil is no one's liability.
It is common to invest in commodities as an "inflation hedge". If the central bank prints too much money, you need wheelbarrows to buy bread. If you have a sack of wheat, you will have your bread whatever the central bank does. But if everyone buys wheat, the price of grains will rise, even if the central bank does nothing at all.
Just as the fear of a bank's insolvency can precipitate a run that drives a bank to ruin, loss of confidence in a central bank can provoke a great inflation. The Federal Reserve, much I might criticize it, has not gone on a printing spree. It has lowered interest rates, and altered the composition of bank assets by replacing less liquid with more liquid securities. But the most these measures should do is bring us back, monetarily speaking, to the status quo ante, back to a year ago when asset-backed securities were liquid. The Fed's actions are best described as antideflationary, not inflationary.
But confidence is a funny thing. Central bankers are supposed to be dour and dependable. The current crop is not. Rather than "taking away the punchbowl", central bankers have become the life of the party. Japan's central bankers hand out Yen like free acid. China's guy will give you a microwave oven and a DVD player if you draw him a picture (and sign Henry Paulson's name to it). Our man Ben is an Amadeus-cum-Macguyver, he's brilliant, unpredictable, he'll improvise a Delaware company from paper clips and vacuum up your derivative book with a toenail clipper. Even the ECB's Trichet, who at first comes off like a sourpuss, turns out to be alright, when you've got some Spanish mortgages to pawn.
Some of us think that something's wrong, and these guys we're drinking with aren't serious enough to fix it. We know that trillions of dollars in presumed housing wealth have disappeared, but we don't know who's ultimately going to bear the loss. Americans know that as a nation, we cannot afford our clothes, furniture, or gas, unless the people who are selling it to us lend us our money back. Economists fret about "imbalance" and "adjustment", but we've yet to see a serious plan, other than let's-keep-this-party-going.
So, we lose faith. When we lost faith in Northern Rock, Bear Stearns, Citigroup, or Lehman, the central bankers stepped into the fray, and stood behind them. So, we ask, who stands behind the central bankers? We take a peek, and all we see is our own money. Which we quickly start exchanging for something else.
Although commodity prices have been increasing for years, you'll notice that the very sharp run-up began last summer, at roughly the same time as the credit crisis. Commodities soared when interest rates were still high, but predicted to fall. Commodities are soaring today, even though US interest rates are now predicted to rise. Commodities have soared in euro terms, despite the ECB's refusal to drop interest rates.
I can't tell you where the inventories are, except to wonder why anyone would put them where they would be counted. Hoarders tend to get nervous, and not advertise their hoards. (But this is pretty obvious.) Perhaps producers of storable commodities who lose faith in paper quietly hold back production. Interestingly, people who no longer trust the very core of the financial system remain comfortable with collateralized, centrally-cleared futures exchanges. These are well designed to manage credit risk, but they can default, have defaulted, and will default in extremis. I heartily endorse Cassandra's suggestion that they step up their margin requirements, ASAP.
None of this is any good at all. Capital devoted to precautionary storage would be better employed building new enterprises, laying a foundation for tomorrow's prosperity. But claims on future money are only promises, easily broken or devalued. A run on central banks, a flight from financial assets to stored goods, sacrifices the hope of future abundance for certain present scarcity. Governments can shut futures exchanges, confiscate gold, ban "hoarding, profiteering, and price-gouging". People will hoard anyway if they don't believe in the paper. People are losing faith in financial assets for good reason. Rather than organizing productive economies, the machinery of finance has recently functioned as an anesthetic, masking the pain while resources were mismanaged and stolen. We need a solid financial system, but confidence cannot be imposed or legislated. It will have to be earned. There has to be a plan. Earnest promises to do better soon won't suffice. Nor will yet another drink from the punch bowl.
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13 May 2008 HARPERS MAGAZINE, MAY, 2008
Washington's harping on weapons of mass destruction was essential to buoy public support for the invasion of Iraq, the use of deceptive statistics has played its own vital role in convincing many Americans that the U.S. economy is stronger, fairer, more productive, more dominant, and richer with opportunity than it actually is.
The corruption has tainted the very measures that most shape public perception of the economy-the monthly Consumer Price Index (CPI), which serves as the chief bellwether of inflation; the quarterly Gross Domestic Product (GDP), which tracks the U.S. economy's overall growth; and the monthly unemployment figure, which for the general public is perhaps the most vivid indicator of economic health or infirmity. Not only do governments, businesses, and individuals use these yardsticks in their decision-making but minor revisions in the data can mean major changes in household circumstances-inflation measurements help determine interest rates, federal interest payments on the national debt, and cost-of-living increases for wages, pensions, and Social Security benefits. And, of course, our statistics have political consequences too. An administration is helped when it can mouth banalities about price levels being "anchored" as food and energy costs begin to soar.
The truth, though it would not exactly set Americans free, would at least open a window to wider economic and political understanding. Readers should ask themselves how much angrier the electorate might be if the media, over the past five years, had been citing 8 percent unemployment (instead of 5 percent), 5 percent inflation (instead of 2 percent), and average annual growth in the 1 percent range (instead of the 3–4 percent range). We might ponder as well who profits from a low-growth U.S. economy hidden under statistical camouflage. Might it be Washington politicos and affluent elites, anxious to mislead voters, coddle the financial markets, and tamp down expensive cost-of-living increases for wages and pensions?
Let me stipulate: the deception arose gradually, at no stage stemming from any concerted or cynical scheme. There was no grand conspiracy, just accumulating opportunisms. As we will see, the political blame for the slow, piecemeal distortion is bipartisan-both Democratic and Republican administrations had a hand in the abetting of political dishonesty, reckless debt, and a casino-like financial sector. To see how, we must revisit forty years of economic and statistical dissembling.
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ARROYO GRANDE, Calif. (MarketWatch) -- Remember that big ah-ha moment in the 1939 classic "The Wizard of Oz?" Dorothy wants to see the Wizard. His voice booms: "Do not arouse the wrath of the Great and Powerful Oz! Come back tomorrow!" Afraid, Lion, Tin Man, Scarecrow shake. Dorothy's dog runs up, tugs on a curtain. She chases Toto, pulls curtain open:"Who are you?" Dr. Marvel stutters: "Well, I - I - I am the Great and Powerful, Wizard of Oz." Dorothy: "You are? I don't believe you!" He replies: "No, it's true. There's no other Wizard except me." Dorothy's miffed: "Oh, you're a very bad man!" Wizard: "Oh, no, my dear. I'm a very good man. I'm just a very bad Wizard."
2009 Sequel: Script exposes diabolical cover-up conspiracy
Flash forward: Real life, Washington, new leaders, a new Congress, old wizardry. Be forewarned: No matter who's elected president, America will soon see a massive statistical curtain pulled back, exposing a con game of historic proportions. And when that happens, you and I will suffer another ear-splitting global meltdown, bigger than today's housing-credit crisis, dragging us deep into a recession and bear market for years.
Cast: New 'leading man' from old Nixon political machine
Yes, the lead character pulling back the curtain is none other than Kevin Phillips, a former Republican strategist for Nixon, and today America's leading political historian. Phillips just published "Bad Money: Reckless Finance, Failed Politics & the Crisis of American Capitalism," everything you need to know about today's credit meltdown.
Scene 1: Numbers racket hiding behind Washington curtain
Opening shot: Phillips pulling back the curtain, exposing charlatan Wizards in a brilliant Harper's Magazine article: "Numbers Racket: Why the economy is worse than we know." Far worse. Buy it, read it -- this is essential reading if you really want to understand the depth of today's political as well as economic impending meltdown, and the harsh realities facing Washington, Wall Street, Corporate America, and Main Street in 2009 and beyond ... harsh because we cannot cover up the truth much longer.
Scene 2: Statistics, Washington's new WMDs, a time bomb
"If Washington's harping on weapons of mass destruction was essential to buoy public support for the invasion of Iraq, the use of deceptive statistics has played its own vital role in convincing many Americans that the U.S. economy is stronger, fairer, more productive, more dominant, and richer with opportunity than it really is. The corruption has tainted the very measures that most shape public perception of the economy," especially three key numbers, CPI, GDP and monthly unemployment statistics.
Scene 3: Backflash, 'It's always the cover-up, stupid!'
As I read further I couldn't help but think about similar traps politicians get themselves (and us) into. Remember nice guys like Scooter Libby and Bill Clinton: The crime wasn't their original stupidity, but their lying during the cover-up. Here, Phillips reviews endless statistical cover-ups since the 1960s and concludes there was no "grand conspiracy, just accumulating opportunisms." I call it plain old greed. And every step of the way the media went along with the con game played by politicians and economists.
Scene 4: Real numbers torture us ... like water-boarding!
How bad is it? "The real numbers ... would be a face full of cold water," says Phillips. "Based on the criteria in place a quarter century ago, today's U.S. unemployment rate is somewhere between 9% and 12%; the inflation rate is as high as 7% or even 10%; economics growth since the recession of 2001 has been mediocre, despite the surge in wealth and incomes of the superrich, and we are falling back into recession."
Scene 5: Most economists hushed, work inside conspiracy
Compare that to the phony stats Washington feeds the press and public: Unemployment 5%, inflation 2% and long-term growth at 3%-4% (actually more like 1%). For example, just last week the L.A. Times reported that while "gasoline prices are up more than 20% from a year ago and food prices have risen 5%," Washington says "inflation was fairly mild last month." A Wells Fargo economist shook his head in disbelief: That report isn't "worth the paper it was printed on." Most economists are quiet, working for the conspiracy.
Scene 6: No integrity, they cannot be trusted to tell truth!
The same can be said of any government report, every speech made by today's leaders: All hype, lies and propaganda intended to deceive us. Treasury Secretary Henry Paulson's clearly playing the game: Remember what the former Goldman Sachs CEO told Fortune last July as our credit meltdown was metastasizing into a worldwide contagion: "This is far and away the strongest global economy I've seen in my business lifetime." He has no credibility. He knew the truth. He knew the government's "numbers racket;" after all, he helped create the problems years earlier at Goldman.
Scene 7: There's enough Kool-Aid for everyone to drink
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The mention of the Mortgage Lender Implode-O-Meter in the introduction of Kevin Phillips' new book Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism was a good sign of what might lie ahead. Then there was the early reference to the work of John Williams at the Shadow Stats website and liberal use of his findings later on.In the recent article at Harpers Barry Ritholtz was mentioned, his "inflation ex-inflation" meme picked up as a central element in Numbers Racket: Why the Economy is Worse Than We Know.
But it was something of a surprise to see the chart below show up on page 86 in this new book that is opening the eyes of many across the land (see How owners' equivalent rent duped the Fed at Seeking Alpha).
The chart looks much better in color, as shown below, which reminds me that I'm seriously delinquent in updating that series of charts that have the Case Shiller Home Price Index laid up against all kinds of other economic data with interesting results.Yesterday brought this story in MarketWatch where Paul Farrell credits Kevin Phillips with pulling back the veil of the economic data, noting that "most economists are quiet, working for the conspiracy".
An interesting conclusion indeed - I always thought "unwitting accomplice" was a better characterization than "co-conspirator". There are about 500 comments on this story at MarketWatch with some interesting perspectives.
All it took was $4.00 gasoline for people to finally notice.
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Calculated RiskFrom the WSJ: Fed Signals Rate Cuts Are Done, Lowers Growth Forecast for 2008
The Federal Reserve on Wednesday appeared to shut the door to the possibility of further interest rate cuts, saying in April meeting minutes that the last rate cut was a "close call," and that many officials think future reductions are unlikely even if the economy contracts.
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The Fed also released updated quarterly economic forecasts with the April minutes. The central tendency of officials' forecasts is for gross domestic product to rise between just 0.3% and 1.2% this year, down from the last forecast of growth between 1.3% to 2%. Officials also raised their forecasts for the unemployment rate and both headline and core inflation as measured by the price index for personal consumption expenditures.
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Though our government has increasingly influenced our markets since the creation of the Federal Reserve in 1913, we have recently reached the point where it would be a glaringly obvious misnomer to call the markets "free." And while some aspects of a free market remain, those who've studied the day-to-day operations of our nation's banking system and the stock markets' performances at certain times, would likely come to the conclusion that, on occasion, the state, through the Fed and certain banks, intervenes to engineer market bottoms.Am I talking about something that is done is secret to which only the most privileged are privy? While the history of global politics and global banking has always been based on secret meetings, those who've read about the government's extensive intervention, at critical points in our markets - usually occurring at the rule-making level - are well aware of the manipulation about which I write.
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We only need to look at recent history to see the merits of our previously stated hypothesis. If I am correct, then we must set aside the tired assumptions of the market's "random walk" or "the average investor's reaction" to the latest breaking news as the impetus for large market moves. Instead, we must consider Wall Street and the Fed's actions when prices start to decline. Do they focus on facilitating exchanges between buyers and sellers, or has their focus shifted to engineering US equity market bottoms when critical price levels are met? Far from an academic discussion, this issue strikes at the very heart of confidence in our markets, which was born out of the "freedom" that has been associated with capital markets for generations.
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LAS VEGAS -- Retail construction, which surged in recent years amid easy financing and robust consumer spending, has lost momentum as retailers curtail growth plans and lenders remain stingy.
Many of the largest U.S. developers of malls and shopping centers have reacted to retailers' waning demand for space by postponing by a year or more some of their projects. Other venues will be built piecemeal as leasing progress allows. Still others have been canceled before the start of construction.
The slowdown comes as consumers rattled by the credit crisis rein in spending, causing retailers to rethink their previously aggressive expansion plans. Among the national chains that recently pared their growth plans are J.C. Penney Co., Chico's FAS Inc., Starbucks Corp. and Home Depot Inc. At least partly because of the spending lull, nearly 6,500 U.S. stores are expected to close this year, the highest tally since 2001, according to the International Council of Shopping Centers.
Standing in the way of a recovery are deep-seated problems such as depleted home equity and high personal-debt levels. "We believe it is going to be harder for consumer confidence to come back quickly until some of these issues are resolved," J.C. Penney's chairman and chief executive officer, Myron Ullman, said Monday at the shopping-center council's annual trade show here.
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Mr. Practical was commenting on the variance between the crude goods PPI and the finished goods PPI. This is what Mr. P has to say:
I sent this chart of the Producer Price Index out to a few friends. I began getting calls from people I barely knew. Apparently, the chart really made the rounds and astounded people.The charts show there is virtually no ability to pass on rising input costs. This will translate into declining profits. Declining profits are never good for stock prices. There is simply no other rational way of looking at this.
click on chart for sharper image
I've talked about this before. I'm surprised people still don't get this. They look at the headline statistics the government puts out and don't bother to think about the real information embedded in the numbers.
The crush on profits is beginning to take full force as companies are having more and more difficulty passing higher input costs on to consumers, as they're getting squeezed too.
This is the most important statistical relationship to stock prices by far.
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Profesor Sedacca was also talking about dilution today in Debt, Dilution, Default and Denial.
As a result of their own greed, banks and brokers have been forced, on a global scale, to write down more than $315 billion since the crisis began last summer. Most of the write-downs have been confined to the sub-prime sector to date, but I'm highly uncomfortable that the crisis, in the end, will be confined to sub-prime.
In fact, we're already beginning to see strains on other parts of the credit markets. The problems stretch all the way from credit card receivables, Alt-A loans, prime loans, auto loans and motorcycle loans. The problem is not at all contained, as many analysts, economists, TV commentators and other "hopers" would like us to believe. Unfortunately, contagion is here, perhaps for a while. To make matters worse, when we add exploding commodity prices and a rising unemployment rate to the picture, the takeaway is far from optimistic.
As a result of all the write-downs that have occurred, many financial institutions have been forced to come to market with common equity, convertible preferred and straight preferred deals. Companies on this list include the likes of Merrill Lynch (MER), Fannie Mae, Freddie Mac, National City (NCC), Regions (RF), Fifth Third Bancorp (FITB), MBIA (MBI), AMBAC (ABK), J.P. Morgan (JPM), Lehman Brothers (LEH), Citigroup (C) and so on.
Some of the companies, like National City, have diluted existing shareholders by 50% just to stay in business. The same, sadly, can be said for MBIA and AMBAC, two municipal insurers that got burned when they entered the vague world of Credit Default Swaps and CDO's.
For what it is worth, I highly doubt that AMBAC and MBIA will survive this crisis as they now have nearly three times their shareholder equity in "deferred tax assets." Even Freddie Mac disclosed it now has deferred tax assets on its books, a potential sign of financial stress.
It is clear to me that what many of the aforementioned companies should be doing is not what they are actually doing. Take Merrill Lynch, for example. Merrill has said on several occasions that it doesn't need to raise capital, only to raise billions of capital a week later, paying as much as 8 5/8% for preferred stock.
If you owned your own company, business was slowing, your cost of capital was rising, profits disappeared, you were writing down the value of your net worth and assets, employees were leaving and you were levered up to your eyeballs, what would you do? A prudent investor would cut dividends to shareholders, reduce headcount, try to cut leverage and find a way to raise equity even if you dilute your own holdings just so you can fight to live another day.
Those companies that resist these measures will live to regret it, in my opinion, even to the extent that their stubbornness to please Wall Street and investors over the near term could result in insolvency.
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Ignoring bad debt and postponing inevitable losses was one of the main reasons behind Japan's decade-long economic slump that began in the 1990s, said Boston University law professor Charles Whitehead.
Faced with new capital requirements and a weakened ability to meet them, Japanese banks deferred the recognition of their losses, aided by regulators who refrained from implementing the rules, Whitehead wrote in a 2006 paper published in the Michigan Journal of International Law.
"U.S. regulators may be tempted to go soft on banks too," said Whitehead, who teaches securities regulation, in an interview. "The new capital rules already rely significantly on self-modeling by the banks. So if anything, the risks may be greater in the U.S. today than they were in Japan in the 1990s."
The new bank-capital regime, known as Basel II, has gone into effect in some European countries and is being implemented in the U.S. and others starting this year. It allows financial institutions to use in-house risk models instead of just relying on external credit-worthiness ratings in calculating their risk- weighted capital requirements.
The largest U.S. securities firms have been under capital requirements shaped by Basel II since 2004.
Shareholders at Stake
Even if regulators are soft on banks and brokers when it comes to capital requirements, investors won't be, according to Samuel Hayes, professor emeritus at Harvard Business School in Boston.
The collapse in March of New York-based Bear Stearns Cos., once the fifth-largest U.S. securities firm, shows that fulfilling regulatory capital requirements isn't sufficient to survive, Hayes said. The SEC has said Bear Stearns was "well-capitalized" until the moment it faced bankruptcy as clients and creditors lost confidence and withdrew their money.
"They have to keep raising capital levels, there's no getting around that fact," Hayes said. "Perception is so important here. If investors or creditors feel a bank doesn't have a strong capital cushion to face further writedowns, that could prove problematic."
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'It's Like Shampooing'
The sovereign funds, which bought shares at 20 percent above today's market prices, are probably not coming back soon, said Jeffrey Rosenberg, a New York-based managing director at Bank of America Corp., who was among the first analysts to warn clients about the mortgage crisis.
Banks can't keep selling hybrid bonds because ratings firms place limits on how much of their capital can be tied up in such securities. Rosenberg said the next round of equity-strengthening probably will be in the form of common stock.
"It's like shampooing: lather, rinse, repeat -- write down, raise capital, repeat," Rosenberg said. "How long can they keep doing it? Shareholders are in for a long ride."
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First a great quote via CNNMoney:"On the commercial side, best I can tell the problems are in all of it - offices, retail, hotels. I think we will see a prolonged decline."And from a Reuters article: Retail properties dressed for distress
Kermit Baker, chief economist for the American Institute of Architects, CNNMoney May 17, 2008The retail sector is expected to soften through 2009, according to a report by real estate brokerage Marcus & Millichap. The report, obtained by Reuters, forecasts the overall retail real estate vacancy rate will rise 1.4 percentage points this year to 11.1 percent, after a 0.9 percentage-point increase last year.
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``A recessionary environment will arise during this year, triggered by housing weakness,'' said Michelle Meyer, an economist at Lehman Brothers Holdings Inc. in New York. The drop in sales and rising glut of properties on the market are ``discouraging construction and depressing home prices.''
...As institutions are getting more conservative in making new loans, that ``has implications for the broader economy,'' Bernanke said at a conference in Chicago.
...Businesses are struggling to pass on higher raw material costs, including those for metals and imported goods. That's hurting profits."The rise in commodity prices is showing through in the PPI for earlier stages of production,'' Citibank economists said in a note to clients. ``While these increases may catch the market's attention, it is highly unlikely that inflation pressures build in an environment of slackening demand.''
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In either case, many strategists say that there are few attractive options for investors who may worry most about inflation, like retirees and others who rely on their portfolios to supplement their incomes.For example, prices for all kinds of commodities - from energy to basic materials to gold - have risen sharply in recent years. Investing in commodities has often been regarded as a good way to hedge a portfolio against inflation, but "just look at gold in the decades after the 1970s," Professor Bodie said. "Gold's performance for the subsequent 20 years was terrible."
On the other hand, Professor Bodie is still a big fan of Treasury inflation-protected securities, or TIPS, as well as municipal and corporate bonds that also adjust for inflation. These bonds are often regarded as an alternative way to protect a portfolio from inflation, because of regular adjustments in the bonds' principal based on changes in the Consumer Price Index.
In fact, he said he would not personally own any bonds now that did not adjust for inflation. "I don't have to guess with TIPS," he said. "I can lock that inflation-adjusted return in today."
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In either case, many strategists say that there are few attractive options for investors who may worry most about inflation, like retirees and others who rely on their portfolios to supplement their incomes.For example, prices for all kinds of commodities - from energy to basic materials to gold - have risen sharply in recent years. Investing in commodities has often been regarded as a good way to hedge a portfolio against inflation, but "just look at gold in the decades after the 1970s," Professor Bodie said. "Gold's performance for the subsequent 20 years was terrible."
On the other hand, Professor Bodie is still a big fan of Treasury inflation-protected securities, or TIPS, as well as municipal and corporate bonds that also adjust for inflation. These bonds are often regarded as an alternative way to protect a portfolio from inflation, because of regular adjustments in the bonds' principal based on changes in the Consumer Price Index.
In fact, he said he would not personally own any bonds now that did not adjust for inflation. "I don't have to guess with TIPS," he said. "I can lock that inflation-adjusted return in today."
But Mr. Schweitzer pointed out that inflation-protected bonds have already had a very good run. The Morningstar category for inflation-protected bond funds shows that they have returned 11.5 percent, on average, in the last 12 months. Although these bonds may be good for capital preservation, Mr. Schweitzer said that their current rich prices might mean that they will generate disappointing returns in the coming years - unless, of course, the economy is entering a long period of high inflation.
"The bottom line is there is no free lunch," he said. "If you try to protect yourself against inflation with either or both of these approaches, then you have to either give up return," by accepting the lower yields that are now available on TIPS, "or take on more risk" in the commodity markets.
Some strategists adhere to the common advice that equities offer the best chance to beat inflation over the long haul.
"If you are looking to outpace inflation, you should be investing in stocks," said Sam Stovall, the chief investment strategist at Standard & Poor's.
For the moment, Mr. Stovall recommends underweighting bonds while maintaining a neutral position on stocks. For example, if an investor keeps 60 percent of her total portfolio in stocks, he might advise that she keep 25 percent of the total in bonds and 15 percent in cash. His usual recommendation would have been to put 30 percent of the portfolio in bonds and just 10 percent in cash.
Moreover, Mr. Stovall said that once investors felt comfortable enough to put more money into the markets, they should buy stocks rather than bonds.
Jim Floyd, a senior analyst and mutual fund manager at the Leuthold Group, an investment research and mutual fund company in Minneapolis, recommends a more defensive stance.
"I think you should keep half of your portfolio in stocks and the other half in bonds, but I wouldn't put any of that in U.S. Treasuries," he said. Mr. Floyd said that Treasuries were now too pricey and that he saw better opportunities in the foreign sovereign debt markets.
Mr. Floyd, who edits Inflation Watch, a monthly newsletter for Leuthold, said he was most concerned about sky-high commodity prices.
"I think there is a real risk that they could burst just like the housing bubble," he said.
Instead of focusing too much on the price spikes at the gas pump and in the grocery store - and the huge profits that those increases have generated for commodity producers - Mr. Floyd recommended taking a fresh look at some stocks that have suffered recently. He said that there might be opportunities in consumer products, utilities and financials, including insurance companies, banks and real estate investment trusts. "You want to buy the companies that are beaten down before the good news comes out," he said.
But there are still plenty of commodity bulls around.
Ed Yardeni, the president of Yardeni Research, based in Great Neck, N.Y., said he thought that commodity prices could have further to run. He cited rising demand in developing nations like China and India, combined with dwindling discoveries of raw materials that are relatively easy to extract.
"Let's face it, as much as we try to scratch the planet Earth, we don't find any cheap stuff around anymore," Mr. Yardeni said.
But he warned individual investors against buying commodities, for example, through one of the scores of commodity exchange-traded funds that have sprouted in recent years. Commodity prices are so volatile, he said, that individual investors who bought them would probably not sleep too well at night.
Instead, he advised investors to take a page from the San Francisco gold rush.
If you are an investor who thinks that the commodity boom is far from over, he said, "don't get yourself dirty digging for gold; open up a shop that sells picks and shovels."
He said that such "pick-and-shovel" stocks include shares of oil-field services companies, specialty chemical manufacturers, fertilizer makers and other companies that provide the materials or services on which the mining and agricultural industries rely.
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Calculated RiskPerhaps something more fundamental is happening. What if certain HELOC borrowers were using the HELOCs as ATMs, paying their HELOC (and first lien) monthly payments using borrowed money? Yes, a different bred of NegAm loans! Then, when the lenders started to rescind or reduce these HELOCs earlier this year, many of these Home ATM junkies were stuck without a fix.
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Sudden DebtWhat do oil sands, drilling in very deep oceans, corn ethanol and resource wars (Iraq, Afghanistan..) have in common? They are very low EROEI energy sources compared to the rapidly declining high EROEI sources (e.g. Texas and Mexico). The fact that we have to increasingly depend on them to meet demand is the surest proof that "cheap" oil is rapidly becoming a thing of the past. And this, ladies and gentlemen, is as good a definition of Peak Oil as any.
In closing, you may wish to read this article from UK's The Daily Telegraph: Oil Is Expensive Because Oil Is Scarce.
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May 14, 2008 | Sudden Debt
A friend of mine with many decades in the finance business has a saying: "If this goes on much longer they will end up with all the money in the world". He uses it to point out various cases of extreme pricing and market power, which sometimes (but not always) evolves to become a bubble. Prima facie evidence suggests that in today's environment his saying readily applies to crude oil.
Look at the chart below: at $120 per barrel, revenue from exporting crude oil and its products comes to over $1.85 trillion per year. The Middle East alone gets nearly a trillion and the former Soviet Union $300 billion - and that's before including natural gas.
Export-Import Data: BP (2006)
At current oil prices, this is by far the largest capital recycling and concentration pump in the entire history of the world. A dollar may not buy as much as it used to, but a trillion every year still buys plenty, even after liberal handouts pour epater les bourgeois. Very plenty, in fact: US and European banks, other resource companies like ore and coal miners, shipping and port operators, electricity, water and telecom providers and a host of other essential businesses. That's where all the SWF and private oil money is going, most commonly channelled through secretive private equity funds.Obviously, the oil exporters are furiously planning for their post-Peak Oil future: sensibly, they don't want to ride camels again. And if this goes on much longer, by the time their oil wells start to decline they will own everything that matters and will be sitting - literally - atop all the money in the world.
What are the rest of us - Americans and Europeans alike - doing to plan our post-peak future? Next to nothing, is the painful answer. If a few EU nations like Germany, Denmark and Spain are attempting to face the alternative energy challenge, the US as the largest oil consumer is making a momentous mistake by its absence. Stubborn reliance on imported oil is rapidly impoverishing the nation. That sucking sound we all hear in our pockets is money vacuumed out by the oil exporters, only to come back as foreign equity ownership of everything.
The American administration is repeating the glaring mistake of the French and German armies' Russian invasion, albeit in a different context. Like arrogant generals whose prior easy victories made them blind to current harsh realities, Bush & Co. are throwing away America's post-Cold War advantage into the maws of the giant oil recirculation pump. Like Napoleon and Hitler before him, George W. Bush has failed to provide the nation with the protection of a sensible energy plan.
To make matters worse, the current monetary policy is designed solely as a bail out of a bankrupt shadow financial system. By preventing the liquidation of excessive debt that could result in a more efficient and sustainable economy, it keeps the dollar/oil recirculating pump going at full speed.
America is in the unfortunate position of being at the hands of a dogmatic incompetent and a near-sighted academic. For different reasons, both blithely believe they are right beyond doubt. One because he converses with God and the other because he trusts his econometric models with religious fervor.
But if they are wrong the price of failure is the end of Empire. That's too much to bet, by a long shot.
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Gasoline sales were up 16.3%. And food sales were up 6.1%. 77% of the increase in retail sales this year has been from increases in food and gas sales. If you take out food and gas, retail sales are down by about 2% in the last three months.
Leslie Dach, executive vice president of corporate affairs and government relations at Wal-Mart, said the cycle of shoppers running out of money in between paychecks and then flocking to its stores on payday is 'more pronounced, more visible.'
... ... ... Looking at the latest Commerce Department data, we find that US import prices are up 15% year over year. Even taking out gasoline, prices are up 6.2%. And it is somewhat surprising that it is only 6.2%. Why?Because the dollar has fallen by more than 6%. The Chinese ambassador to the US, Mr. Zhou Wenzhong, recently pointed out that the Chinese renminbi has appreciated almost 19% since July of 2005. I have been writing for years that the Chinese would allow their currency to appreciate slowly and steadily for their own purposes and on their own schedule. They need to do so in order to contain their own rising inflation. Look for it to rise another 10% by the middle of next year.
... ... ...
Accounting for Inflation
If beauty is in the eye of the beholder, inflation is in the eye of the statistician. Because the number you end up with is dependent on the models and assumptions you choose. As the chart below shows, there have been two major revisions to how inflation is figured, one in 1983 and another in 1998. (Thanks to Barry Ritholtz at The Big Picture for this source.)
Note that using the same methodology as was used in 1983, inflation would be around 11.6% today. Before 1983, the BLS used actual home prices to account for inflation. After that time, they used something called Owners Equivalent Rent or OER. This is the theoretical price a home would rent for. There are sound reasons to use OER and equally good reasons to use actual home prices (as is done in Europe). But both methods have flaws.
... ... ...
Also, notice in the chart that in 1998 the Clinton administration adopted new methodologies, among them hedonic pricing. Hedonic pricing suggests that as a product or service improves, the price for the equivalent item in today's market will fall. As an example, if we buy a computer that is twice as powerful as it was a few years ago, the statisticians assume that prices have fallen even if we pay the same for the computer.In the same way, if in one year you had to pay extra for features like power steering or power windows in a car, and a few years later they were considered standard, then once again the price would be deemed to have gone down, as you were getting more "value" for your dollar. This is considered to be the case even if in actual dollars you paid more for the car.
Again, you can make a rational and serious economic argument for hedonic pricing. And believe me, many economists do. But those changes, along with others, have lowered the official rate of inflation. And since many government benefits are also tied to the official rate of inflation, the current methodology has lowered government expenses as well, including inflation adjustments for Social Security and pensions.
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...the Alberta Tar Sands are producing a couple million barrels per day of oil (with prodigious inputs of water and natural gas)... they MIGHT be able to ramp that up to 3 or 4 mbbl/day eventually (but the infrastructure up there is strained to bursting as it is).
But global consumption is 85mbbl/day... the Canadian Tar Sands can't save us (unfortunately). It's like having a billion dollar bank account, but a $100 daily withdrawal limit.
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CalculatedRisk From Paul Kasriel and Asha Bangalore at Northern Trust: In the Eye of the Economic HurricaneThere seems to be sentiment developing that the U.S. has weathered the worst of the current cyclical economic storm and blue skies are ahead. We disagree. Any blue skies you see are likely to be short lived. The economy is in the relative calm of the eye of the business-cycle hurricane. The mortgage credit problems are not over. And credit problems in other sectors are just beginning as the housing recession spreads to the rest of the economy.The "eye of the hurricane" meme is definitely gaining traction!
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May 16, 2008 | Nakedcapitalism.com
The ECB has uncovered gambling in Casablanca. The central bank is shocked to learn that banks appear to be originating crappy assets solely for the purpose of dumping them in a liquidity facility intended to help them through a rough patch, not to provide an ongoing subsidy.
Regulators should know better. Indulgent parents generally wind up with spoiled kids who posses a sense of entitlement and react particularly badly when restrictions are imposed. In this case, the ECB took it as a point of pride that it accepted a broader range of collateral than other central banks, but its liberalmindedness appears to be working against it. Financial firms are first and foremost loyal to their own wallets. Any program that can be used to generate profit or other competitive advantage can and will be exploited.
Comments
- tom a taxpayer said...
- That's those naughty foreign bankers. At least we can sleep at night knowing that our Wall Street bankers would never think of pawning fake Rolexs and Gucci bags as collateral to the Fed.
- ""That means there must be an exit strategy."
The exit strategy of the banks is clear: stuff the ECB with the losses.
- The central banks have taken the insolvent banks as partners. The insolvent banks have taken the central banks as suckers. Right now, the insolvent banks are in the money.
The one thing no one wants to take is responsibility for the true scale of the losses in the financialy system which all this massive shifting of assets at the top of the financial system is designed to conceal but cannot mitigate. It's musical chairs played minus the chairs to the tune of 'Col. Bogey,' and when as as the marchers fall out from dehydration they will be shot by vulture capitalists. . . . I've got a great sunrise on my lefthand, and a bowl of popcorn on my right hand, and good view from where I'm sitting: Let's get on with the show.
- Peripheral Visionary said...
- There is an exit strategy: it's not called a "swap" for nothing. All of these alphabet-soup facilities have a built-in expiration, all the central banks need to do is not renew them. It won't be popular, but it certainly will be possible.
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May 15, 2008 | nakedcapitalism.com
Let me give you a mundane example. A recent Countrywide employee wrote me to describe many of the bank's bad practices. One was that the bank had launched a national campaign for a no-fee mortgage. He said he was certain not a single mortgage of the type promoted had ever been issued because the customer service people had all been given scripts to steer callers into other products (the no-fee loan had sufficiently high interest costs to make loans with fees look more attractive). I called a litigator I know. She said the fact set would constitute advertising fraud and would indeed make for a good suit. However, most firms would wait for initial suits over more basic forms of fraud to proceed, since it would be easier to build the case for advertising fraud based on their causes of action and evidence.
That's a long winded way of saying that if Countrywide is indeed the serial miscreant many believe it to be, the lawsuits will build on themselves.
Peripheral Visionary said... "Rejecting the arguments of Countrywide executives and directors that they were unaware of lax loan operations that led to ballooning defaults . . . " Pleading incompetence seems to be the securities law equivalent of pleading insanity under criminal law. But wasn't the executive accountability portion of Sarbanes-Oxley supposed to close this particular loophole?
"The plaintiffs contend that the directors and officers dumped shares even as the company spent $2.4 billion to repurchase its own stock in late 2006 and early 2007."
If corporate executives dumping shares while the company repurchases shares is grounds for litigation, there wouldn't be enough courtrooms in the country for all the lawsuits.
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May 15 | Bloomberg
Blackstone Group LP President Tony James said banks are mistaken if they think credit markets have begun a sustained recovery.
"It's not clear to me if it's a permanent upswing as I think many of the banks are saying or the eye of the hurricane,'' James told reporters on a conference call today.
High-yield, high-risk loan prices have climbed from a low of 86.3 cents on the dollar in February to 92.42 cents after banks whittled down a backlog of buyout debt to less than $100 billion from more than $300 billion last year, James said. Banks still must find a way to sell loans and bonds backing the takeovers of telephone company BCE Inc. and Clear Channel Communications Inc.
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The U.S. strategic Petroleum reserve currently stockpiles 698 million barrels of oil. Bush announced last year that he intends to double this amount by 2027 to 1.5 billion. Has this become a revenue stream for the federal government? In a single day, a jump of $3 represents a $4.5 billion dollar return on investment. Oil is removed from the reserve at a much slower rate. There are hedge markets for oil, there are consumer incentive pricing to lock in an oil price at today's rate, airlines and other transportation companies are savy about these things (or they fail). Chrysler hopes to sell cars by offering a fuel-price guarantee (on the first 12,000 miles of a new car) … which Cerberus Capital Management (the new owner of Chrysler) will pay for by hedging the price. These are new players in the market … new revenue streams for private enterprise and government entities alike.
- Posted by E.L.
"…a realistic view of what's happened over the past few years suggests that we're heading into an era of increasingly scarce, costly oil."
All you need to do is a little research and crunch the numbers. For example, based on published/proven reserves, at the current rate of usage, the world has a total reserve life of 44 years (this includes everything, including Canada's oil shale deposits). Yes, that's right, 44 years. And this doesn't take into cosideration increasing demand, which is surely happening.
To illustrate further just how fast the world is consuming oil (80 million barrels every day), calculate how long it will take to burn through the 16 billion barrels optimists claim to exist in the Arctic National Wildlife Refuge: 6 months. The US, a little longer: approx. two years.
I'm an optimist too, but a realist. Oil will soon be gold in a world unprepared to deal with a deepening energy crisis.
- Posted by TomV
1. I agree that the Strategic Oil Reserve could have used a mention.
2. As to supply and demand, has supply gone up in the last 5 years (domestic refined)? No. Has demand abated (domestic)? No. Therefore there was plenty of supply 5 years ago as the price was going up. What has changed to make now any diferent from then?
3. Mass Transportation. Not that I need a reason to be Anti-Obama. But, if you look at his "energy plan" (cough cough) Mass transport is not a priority. "Democrats and Busing" jokes aside, this seems to be a faithful Left of Center soldier that is MIA.
4. Oil is Gold like in it's inverse relationship to the Dollar. Dollar, Gold and Oil are essentially currencies unto themselves.
5. I've known Paris, Paris was a friend of mine, NYC is no Paris! It makes no sense to compare European cities to the US population model because of the vast suburban landscape of the US.
- Posted by Dredpiraterobts
See this weekend's USA Today where there was a series of articles about how families are coping with higher fuel prices by going car-less on the weekends and eliminating and consolidating trips requiring use of the family's cars.
- Posted by Spiv
- Posted by Sherry Donaldson
- Posted by Gene Weinshenker
1. The price of oil increased
rapidly after the Iraq invasion in 2003.
It seems that security costs for the Middle
East have increased enormously.
2. Contrary to what most people believe,
the US gets around 70% of its gasoline from
a combination of Mexico, Venezuela, Canada
and Nigeria. So, while we get 30% from other
nations, our real problem is with these
other nations. Mexico has extreme problems
with drug lords (some have referred to this
problem as an outright war) and crazy weather
problems, Venezuela has their current "dictator"
who has just recently nationalized most
of the foreign companies that are extracting
its oil (Exxon, Chevron, etc.) and Nigeria
has a huge problem with an uprising in the
Delta region that is hampering the cost
of oil.
3. Add to the fray that the Dollar is worthless.
The idea is that most nations don't use
Dollars as their national currency, so the
oil companies extract oil in the local national
currency, sell the oil in Dollars (requiring
conversion), most of the nations around
the world have their own currencies, thereby
selling those $s off again and the cycle
continues. So yes, the Dollar value has
a HUGE part to play on this issue.
4. Gold is considered more of a luxury good.
Gasoline is considered a necessity and most
of the world has already proven that they
are willing to pay almost anything to drive
their gas driven vehicles, not to mention,
the US has proven that they will drive,
regardless.
5. So, one question might pop-up, why don't
for example Europeans pay less for oil since
its purchased in Dollars? The reason is
because most governments are using the rising
oil cost to increase their tax revenues
to pay for whatever they need. For example,
the Netherlands made an extra 3 billion
Euros on top of their expected income in
2006. They spent that money by cutting back
on taxes in other areas.
- Posted by Chris
If inventories are the only thing which are used for crude oil price determination in this discussion and using U.S. inventories rather than world inventories as the primary metric, U.S. crude oil inventories peaked in absolute terms in the summer of 2007 at 354 million barrels. In days of supply this was 23.1 days. Using the front month NYMEX crude oil contract, crude oil prices averaged $74.15 per barrel in July 2007.
By the end of 2007 U.S. crude oil inventories declined by 72 million barrels to 282 million barrels by January 4, 2008; based on EIA's formula, crude oil inventories in days of supply was unchanged at 18.4 days on January 4, 2008. Crude oil prices averaged $91.74 in December 2007. So far, it seems reasonable that prices would rise.
U.S. crude oil inventories have rebounded since the beginning of the year to 313 million barrels on April 30, 2008 and 22 days of supply. Nevertheless, crude oil prices (based on the NYMEX front month contract) averaged $107.18 per barrel in April.
U.S. gasoline inventories have exhibited similar behavior as U.S. gasoline consumption has declined sharply since the end of 2006 (see U.S. highway administration data for that).
While more analysis is required, it appears that inventory changes have little to do with the recent rise in crude oil prices.
Perhaps it is important to look at the large flows of dollars into commodity investment vehicles tied to commodity indices; these indices are weighted between 70% and 80% to energy.
- Posted by Max Pyziur
Gold prices are tracking fairly close to oil prices, no?
OPEC is getting paid AS IF they were being paid in gold. Go figure!
- Posted by Barnegat Leight
- Posted by Dave
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Bernanke concludes that it's the responsibility of the central bank to stop such self-fulfilling instability. But he neglects to discuss the key feature of a healthy financial system that is supposed to prevent such a problem from ever arising. Specifically, any institution that is in this position of borrowing short and lending long needs to ensure that a certain fraction of the funds it is lending came not from borrowers but instead from the owners of the institution itself, in the form of net equity. The goal is for the size of this net equity to be larger than the losses the institution would incur from selling its less-liquid assets at steep discounts. As long as it is, no creditors ever have reason to demand cash, and there would be no need for the central bank to step in to prevent a self-fulfilling breakdown.
And the core reason we are in the mess we are today is that these equity stakes were nowhere near sufficient for this purpose. Instead, financial institutions were allowed to take highly leveraged positions whose details are largely opaque to readers of publicly available financial statements. Exhibit A here might be Bear Stearns, whose 2007 10-K reported that Bear had outstanding derivative contracts whose notional value was $13.4 trillion. Much of these were credit-default swaps, in which the seller receives a fee in exchange for promising to pay any losses incurred by the buyer on some specified asset and time interval. If every such asset lost 100% of its value over the period, then maybe Bear is supposed to pay or receive $13.4 trillion. In practice, the actual price moves and net sum owed would be a small fraction of that notional total.
Now, there is nothing inherently wrong in making financial investments in the form of derivative contracts rather than outright loans. You're doing something similar whenever you buy or sell an option rather than the stock itself. But, if you were to sell an option through an organized exchange, the exchange would require you to satisfy a margin requirement, delivering for safekeeping good funds such that if the price of the underlying asset against which the derivative is written moves against you, you are able to make good on your commitment.
If anything like a reasonable margin requirement had been in effect, Bear Stearns could not possibly have gotten into contracts totaling $13.4 trillion notional. But these weren't traded on a regular exchange, so there was no margin requirement, and apparently no real limit on the size of the exposures that Bear Stearns could take on, or the size of what they could bring down with them if they fell.
And that raises the question, Why were counterparties willing to accept these trades with no margin to guarantee payment? To this I'm afraid the answer is, they figured Bear was too big for the Fed to allow it to fail. And on this, I'm afraid they proved to be exactly correct.
I would feel better if Bernanke were less focused on how to "provide liquidity" and more focused on how to get the system deleveraged and more transparent.
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TelegraphLike others, I have been waiting and watching since the Fed went nuclear with emergency rate cuts in January, and even more nuclear in March by invoking Article 13 (3) for the first time since the 1930s to save Bear Stearns - and by extension to save the derivatives system.
I briefly shared a degree of "market infantilism" about a recovery. After all, the Fed has never acted quite so dramatically before. But it has since become evident, at least to me, even if it was already evident to Nouriel Roubini, Michael Panzer, and other Stern bears, that rates of 2 per cent cannot stop an ugly debt purge, and nor should they do so.
This is not to dismiss the latest Fed actions as a "failure". The Bernanke rescue has averted a downward spiral that risked ending in depression. There will be no depression now, but nor will there be an easy recovery.
By using the term Global Slump, I do not mean a global depression along the lines of the 1930s. I mean a global downturn that persists long enough to do serious damage and change the lives of a lot of people.
The IMF defines a `global recession' as fall in world growth below 3 per cent - a very rare event. It says there is a 25 per cent chance of this happening. Will the sky fall if that happens? That depends on who you are, and where you live. It did not fall for most people even in the 1930s.
One can glimpse a flicker of light already at the end of the American tunnel. The economic woes are still spreading as the delayed effects of the credit crunch hit home, but the shape of the downturn is becoming clearer - it looks like a W, with deeper dip on the second V. America's bad news is mostly in the market.
What is not fully priced into the market is the second half of the story: that Europe, Japan, and arguably China are also coming unglued. This is not US contagion as such - though for Japan it surely is - but rather because these regions face their own internal boom-bust cycles.
Europe's Latin bloc, the Baltics, Ukraine and Kazakhstan, all risk a crunch after letting rip with credit - indeed, Italy is now brushing recession and Spain is crumbling by the day.
Britain has become a disaster area, of course. Today's RICS (Chartered Surveyors) report on housing was the worst since records began in 1978.
Commercial property has fallen by almost a third in the London region. The budget deficit reached 3 per cent at the top of cycle, leaving no fiscal ammo to fight the downturn. Household debt is 103 per cent of GDP. I weep for Britain as much as I weep for America.....
In answer to the commodity bulls, yes, the super-cycle is here to stay. Peak oil, peak metals, and peak food all loom, to some degree. But that does not preclude vigorous mini-cycles along the way.
The International Energy Agency has downgraded its oil forecast yet again, predicting that consumption will grow just 1m barrels a day this year, down from its 2.2m bpd call last July. Inventories are building up across the world, including China, nota bene. China's copper stocks are rising too.
I dismiss the Goldman Sachs suggestion of $200 oil this year as one of those silly utterances that occur at the top of a spike.
Yes, I know that the Goldman seer Arjun Murti struck lucky with an equally outrageous prediction before, but that is just a curiosity. His arguments this time were very thin gruel, at least in the report I received. It seemed to rely - implicitly - on speculative momentum.
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For an example of this sort of thinking, let's turn to a recent interview with Silicon Valley venture capitalist Vinod Khosla, who is justifiably renowned for his foresight and investing acumen. In this interview, he predicts $1/gallon biofuels will make oil and gasoline uncompetitive; who bother with oil when biofuel is so much cheaper?
ON THE RECORD: VINOD KHOSLA (S.F. Chronicle)
I have no question that in 10 years, there's no way oil will be able to compete with biofuels. Even in five years. Now it will take a long time to scale biofuels, but I'm the only one in the world forecasting oil dropping in price to $35 a barrel by 2030. I'll put it on the record: Oil will not be able to compete with cellulosic biofuels.According to Department of Energy Quick Oil Facts, the US consumes about 390 million gallons of gasoline per day. At 28 gallons of gasoline/barrel of crude that amounts to 13 million barrels of crude oil equivalent-- about 65% of the crude oil consumed by the USA (21 million barrels a day).So even if wind, solar, geothermal, nuclear, tidal, etc. was generating all the nation's electrical power, our current lifestyle would require about 450 million gallons of gasoline or equivalent per day.
(Recall that biofuels only provide at best 85% of the energy density of gasoline, hence you need 115 gallons of biofuel to generate the same energy in 100 gallons of gasoline/petrol.)
Is it plausible that giant algae farms, switch grass, wood chips, lawn clippings, etc. can possibly generate 450 million gallons of liquid fuel a day?
And what if these enormous new industries actually require more energy than the current petroleum complex to operate? Then perhaps we'll need 500 million gallons of gasoline equivalent liquid fuels because the harvesting, cooking, distilling, refining and transporting of biofuels requires more energy than pumping, cracking and transporting petroleum products.
Away from the glow of wishful thinking, it seems there are a couple of serious problems with biofuels:
1. it requires turning over the entire U.S. arable cropland from growing food to switchgrass or what-have-you for ethanol
2. the process requires so much energy it is net-negative, i.e. requires more energy than it produces.Let's start with an article from Scientific American: Biofuels Are Bad for Feeding People and Combating Climate Change By displacing agriculture for food-and causing more land clearing-biofuels are bad for hungry people and the environment
The studies do find some benefit from biofuels but only when planted on agricultural land too dry or degraded for food production or significant tree or plant growth and only when derived from native plants, such as a mix of prairie grasses in the U.S. Midwest. Or such fuels can be made from waste: corn stalks, leftover wood from timber production or even city garbage.Here is the academic paper which blew the doors right off the fantasy that biofuels could replace fossil fuels in some sort of seamless transition that left all 220 million vehicles in the U.S. purring along on billions of gallons of biofuels.But that will not slake a significant portion of the growing thirst for transportation fuels. "If we convert every corn kernel grown today in the U.S. to ethanol we offset just 12 percent of our gasoline use," notes ecologist Jason Hill of the University of Minnesota. "The real benefit to these advanced biofuels may not be in displacement of fossil fuels but in the building up of carbon stores in the soil."
I strongly recommend reading the entire 12 page paper, which is written in clear English and is supported by tables and well-sourced data. Ethanol Production Using Corn, Switchgrass, and Wood; Biodiesel Production Using Soybean and Sunflower.
Here is the summary:
Energy outputs from ethanol produced using corn, switchgrass, and wood biomass were each less than the respective fossil energy inputs. The same was true for producing biodiesel using soybeans and sunflower, however, the energy cost for producing soybean biodiesel was only slightly negative compared with ethanol production.Consider the consequences of these points from the report:Findings in terms of energy outputs compared with the energy inputs were:
• Ethanol production using corn grain required 29% more fossil energy than the ethanol fuel produced.
• Ethanol production using switchgrass required 50% more fossil energy than the ethanol fuel produced.
• Ethanol production using wood biomass required 57% more fossil energy than the ethanol fuel produced.
• Biodiesel production using soybean required 27% more fossil energy than the biodiesel fuel produced (Note, the energy yield from soy oil per hectare is far lower than the ethanol yield from corn).
• Biodiesel production using sunflower required 118% more fossil energy than the biodiesel fuel produced.About 50% of the cost of producing ethanol (42c/ per l) in a large-production plant is for the corn feedstock itself (28c//l) (Table 2). The next largest input is for steam (Table 2).Now perhaps it could be argued that if the U.S. scaled up alternative sources for electricity to some nearly unimaginable height, then the excess power could be converted to steam to cook and process 500 million gallons of liquid fuel a day.Clearly, without the more than $3 billion of federal and state government subsidies each year, U.S. ethanol production would be reduced or cease, confirming the basic fact that ethanol production is uneconomical (National Center for Policy Analysis, 2002).
If the production costs of producing a liter of ethanol were added to the tax subsidies, then the total cost for a liter of ethanol would be $1.24. Because of the relatively low energy content of ethanol, 1.6 l of ethanol have the energy equivalent of 1 l of gasoline. Thus, the cost of producing an equivalent amount of ethanol to equal a liter of gasoline is $1.88 ($7.12 per gallon of gasoline), while the current cost of producing a liter of gasoline is 33c/ (USBC, 2003).
Therefore, even using Shapouri's optimistic data, to feed one automobile with ethanol, substituting only one third of the gasoline used per year, Americans would require more cropland than they need to feed themselves!
The cost per ton of switchgrass pellets ranges from $94 to $130 (Samson, Duxbury, and Mulkins, 2004). This seems to be an excellent price per ton.
However, converting switchgrass into ethanol results in a negative energy return (Table 4). The negative energy return is 50% or slightly higher than the negative energy return for corn ethanol production (Tables 2 and 4).
The cost of producing a liter of ethanol using switchgrass was 54c/ or 9c/ higher than the 45c/ per l for corn ethanol production (Tables 2 and 4). The two major energy inputs for switchgrass conversion into ethanol were steam and electricity production (Table 4).
But exactly what are the cost and resource inputs for this stupendous amount of energy? Thermonuclear power? Nice, but that is science fiction at the moment, not science.
Given the evidence before us, it seems completely improbable that the U.S. can produce billions of gallons of biofuels without burning stupendous quantities of imported petroleum to do so.
The cycles and the end-games are intersecting, and technological fantasies are not actually addressing the problems at hand. Energy densities will have to drop significantly, and net energy production must rise significantly (energy produced minus fossil fuels required to harvest, mine, process and transport the alternative fuel). There is precious little evidence that biofuels can be produced in such massive quantities without using equivalently massive quantities of fossil fuels.
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Megan McArdle, Physiocrat, writes:Megan McArdle: I think I'm crazy too: Economics of Contempt:
Call me crazy, but I think a permanent doubling of food and energy prices would slow our rate of economic growth pretty significantly. How long it would take incomes to recover "at current rates of economic growth" is irrelevant when the doubling of food and energy prices would lower the rate of economic growth.
Given that we and all our machines run on either food or energy, it's a pretty safe bet to say that doubling their prices would have a sizeable impact on growth...
This casts me in mind back to Paris in the late eighteenth century, and to the salon of Anne-Robert-Jacques Turgot; François Quesnay; Pierre Le Pesant, Sieur de Boisguilbert; and Pierre Samuel du Pont de Nemours. They argued:
- Artisans use the food and other products of the agricultural sector to maintain themselves (at a subsistence standard of living) and to make crafts, which they then sell in order to buy the agricultural products they need to survive (at their subsistence standard of living) and to prepare for the next round of production.
- Farmers grow agricultural which they then consume (including in consumption the transformed agricultural goods that are the products of the artisans), pay to the landlords in rent and taxes, and save as raw materials for the next round of production.
- Land-owning aristocrats produce nothing, but they and the government take their rents and their taxes and spend them: on luxury, on war, on bureaucracy, and on works of charity and civil improvement.
It is then plain that the right way to value the economic output of society is via the net product: the difference between the value of farm production and the subsistence requirements of farmers. That net product can be used in many ways:
- to boost the standards of living of peasants and artisans above subsistence, either through lower rents and taxes than the maximum sustainable or through works of charity.
- for war.
- for the luxurious consumption of the landed aristocracy, the bureaucracy, and the court.
- for investment in works of civic improvement
To the Physiocrats, it was clear that the net product could be increased by either (a) boosting the number of farmers (holding the surplus of farm production per worker minus subsistence per worker constant), or (b) boosting the surplus above subsistence per farmer (holding the number of farmworkers constant). The government's role in economic policy should therefore be:
- to discourage people from moving to the country to the city--in the country they add to the net product, but in the city they don't, becoming either workers in the sterile artisanal craft-making sector or flunkies serving as part of elite luxury consumption.
- to encourage farmers and farmworkers to learn the newest and best agricultural techniques--especially those involving the seed drill and the turnip--to increase net product per farmworker.
- to pay no attention whatsoever to the sterile craft-making artisanal sector--it is not "productive."
- to streamline and simplify the tax system by taxing land rent only--taxes levied on anybody else simply lead to increased bureaucratic inefficiency and waste, since ultimately the only place from which the surplus to pay taxes can come from is the net product, and the entire net product comes out of the agricultural sector.
Now what do we think of this analysis? Let's give du Pont de Nemours, Boisguilbert, Quesney, and Turgot a bye on their assumption that the bureaucracy, landed aristocracy, and court of eighteenth-century France were parasitic--that seems a reasonable model-building assumption. But let's note two implicit assumptions in the Tableau Economique that are not correct and not unimportant. They are:
- that the artisanal craft-making sector is sterile, in that the utility value of what farmers (and landlords, court, and bureaucracy) buy from it is equal to the utility value of the agricultural goods the farmers sell to it.
- that the artisanal craft-making sector consumes at a subsistence level.
Make these two assumptions, and the Physiocrats' argument goes through. But it is not the case that what the farmers and the landlords buy from the artisan sector is no more valuable in utility terms than what they sell. It is true that the wagons, clothes, Louis XVI furniture, and marzipan purchased from are together worth the same on the market as the large piles of wheat and wood sold to the craftsmen. But the landlords, bureaucracy, court, and farmers value the first bundle in utility terms more than they value the second--that's why they buy the first and sell the second. And it is definitely not true that the non-agricultural workers of France in the eighteenth century lived at a "subsistence" level. So the Physiocratic model does not go through--as Adam Smith argues at interminable length in Book IV of the Wealth of Nations.
Similarly, Megan McArdle's and the Contemptuous (Contemptible?) Economist's argument that there is something especially key to growth in the food and energy sectors would go through if the rest of the economy were either (a) parasitic (in the sense of the eighteenth-century French bureaucracy, landed aristocracy, and court) or (b) sterile (in the sense the Physiocrats mistook the French craft-making artisanal manufacturing sector to be).
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Meredith Whitney joins Bloomberg to discuss her outlook for Citigroup and the financial industry as a whole. There too much to summarize in this clip but suffice it to say Whitney appears extremely pessimistic about Citigroup's earnings for 2008 and further believes that the industry is significantly underestimating the "horrendous" credit losses related to the collapse of the mortgage and other consumer related credit markets.
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Eli Broad, co-founder of KB Home, joins Bloomberg to discuss, amongst other things, the state of the economy and outlook for housing. Broad states that "I don't think we are anywhere near a bottom in housing" adding further that he sees 15%-20% price drops from current price levels. Further Broad sees the process of clearing out the inventory of unsold and unoccupied homes another taking 3 – 4 more years.
Originally aired on: 4/28/2008 on Bloomberg
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Inflation is a topic that does not receive enough attention. I'll try to address that deficiency in this week's column.
Regular readers know my motto (which is on the masthead of my Web site): "In a social democracy with a fiat currency, all roads lead to inflation." Over the past couple of decades, through all the occasional chatter about deflation, I have resolutely maintained that deflation would not be the outcome we would see because the Fed would do what the Fed has done.
One major force helped hold inflation at bay during the 1990s: globalization. As Jim Grant points out in a brilliant essay titled "The Close of the Era of Peace and Quiet" in the current Grant's Interest Rate Observer (subscription required): "Between the early 1980s and the late 1990s, an estimated 2 billion new pairs of hands had joined the global labor force. Employers never had it so good, especially so in countries like the United States, where relocation to low-cost meccas of the East was no idle threat, but an actionable business plan."
Cheap labor, when combined with the technological advances of the late 1990s -- which were powerful, though no more potent than those we'd seen in the 1920s and 1960s, for instance -- helped offset the Federal Reserve's money printing.
However, in the wake of the stock bubble, that money printing set off the U.S. housing boom and began to cause different consequences.
In addition, because so many countries see their currencies as linked to ours, the Fed's money printing has led to global money printing, which continues to this day. And, in the wake of the mortgage debacle, we have once again chosen to flood the system with easy credit. That has forced parts of the world in the late stages of an economic boom, with already-high inflation rates (such as the Middle East and some Asian countries), to follow our ill-advised and shortsighted policies.
The global boom's bite
Exacerbating those inflation trends is the synchronized economic boom that the world has enjoyed for the past couple of decades, which is a major focus of Marc Faber, the editor of the Gloom, Boom & Doom Report (subscription required).Combining Grant's and Faber's views, we see that the first decade of the global economic boom and the attendant expansion in the labor force held inflation in check. Now those laborers all over the world want more money, and economic expansion in countries everywhere is creating a tremendous drain on the world's resources, leading to higher commodity prices (exacerbated by more money printing).
That, ladies and gentlemen, is a recipe for accelerating inflation. And that is not going away anytime soon.
As Faber pointed out to me during our recent meeting: "Central bankers have become hostage to inflated asset markets. Tight money will be difficult to implement."In fact, Faber says, tight-money policies will be impossible to put in place, given the socialization of central bankers.
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That leads to one of Faber's conclusions: "It is quite likely that the current synchronized global economic boom and the universal, all-encompassing asset bubble will lead to a colossal bust." In other words, the synchronized boom will have a synchronized bust.
What folks would like to know is when that will happen. It's impossible to say, but Faber would not be surprised if it were to occur in the next couple of years (though I expect it could happen sooner). We do know that when an economy enters the late stages of an economic cycle, what happens next is a slowdown, though we cannot know whether that slowdown will be dramatic or gentle. What we know is that the likelihood is quite high, given that the latest worldwide economic boom is now quite old.
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Bob Rod: Inflation Is a Long-Term Problem
Bob Rodriguez, founder of FPA Capital (NASDAQ:FPPTX - News), thinks we're in for it: higher levels of inflation for the long haul, that is. In his latest commentary for shareholders, entitled "Crossing the Rubicon," he lambasts the Fed's response to the latest credit and liquidity crisis. Aside from pointing to the moral hazard risk that the Fed's rescue of Bear Stearns (NYSE:BSC - News) raises--that the government will be there to bail out irresponsible risk-takers--he also suggests that the Fed seems more concerned with saving troubled mortgage borrowers and corporations than it is with fighting excesses and inflation, and its moves are not without long-term consequences, inflation being a primary one.Rodriguez' overall outlook is very cautious, and that viewpoint is reflected in the funds. He's gone so far as to call a buyer's strike that extends to all equities and high-yield bonds. He sees more storm clouds on the horizon and doesn't think stocks and high-yield bonds are cheap enough to compensate for the prospect of higher inflation, along with bigger risks facing the financial system.
PIMCO Calls for Mild Stagflation
PIMCO is well known for its ability to follow and accurately predict the direction of macroeconomic drivers, such as inflation. The firm nailed the depreciating dollar, housing slump, and economic slowdown in the U.S. Bill Gross and others at PIMCO now think that mild stagflation (inflation together with slowing growth) is in store for the next year. While they think the U.S. and other developed economies are well into a slowdown, they point to still-strong demand for commodities from emerging markets, which is keeping inflation pressures up for the time being. PIMCO has increased its inflation expectations slightly but still forecasts relatively mild rates (between 2% and 2.5%) for the next six to 12 months.At PIMCO's last annual secular forum--where it develops its three- to five-year views--in May 2007, manager Bill Gross expressed concern about the longer-term inflation picture and pointed out that while some disinflationary pressures such as globalization and a growing labor pool may stem inflation for a while, he thinks those forces will lose some of their disinflationary power as global markets become more integrated. Given its outlook, PIMCO is gearing its portfolios toward high-quality bonds that are paying attractive yields, such as high-quality mortgage-backed bonds and municipal securities. They have also reduced several funds' sensitivity to rising interest rates.
Marsico Is Less Concerned
Tom Marsico and the other managers and analysts at Marsico Capital Management do an excellent job mixing their top-down macroeconomic views with stock-by-stock research to build concentrated growth portfolios. Having an opinion on inflation is a critical input into their analysis. In his year-end 2007 commentary, Marsico didn't express a high level of concern about inflation. He pointed to soaring commodity prices as a key reason why he couldn't afford to ignore it but said that he believes in the durability of structural disinflationary forces such as globalization and a growing labor pool (the very forces that Bill Gross and crew think will eventually become less disinflationary). On top of that, he opined that the softening economy would also help keep inflation under wraps.He must not be too worried about inflation or its effect on the consumer because McDonald's Corporation (NYSE:MCD - News) is one of his largest holdings in Marsico Focus (NASDAQ:MFOCX - News) and Marsico Growth (NASDAQ:MGRIX - News). He thinks that McDonald's is improving the quality of its menu and bringing in a larger variety of items that should keep people coming to the fast food chain for more than just a meal.
And So Is Bill Miller
Bill Miller, longtime manager of Legg Mason Value (NASDAQ:LMVTX - News), thinks we're well into a commodity bubble, one that may have longer to run before it ends. He thinks that the Fed could help the situation by putting an end to its interest-rate cuts. If the Fed does that, he says, the dollar would likely stabilize, commodity prices would stall, and inflation pressures would relax. The end of the commodity price boom would undoubtedly help Miller. Legg Mason Value, which has excellent long-term returns, has been held back in recent years in part because it has avoided high-flying energy stocks. Miller is optimistic about equities more generally and thinks that the stocks in the portfolio have declined more than their business values. So, he's sticking with it.There you have it: Two investors who run bond funds are worried about higher inflation and two equity investors aren't as concerned. The differences in opinion may be somewhat reflective of the different lenses with which these managers view the world. Any threat of inflation is worrisome for bond managers because it drives down the prices of the fixed-rate bonds they own. On the other hand, stock investors might think--well, my companies can raise prices, too, and if their revenues are rising at a faster clip than their variable costs, then that's a good thing.
Karen Dolan, CFA has a position in the following securities mentioned above: MFOCX
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Whenever Congress puts together a bill attempting to find a solution to some sort of real or imagined problem, my immediate thought is that the bill do one of four things:Consider the ethanol plan. Growing corn to produce ethanol was supposed to help make us energy independent. What happened was that subsidies to grow corn (an energy wasteful process without the subsidies), did not cause gasoline prices to drop, instead it diverted food products to inefficient energy processes. This raised the price of grain which feeds livestock and corn syrup (used in practically everything as a sweetener).
- It will worsen the problem at hand
- It will do nothing to solve the problem but instead create a new problem somewhere else
- It will worsen the original problem and create new problems
- In the very best case it will do nothing at all
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The avalanche of bankruptcies has begun. Six US companies of substance have defaulted on bonds over the past fortnight, against 17 for the whole of last year.
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As the Fed's latest loan survey makes clear, lenders have dropped the guillotine. With the usual delay, the poison is spreading from banks to the real world.
Diane Vazza, S&P's credit chief, says defaults are rising at almost twice the rate of past downturns. "Companies are heading into this recession with a much more toxic mix. Their margin for error is razor-thin," she said.
Two-thirds have a "speculative" rating, compared to 50pc before the dotcom bust, and 40pc in the early 1990s. The culprit is debt. "They ramped it up in the last 18 months of the credit boom. A lot of deals were funded that should not have been funded," she said.
Some 174 US companies are trading at "distress levels". Spreads on their bonds have rocketed above 1,000 basis points. This does not cover the carnage among smaller firms outside the rating universe.
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US consumers are juggling plastic to put off their day of reckoning. The Fed survey said credit card debt had jumped 6.7pc in the first quarter to $957bn, or $6,000 per working American, despite usury rates near 20pc."My guess is that many Americans continue to run up massive credit card debt because they have little intention of paying it off," said Peter Schiff at Euro Pacific Capital. Quite.
Thankfully, the Fed's monetary blitz has averted a depression. Emergency lending under the "unusual and exigent circumstances" clause of the Fed Act - the nuclear Article 13 (3), unused since the 1930s - has put a floor under the banking system.
There will be no "reset Armaggedon" as rates vault on honey-trap mortgages. Drastic Fed cuts - to 2pc from 5.25pc in September - have conjured away that disaster, at least....
Despite the rescue, US house prices are likely to fall 25pc from peak to trough (Lehman Brothers, Goldman Sachs). We are barely half done, yet 10m-12m households are in negative equity already.
The bears at Société Générale are going into Siberian hibernation, issuing an "Ice Age" alert. They have slashed exposure to global equities to a minimum 30% for the first time ever.
Their weighting of super-safe "AAA" government bonds has been raised to a maximum 50pc. This is a bet on gruelling "Japanese" deflation. The bank expects equities to fall by 50pc to 75pc.
"Nowhere and nothing will be immune. We are on the cusp of an equity meltdown that will slash and shred portfolios," said Albert Edward, SG's global strategist.
"We see a global recession unfolding. Liquidity will drain away and crush the twin emerging market and commodity bubbles. The recent hope that 'the worst might be over' is truly staggering. Profits are disintegrating," he said.
Today's "bear rally" may live on into June. Don't count on it. Global bourses are no longer rising hand-in-hand with oil in exuberant celebration of liquidity relief (US, UK, and Canadian rate cuts).
Crude ceased to be a friend of equities when it reached around $110 a barrel. At last week's close of $126, it became an outright threat. The Bush rescue package - $600 in rebate cheques per household - has been rendered null and void by the latest spike. The average US home is now spending over 8pc of income on energy or fuel.
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Britain, Europe, Japan, and China will go down before America comes back up. This is turning into a synchronised bust, after all. The Global Slump of 2008-09 is under way.
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The number of companies defaulting on their junk-rated debt and filing for bankruptcy in North America is running at its fastest pace in five years amid the slowing economy and contraction in credit markets.So far this year, 28 "entities" have defaulted, according to Standard & Poor's. The defaulted debt of the one Canadian and 27 US companies totals $18.4bn and exceeds the 17 defaults in the US for all of last year
As economic conditions deteriorated...and volatility in the financial markets protracted, corporate casualties began to emerge at a rate unseen in years," said Diane Vazza, head of S&P's Global Fixed Income Research Group.
"The surge of defaults in the early months of 2008 is the first leg of an extended period of high default occurrences that will characterize the rest of 2008 and 2009."
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May 9 |Bloomberg Taxpayers from Massachusetts to California are paying Wall Street banks to end derivative contracts gone bad as they exit the collapsing auction-rate bond market, with penalties in some cases topping $10 million and compounding the pain of rising borrowing costs.
Sacramento County, California, paid Morgan Stanley $5 million to cancel an interest-rate swap agreement when it refinanced $79.5 million in auction-rate securities last month. The fee added to the cost of the bonds after the rate on the securities more than doubled to 9.8 percent in March as dealers stopped supporting the market.
``It's kind of like damage control,'' said Chris Marx, the county's debt officer. ``It didn't make a lot of sense to us to leave the swap in place.''
The breakdown of the $166 billion market where municipal rates are typically set through bidding run by a dealer is squeezing borrowers already hurt by the first decline in state sales-tax revenue in six years, according to the Nelson A. Rockefeller Institute of Government in Albany, New York.
States, cities, hospitals and colleges face penalties exceeding $10 million to terminate swaps that failed to protect them against higher rates, according to interviews with borrowers and advisers. That's on top of the $1 billion in fees they're paying to dealers to help sell bonds that would replace auction-rate securities they sold, based on industry averages.
`Tough Lesson'
``Some of the termination fees are ugly,'' said Christopher ``Kit'' Taylor, former executive director of the Municipal Securities Rulemaking Board, the market's regulator. ``It's going to be a tough lesson for a lot of issuers.''
Though no data exists on how many municipalities entered into swaps, it was ``the trade du jour,'' said Robert Fuller, a financial adviser who runs Capital Markets Management LLC in Hopewell, New Jersey. Many issuers sold auction-rate securities and then agreed to swaps with their bank, leaving them with a fixed rate derived from the taxable bond market that was often lower than conventional tax-exempt rates, he said.
Citigroup, based in New York, was the top underwriter of auction-rate securities in the municipal market, arranging $55 billion in sales between 2000 and the end of last year, according to data compiled by Thomson Reuters. Zurich-based UBS AG, which said on May 6 it will close or sell its municipal bond department, underwrote $42 billion, followed by Morgan Stanley of New York at $22 billion and 19 others.
``Most swaps are negotiated with the investment bank that does the underwriting,'' Fuller said. ``It's unusual that an issuer would use a counterparty other than the underwriting investment bank.''
Dealers Flee
For almost two decades, auction-rate bonds allowed local governments, hospitals, and closed-end mutual funds to issue debt maturing in as long as 40 years at short-term rates that reset every 7, 28 or 35 days through bidding.
Investors and dealers began to abandon the market in February on concern that the creditworthiness of companies insuring the bonds was deteriorating because of their losses from guaranteeing debt backed by subprime mortgages.
More than two-thirds of auctions failed, data compiled by Bloomberg show, and the average rate on seven-day securities rose to 6.89 percent on Feb. 20 from 3.63 percent a month earlier, according to the Securities Industry and Financial Markets Association. When an auction fails because sellers' orders overwhelm demand from bidders, rates are set at a predetermined ``penalty'' level.
Municipal issuers have replaced or announced plans to refinance more than $63 billion of auction-rate debt, according to Bloomberg data.
New Problem
Because most borrowers entered into swaps where they agreed to make a fixed payment in exchange for variable payments from the banks arranging the transaction, they now have to fix the contracts, said Jeff Pearsall, a managing director at Philadelphia-based Public Financial Management, the largest adviser to U.S. municipalities.
``We're spending the bulk of our time fixing broken, insured auction-rate bonds, many of which have swaps attached,'' Pearsall said. ``It tends to raise their cost of capital.''
A swap is a type of derivative, or financial instrument derived from stocks, bonds, loans, currencies or commodities, or linked to specific events like changes in interest rates or the weather. In a swap, parties exchange payments based on a specified amount of debt.
Interest-Rate Swaps
For issuers of auction-rate bonds, the variable rates they received, based on the London interbank offered rate, roughly matched the cost of auction-rate bonds for more than five years. The relationship broke down this year as rates on auction-rate bonds soared and Libor fell.
``In many cases they've had years of savings that are now being taken back in part or in whole,'' said Peter Shapiro, managing director of Swap Financial Group, a South Orange, New Jersey-based financial adviser to state and local governments.
Redding, California, expects to pay Citigroup $6.7 million to close out a swap on $67.3 million of auction-rate bonds it sold, said Tom Graves, financial manager of the city's electric system, the recipient of the proceeds.
It refinanced the bonds on April 28, selling fixed-rate debt because it was concerned variable rates in the municipal market might shoot up again, he said. Danielle Romero-Apsilos, a spokeswoman for Citigroup, declined to comment.
`Very Good Alternative'
``It was a very good alternative while it worked,'' Graves said in reference to the use of auction bonds combined with fixed-rate swaps. ``Our feeling was that there was still uncertainty in the marketplace that hadn't been resolved.''
Sacramento County did a swap with Morgan Stanley in conjunction with a sale of $79.5 million in auction-rate securities for its airport in May 2006. The contract was to last until the bonds, which were insured by New York-based XL Capital Assurance Inc., matured in 2024.
The county agreed to pay the bank a fixed rate of 3.785 percent in return for a variable payment that was supposed to cover the cost of the bonds. The rate it received from Morgan Stanley was capped at 65 percent of the one-month Libor, which averaged 5.08 percent that month.
Sacramento County paid an annualized rate that reached 9.8 percent at a monthly auction of $39.7 million of its bonds on March 11. The county received a variable rate of about 2 percent from Morgan Stanley, according to the bond documents. Jennifer Sala, a Morgan Stanley spokeswoman, declined to comment.
Wisconsin Public Power
Wisconsin Public Power Inc. in Sun Prairie spent about $11 million to terminate swaps on $192 million of tax-exempt auction-rate bonds it refinanced on April 21, according to a Standard & Poor's report. Marty Dreischmeier, the company's chief financial officer, didn't return calls for comment. The swaps were done with Bear Stearns Cos. and JPMorgan Chase & Co., both based in New York, S&P said.
CareGroup Inc., a hospital system based in Boston, plans to borrow $371.1 million to refinance auction bonds and terminate interest rate swaps with Citigroup and Bank of America Corp. of Charlotte, North Carolina, at an estimated cost of $12 million, according to reports from Standard & Poor's. CareGroup's spokesman Jerry Berger confirmed the information from the reports and declined to elaborate.
Bentley College in Waltham, Massachusetts is preparing to terminate swaps on $56 million in auction-rate bonds that it's refinancing, said Paul Clemente, the CFO. The penalty changes daily depending on interest rates, and Clemente declined to speculate on the final cost. The swap was arranged by Lehman Brothers Holdings Inc. in New York and Bank of America.
``It's probably going to cost us something,'' Clemente said. ``These are the risks of getting into interest-rate swaps.''
To contact the reporter on this story: Michael McDonald in Boston at [email protected].
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Unless wages start going up, higher prices cannot be sustained. With credit becoming harder to get, consumption is going to drop." But that's exactly the answer. Prices can continue going up, without wages going up, if demand grows faster than production. Demand can grow faster than production even wages don't go up, in at least two cases: * Production is shrinking (e.g. oil). * Wages go up in other countries (e.g. China/India). The last point is particularly important: globalization means that the USA economy which was quite insular has become much more integrated with world economy. For example Greenspan has been able to run an ultra-loose monetary policy without triggering a wage and employment boom in the USA because that boom has happened in China and India. Now even if wages and employment in the USA are doing even worse than before, there is still going to be inflation because costs are being inflated by Chinese and Indian demand. And so on. A lot of "rules of thumb" implicitly based on the assumption that the USA is a mostly closed economy are simply no longer true. It it still not very open, but a lot more than in the past.
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Setser, by contrast, said that there "wasn't much to like" in the March report. Ouch. A lot of experts had hoped that the falling dollar would cushion the blow of a weakening economy via more robust exports. And while commodity producers and manufacturers are doing well, we now live in a service economy. Even if the dollar weakens further, the US has sent much of its manufacturing abroad, and we now lack skilled workers and relevant equipment. How long would it take, say, to increase furniture manufacture here (my ex-Ethan Allen sources say there was no inherent reason the US could not have remained competitive in high end furniture production). Who would be willing to bet the dollar will remain cheap long enough for that sort of investment to pay off?
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The improvement in the US trade balance with China (the deficit was $2.2 billion smaller in q1 2008 than in q1 2007) comes far more from the fact that US imports from China have essentially stopped growing.
Comments
I have been waiting for just this number, and was unsurprised that Brad Setser was on top of the issue. As I rather suspected, there is much less to the 'Export-led Recovery' than meets the eye: we are, fundamentally, exporting commodities, both agriculturals, and refined products like chemicals and petrochemicals. Finished manufactures are not rising at a rate which will in any way address our long-term BoP issues. We need to take a long look in the mirror as a country, swear of the sauce, and come up with a national economic policy; like, yesterday.
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Bloomberg.comEconomists anticipate the economy will grow at a 0.1 percent annual rate from April to June, the least since the 2001 recession, according to a monthly survey by Bloomberg News published today. Gross domestic product rose at a 0.6 percent pace in both the first quarter and 2007's final three months.
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...Tennessee is cutting 5% of their state workforce. This is the typical negative feedback loop at the beginning of a recession: a weak economy leads to less tax revenue leads to state and local job cuts that further weakens the economy.
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Insightful, but Incomplete and Rapidly Becoming Dated!,
April 22, 2008
By Loyd E. Eskildson "Pragmatist" (Phoenix, AZ.)
...Phillips points out that over the last 30 years, financial services have nearly doubled to a record 20% of GDP (and an even greater share of corporate profits - 54% in '04), while manufacturing's share has halved to 13% (10% of profits), greatly imperiling the economy. En route, Washington has provided government bailouts and/or liquidity when financial institutions or methodologies got themselves into trouble (eg. S&L crisis; Citibank forced into technical failure, but allowed to stay open; bailing out junk bond investors by lowering federal funds rate; etc.), encouraging bigger problems down the road.
The positive impact of borrowing has declined about 60-70% from the 1970s-80s when such monies would mostly be used for factory and highway construction, compared to today's increasingly likely use for increasing leverage for LBOs, M&A, and hedge funds. Meanwhile, the negative likelihood of families experiencing a 50% drop in income has increased dramatically from 1970 - resulting in a greater probability of default.
Cognizance of our problems has been somewhat covered up with revisions to the CPI (understating costs of home ownership) and unemployment measures (not counting those who gave up and quit looking). Thus, the 2-4%/year CPI increase 2005-2007 would have been 5-7%/year, and unemployment would have been 8%.
Early millennium results include the housing sector (including its "ATM effect") providing 40% of the nation's growth in GDP and employment (an unsustainable rate achieved through financial gamesmanship that set the stage for the current financial and construction crash), while imported petroleum outlays rose from $100 billion in '02 to $302 in '06.
Observing from a distance, OPEC has reduced its foreign-currency reserves held in dollars from 75% to 62.5%, and Iraq and Venezuela began selling oil in euros and yen (admittedly for political purposes, at least at first). Meanwhile, the U.S. has antagonized major oil producers (Iran, Russia, Venezuela), and effectively dismantled Iraq - raising the risk of nations being unwilling or unable to supply the U.S. as supplies grow tighter.
Declining oil supplies, rising demand, global warming, our recession, and global loss of confidence in American financial markets are all converging and demand strong political leadership. Phillips, however, is not optimistic that this will emerge based on strong financial sector support for the Democratic Party and political failures in other nations needing dramatic change.
Phillips makes numerous comparisons between the U.S. today and the Great Depression (Eg. Total indebtedness was three times the size of GDP in 2007, higher than the prior record set in the years of the Great Depression), as well as the declines of Rome, Holland, Spain, and Great Britain. Regardless, no predictions are made about how long or deep our current downturn will be (though his writing hints the more severe possibilities), and he gives little or no attention to the steady amassing of dollars in Asia and associated growing unemployment of Americans. Finally, readers must also keep in mind that throughout the book he refers to $70 oil - obviously outdated vs. today's nearly $120.
Interesting Side Issue: Phillips states that food represents about 14% of the U.S. CPI, vs. 33% and 46% for China and India, respectively. Doesn't auger well for biofuels continuing to take 28% of the U.S. corn crop.
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Financial Armageddon
Wall Street "strategists," TV pundits, regulators, economists, and others who claim to know what is going on have been betting on best-case scenarios throughout this crisis, and for the most part, their optimism has been proved wrong
They expected the government would step in and save the housing market and, in reality, they got a third-rate replay of the disastrous Hurricane Katrina "rescue."
They assumed the Fed would wave its magic wand and turn things around like it did during the Greenspan bubble-blowing era; instead, the central bank is now the proud owners of all sorts of worthless derivative securities -- with little to show for it.
Finally, they figured that Wall Street's best and brightest would somehow come up with the answers, and as it turns out, those people don't even understand the problems.
With that in mind, what do you think is the right response to the question posed in an article by the Christian Science Monitor's Mark Trumbull, "Will Taxpayers Be on the Hook for Subprime Crisis?"
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I get worried when the Financial Times' Martin Wolf starts adopting Stephen Covey-esque sloganeering, particularly when he goes so far as to call his financial services reform proposal "the seven Cs." Eeek.
Earth to UK: one of the big hidden advantages you have is that the lingua franca is your language. That cloying business jargon so popular in America that we have managed to export is not an innovation, it is a debasement. Anyone who can speak and write in an unvarnished manner can trounce those who traffic in gobbledegook.
To be frank, this isn't one of Wolf's best columns, but that may be in large measure due to the near impossibility of setting forth how to fix the global financial system in his word budget. And I have omitted the liveliest part, namely, the set-up, in which he review Paul Volcker's recent speech at the Economic Club of New York, simply because it has been covered elsewhere.
Nevertheless, US readers are likely to find his recommendations to be thin gruel, but remember, there's a valid reason. The UK is a principles based system, so general, high level statements are more meaningful in that system than in ours, where sadly, the devil is in the details. But even giving that allowance, Wolf at points ducks questions he could have addressed. For instance, he mentions the problem of rating agencies, yet fails to mention any solutions. Several are on offer; surely Wolf could have given a thumbs up to one he likes.
Similarly, he sees the main problem in the "originate-to-distribute" model as bad incentives which can be solved by having the originators hold some of the riskiest tranches. Um, don't underestimate their ability to jigger the structures so as to still leave other parties holding the bag. The real problem with the originate to distribute model may be that it is seeking to create a free lunch by reducing the equity that needs to be held against loans. What if that in the end is a false economy? My sources with good regulator contacts tell me they expect to see a good deal more old-fashioned, on-balance-sheet intermediation. Mind you, that it not a view that is convenient for them to have; it implies that banks need to raise not only enough capital to cover their recent losses, but even more to allow for bigger balance sheets. Their view may be pragmatic, in that they see the market for securitized assets as sufficiently burned that it will not come back to its former size for quite some time. That degree of investor repudiation in turn suggests greater changes may be required.
Nevertheless, the advantage of a simple catchy list is that it provides a useful frame of reference.
From the Financial Times:
So here are seven principles of regulation. I call them the seven "Cs".First, coverage. Perhaps the most obvious lesson is the dangers of regulatory arbitrage: if the rules required certain capital requirements, institutions shifted activities into off-balance-sheet vehicles; if rules operated restrictively in one jurisdiction, activities were shifted elsewhere; and if certain institutions were more tightly regulated, then activities shifted to others. Regulatory coverage must be complete. All leveraged institutions above a certain size must be inside the net.
Second, cushions. Equity capital is the most important cushion in the financial system. Also helpful is subordinated debt. If Bear Stearns had had larger equity capital, the authorities might not have needed to rescue it. Capital requirements must be the same across the entire financial system, against any given class of risks. But there must also be greater attention to the adequacy of that other cushion: liquidity.
Third, commitment. The originate-and-distribute model has, it is now clear, a huge drawback: originators do not care sufficiently about the quality of loans they plan to offload on to others. They do not, in Warren Buffett's phrase, have "skin in the game". That makes for sloppy, if not irresponsible or even fraudulent lending. Originators should be required, therefore, to hold equity portions of securitised loans.
Fourth, cyclicality. Existing rules are pro-cyclical. Capital evaporates in bad times, as a result of write-offs, thereby forcing contraction of lending, worsening the economic slowdown and further impairing assets. Mark-to-market accounting, though inherently desirable, has a similar effect. One solution could be to differentiate between target levels of capital and a lower minimum level. Institutions that have minimum capital in bad times would only be required to aim for the higher target level over an extended period.
Fifth, clarity. Lack of information, asymmetric information and uncertainty are inherent in financial activities. These are why they are vulnerable to swings in collective mood. The transactions-orientated financial system is particularly vulnerable, because information has to flow freely across arms-length markets. So a big challenge is to generate as much clarity as is possible. One issue is the calamitous recent role of the rating agencies and the conflicts of interest under which they operate.
Sixth, complexity. Excessive complexity is a significant source of lack of clarity. It is particularly damaging, as we have seen, to the originate-and-distribute model, because markets in complex securitised products may, at times, seize up, forcing central banks to become "market makers of last resort", with all the difficulties this entails. One possibility then is to insist that all derivatives be traded on exchanges.
Seventh, compensation. On this I can do no better than quote Mr Volcker: "In the name of properly aligning incentives, there are enormous rewards for successful trades and for loan originators. The mantra of aligning incentives seems to be lost in the failure to impose symmetrical losses – or frequently any loss at all – when failures ensue." Whether regulators can do anything effective is unclear. That this is a challenge is not.
John Maynard Keynes wrote of an eighth "c". He argued that "when the capital development of a country becomes a byproduct of the activities of a casino, the job is likely to be ill done". He had a point. Features of a casino will always be present in a financial system that performs the essential functions of guarding people's savings and allocating them where they can do most good.
Regulation will always be highly imperfect. But an effort must still be made to improve it.
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The latest results include $4.4 billion in losses on derivatives and trading securities, as well as $3.2 billion in credit-related expenses... ... ...
Looking forward, Fannie said it expects "severe weakness in the housing market to continue in 2008," with the weakness projected to "lead to increased delinquencies, defaults and foreclosures on mortgage loans, and slower growth in U.S. residential mortgage debt outstanding."
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Six out seven refinances in 2006 and 2007 had a cash-out component, Nothaft said, and many borrowers increased their mortgage rates to access that cash. In contrast, during the first three months of this year, more than half of all borrowers who refinanced lowered their mortgage rate.
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CEOs manage companies for their own benefit, and the benefit of insiders, not shareholder benefits. It's important to always keep that in mind, especially when it comes to share buybacks and dividends.
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A derivatives expert who two years ago warned of a potential meltdown in global credit markets has cautioned that the crisis is far from over, and has endorsed recent calls to relax controls on inflation and allow higher prices to help markets trade their way out of their problems.
Longtime critic of derivatives markets, Satyajit Das, says those who believe the US sub-prime loans crisis, and the drought in credit markets it triggered, are nearly over are wrong.
"I think the cycle has some way to run yet," he told a Financial Services Institute of Australasia function in Sydney yesterday. "It's a matter of years, not a matter of months."
In particular, investors in the US stock market, which has climbed off its lows amid a growing mood that the worst of the crunch was over, were being too optimistic, he said.
The author of Traders, Guns & Money warned that many of the problem financial instruments were still hidden and the total amount of debt attached to them largely unknown.
Losses incurred by US banks were certain to rise as $US1 trillion ($1.06 trillion) in sub-prime housing loans was due to reset to higher interest rates in the next two years.
The use of credit card debt -- now totalling $US 915 billion -- was cushioning US home owners. But, in an ominous sign, card issuers were rapidly increasing their provisions for bad debts, by as much as 500 per cent in the case of one bank.
The use of sub-prime debt structures was also a feature of other markets, such as private equity, where $US300 billion in loans were due to be refinanced in the next two years.
Mr Das said another $US1-$US5 trillion of assets would have to come back on to US bank balance sheets as a result of defaults on housing and other debts, and it was unclear how the banks could fund them -- issuance of preference shares by US banks was already at a record high. He said losses at financial institutions from the credit crunch were likely to almost double to $US400 billion.
There were also second-round effects to come as the damage done to the real economy from financial sector losses fed back into further bank losses.
Mr Das said there needed to be a massive reduction in debt levels globally or a "nuclear deleveraging" before the crisis could be said to be over. That could be achieved through an economic crash "on the scale of 1929" but allowing inflation to rise would help to avoid that scenario. Higher inflation was a legitimate policy option since it reduced the real value of debt and gave companies and individuals breathing space to reduce their leverage by helping to put a floor under asset prices.
His comments come as some economists urge Australia's Reserve Bank to relax its inflation targeting policy to help avoid a severe economic downturn.
He acknowledged that as inflation rose higher it was more difficult to control it, but noted the global economy was moving into a period of higher inflation anyway. "It could be the lesser of two evils," he said.
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Below is a provocative line of thought from an anonymous reader. It supports a gut feeling that I have been unable to prove, namely, that lowering of boundaries between markets (ranging from the large number of global macro hedge funds to the large number of retail currency speculators in Japan) is destabilizing. I've found the occasional supporting bit of empirical evidence (for instance, Kenneth Rogoff's and Carmen Reinhart's recent paper on financial crises, which found that greater financial integration was correlated with crises) but no theories. Conventional economic wisdom would tell you arbitrage is always and ever good (it supposedly improves price formation which leads to better allocation of capital), and inefficiencies are bad. However, complex systems theory provides a very different perspective:
Perhaps a lesson to be learned here is that liquidity acts as an efficient conductor of risk. It doesn't make risk go away, but moves it more quickly from one investment sector to another.From a complex systems theory standpoint, this is exactly what you would do if you wanted to take a stable system and destabilize it.
One of the things that helps to enable non-linear behavior in a complex system is promiscuity of information (i.e., feedback loops but in a more generalized sense) across a wide scope of the system.
One way you can attempt to stabilize a complex system through suppressing its non-linear behavior is to divide it up into little boxes and use them to compartmentalize information so signals cannot easily propagate quickly across the entire system.
This principle has been recognized in the design of software systems for several decades now, and is also a design principle recognizable in many other systems both natural and artificial (c.f. biology, architecture) which are very robust with regard to exogenous shocks. Stable systems tend to be built from structural heirarchies which do not share much information across structural boundaries, either laterally or vertically. That is why you don't die from a heart attack when you stub your toe, your house doesn't collapse when you break a window, and if your computer crashes it doesn't take down the entire internet with it.
Glass-Steagall is a good example of this idea put into practice. If you use regulatory firewalls to define distinct investment sectors and impose significant transaction costs at their boundary that will help to reduce the speed and amplitude of signals which will propagate from one sector to another, so a collapse in one of them will be less likely casue severe problems in the others.
It worries me that we've torn down most of these barriers in the last several decades in the name of arbitrage, forgetting that the price we paid for them in inefficiency was a form of insurance against the risk of systemic collapse. This is exactly what I would do if I wanted to take a more or less stable, semi-complex system and drive it in the direction of greater non-linearity.
I think this was to some degree inevitable - it is a symptom of the decay and loss of trans-generational memories from our last great systemic shock in the 1930s. I suspect that something like this is bound to happen every 3-4 generations as we unlearn the lessons our grandparents and great-grandparents learned to their cost.
Comments:
- CrocodileChuck said...
- Great post by Anonymous. The study of natural systems would seem to be essential for our regulators and elected representatives alike.
Re: his point on causation and inter-generational memory loss: see 'Generations' (1991), by William Strauss, Neil Howe on the rhythms of history. By the authors' own framework, we appear to be headed into another phase of 'secular crises'. Worth a read, if only for a different perspective on American history from 1584 to the end of the eighties.
CrocodileChuck
- Anonymous said...
- Agree with everything Anonymous says, it's just good system analysis. Maybe another way to look at it is that Liquidity is NOT equal to Commitment. If it is easy to sell/trade, then you have no commitment to it. If an originator of an instrument had to keep it and live with it, you can depend on most financial instruments being a very different.
- reason said...
- As a software engineer - I often have felt this is the great problem with using outside contractors to produce software - they write it then walk away from it. If they are responsible for maintaining and answering for what they produce, I'm sure the outcome would be different.
- alan greenspend said...
- Wonderful post. My sentiment as well, especially concerning trans-generational memory for the masses. For old money, savvy investors and those wishing to loot, it has always been a way to profit on those less historically studious.
- Anonymous said...
- I like the line of reasoning in the post - the thinking of a true engineer. Just to play devil's advocate for a moment though, don't we also think that all great things, all novelty and progress, come precisely from those complex systems where information is not tightly controlled and is allowed to experience unexpected 'promiscuity'. For example, would we even be having this conversation if the computer had remained a stable tightly controlled system run by the mainframe geeks at IBM? A book I came across recently brings up this question
http://yupnet.org/zittrain/
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From Fed Chairman Ben Bernanke: Mortgage Delinquencies and Foreclosures
As a consequence of rising delinquencies, foreclosure proceedings were initiated on some 1.5 million U.S. homes during 2007, up 53 percent from 2006, and the rate of foreclosure starts looks likely to be yet higher in 2008.
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"We are in an economy in which many people are living right at the margins, even middle- and upper-income people. They have little savings, they've borrowed so much, their credit-card bills are high, and their house values are going down."
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NEW YORK - A Chapter 11 bankruptcy filing by Linens 'n Things is the latest sign that the retail sector is becoming leaner and meaner amid a difficult consumer environment.
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Money News is reporting on an ominous trend for state budgets: U.S. Sees First Sales Tax Revenue Drop in 6 Years
U.S. consumers are cutting back on spending, driving the first nation-wide decline in sales tax revenues in six years, according to a report released Thursday.
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May 3 (Bloomberg) -- Warren Buffett, chief executive officer of Berkshire Hathaway Inc., said the global credit crunch has eased for bankers, and the Federal Reserve probably averted more failures by helping to rescue Bear Stearns Cos.
``In terms of people with individual mortgages, there's a lot of pain left to come.'' Buffett was interviewed before the Omaha, Nebraska-based company's annual meeting, attended by about 31,000 people.
In a question-and-answer session at the shareholder meeting, Buffett said that from a risk perspective, some banks got ``too big to manage.''
Berkshire has risen about 22 percent in New York Stock Exchange composite trading during the past 12 months and gained about 4,700 percent in 20 years through Dec. 31, about six times more than the Standard & Poor's 500 Index including dividends.
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"Buffett Sees More Losses for Banks."Banks will suffer more losses over the next few years from the real-estate crisis, despite the Federal Reserve's successful efforts to prevent contagion in the financial system, Berkshire Hathaway Chairman Warren Buffett said on Sunday.
"The action of the Fed in terms of Bear Stearns prevented contagion where there may have been more bank runs on the investment banks," he said during a press conference. "That doesn't mean the losses are over by a long shot. There's going to be more pain."
"We've looked at several of the investment banks where it's clear more losses are to be taken," he added.
The size of future losses depends on the outlook for the economy and the housing market, he explained.
Listings of homes for sale in some areas of the country, such as Broward County, Fla., are up a lot from last year, Buffett noted.
"That will work its way out," he said, but stressed that it's difficult to know how long that will take.
Berkshire owns a big stake in Wells Fargo, one of the largest mortgage lenders in the U.S., and holds shares in other banks such as US Bancorp.
"Wells Fargo is going to have above average losses as will other banks on things that relate to real estate over the next few years," Buffett said.
Berkshire is not selling its Wells Fargo shares though, he noted.
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From Reuters: JPMorgan says no near end to financial crisis: report"We can only speculate how deep and how long the recession in the United States will really be and how that in turn will impact banks," [JPMorgan Chase & Co CEO] James Dimon told "Welt am Sonntag".And from Goldman Sachs: Eye of the Storm (research report no link). Goldman argues there is a "gaping hole in the side of the U.S. economy" from falling house prices (significantly more price declines to come in their view) and too much supply."But we are not done with the crisis for a long time," Dimon said ...
[Fiancial market] relaxation is unlikely to mark the start of a sustainable recovery.And from the WSJ: Downgrades Show Storm Isn't Over... the evidence for spillover effects from housing via the credit crunch, wealth effects, and multiplier effects in the broader economy is mounting, particularly as far as consumption is concerned. ... In an absolute sense, the data this week were clearly quite poor.
ResCap's credit rating was cut deep into "junk" territory after it unveiled plans to restructure $14 billion of debt and possibly borrow billions more from its parent, GMAC LLC.Being in the eye of the hurricane can lead some people into thinking the storm has passed. Maybe. But probably not.Countrywide's debt rating was slashed to junk from investment grade by Standard & Poor's after Bank of America Corp. said it isn't sure it will stand behind roughly $38 billion of Countrywide debt.
Credit markets have become substantially calmer since the Federal Reserve helped avert a complete collapse by Bear Stearns Cos. in March. Friday's downgrades were a reminder that other big financial institutions are still struggling under the weight of problem mortgages.
With falling house prices, less mortgage equity extraction, less consumption, and falling business investment (especially for non-residential structures), there is more storm damage to come.
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That's what NPR told listeners this morning. Actually, NPR just told us that the experts expect the recession to be brief, they didn't tell us that their experts didn't have a clue as far as seeing the recession coming. Given the track record of NPR's records maybe they could better used their air time talking about something else.
For the record, non-surprised economists noticed the data from the Case-Shiller indexes that was released yesterday. These indexes showed that house prices were falling at close to a 25 percent annual rate over the last quarter. If this rate of price decline continues, it will imply a lose of close to $6 trillion in real housing wealth over the course of the year. This will lead to large cutbacks in consumption, millions of additional foreclosures, much more turmoil in financial markets, and many more surprised economists.
The good news is that economists don't have to worry about losing their jobs or even getting a pay cut when they mess up.
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CNN told its audience that Clinton's elimination of the gas tax for the summer would save consumers $30. This is not true. Since the supply of gas is more or less fixed, refineries are likely to be running at capacity, the price is determined by demand. This means that if the government eliminates the tax, the price will stay the same. The only difference is that the $18.4 cent a gallon will go to the oil companies rather than the government.
That is why economists call Clinton's tax cut a gift to the oil industry, unfortunately CNN missed the story.
--Dean Baker
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are excerpts from two years worth of FOMC policy statements from the Ben Bernanke-led Federal Reserve on the subject of the future course of inflation in the U.S.
With gasoline at $4 and food prices soaring, does anyone really believe that anything having to do with prices is going to moderate anytime in the foreseeable future?
Well, that is, aside from iPods and iPhones. It's too bad you can't run your car on Apple products or feed a family with them.
March 28, 2006There appears to be no theoretical limit on how long you can continue to expect something to happen, however, practically speaking, at some point in time, people stop believing what you say.
... inflation expectations remain contained.May 10, 2006
... inflation expectations remain contained.June 29, 2006
... inflation expectations remain contained.August 8, 2006
... inflation pressures seem likely to moderate over time, reflecting contained inflation expectations...Sep 20, 2006
... inflation pressures seem likely to moderate over time, reflecting reduced impetus from energy prices, contained inflation expectations...Oct 25, 2006
... inflation pressures seem likely to moderate over time, reflecting reduced impetus from energy prices, contained inflation expectations...Dec 12, 2006
... inflation pressures seem likely to moderate over time, reflecting reduced impetus from energy prices, contained inflation expectations...Jan 31, 2007
... inflation pressures seem likely to moderate over time.Mar 21, 2007
Although inflation pressures seem likely to moderate over time, the high level of resource utilization has the potential to sustain those pressures.May 9, 2007
Although inflation pressures seem likely to moderate over time, the high level of resource utilization has the potential to sustain those pressures.Jun 28, 2007
... a sustained moderation in inflation pressures has yet to be convincingly demonstrated.Aug 7, 2007
... a sustained moderation in inflation pressures has yet to be convincingly demonstrated.Sep 18, 2007
Readings on core inflation have improved modestly this year ... some inflation risks remain...Oct 31, 2007
Readings on core inflation have improved modestly this year ... some inflation risks remain...Dec 11, 2007
Readings on core inflation have improved modestly this year ... some inflation risks remain...Jan 22, 2008
The Committee expects inflation to moderate in coming quarters...Jan 30, 2008
The Committee expects inflation to moderate in coming quarters...Mar 18, 2008
... some indicators of inflation expectations have risen. The Committee expects inflation to moderate in coming quarters...Apr 30, 2008
... some indicators of inflation expectations have risen in recent months. The Committee expects inflation to moderate in coming quarters...
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Unstoppable Credit Contraction
Steve Saville wrote an interesting article entitled Credit Contraction, Economic Bust, and Deflation. Inquiring minds will want to take a look.Saville: Members of the deflation camp assert that the large-scale contraction of credit happening within the banking system means that deflation is upon us, even if the money supply is expanding. At the same time, another camp is pointing to the breathtakingly rapid growth in M3 money supply as evidence that hyperinflation is a near-term threat. In our opinion, both camps are wrong*.
The argument of the first camp can, we think, be summarised as follows: Inflation is an expansion in the total supply of money AND credit, whereas deflation is the opposite (a contraction in the total supply of money AND credit). At the present time the money supply may well be expanding, but this monetary expansion is being more than offset by credit contraction.
Mish: So far so good. That is nearly my exact argument. The only thing I want to add is that credit needs to be marked to market, as opposed to some inflated book value.
Saville: The flaw in the above argument can best be explained via a hypothetical example. Consider the case of Johnny, who wants to borrow $1M to buy a house. If Johnny borrows the money from his friend Freddy then the transaction results in a $1M increase in the amount of credit within the economy, but no inflation has occurred. All that has happened is that $1M of purchasing power has been temporarily transferred from Freddy to Johnny. By the same token, when Johnny pays Freddy back there is a contraction of credit, but no deflation. There is also no deflation even if Johnny defaults on his loan obligation to Freddy. In this case Freddy will have made a bad investment, but the money he lent to Johnny will still be somewhere in the economy. The point is that credit expansion is not inherently inflationary and credit contraction is not inherently deflationary.
Mish: The flaw in Saville's analysis is that I agree with him! The reason is that he is ignoring the word "net". When Johnny loaned his friend $1M, money supply (savings) decreased by $1M but credit expanded by $1M. In Saville's example there was no "net" expansion of money (savings) or credit. As I see it, we are in "violent agreement".
Saville: But what if Johnny, instead of borrowing the million dollars from Freddy, takes out a loan at his local bank and the bank makes the loan by creating new money 'out of thin air'? In this case inflation has certainly occurred. Nobody has had to temporarily forego purchasing power in order for Johnny to gain purchasing power, but the total existing supply of money has been devalued to some extent.
Mish: Bingo! That is inflation. No argument in this corner.
Saville: The critical difference is that when Johnny borrows from a bank the transaction leads to an increase in the supply of MONEY. Inflation is the increase in the supply of money that SOMETIMES results from credit expansion; it is not credit expansion per se.
Mish: In my opinion, the critical difference is that Saville misses the word "net", conveniently looking at credit all the time, while ignoring money supply the rest of the time.
Skipping ahead....
Saville: This leads to the question: is the money supply currently expanding? The answer is yes, but not anywhere near as rapidly as many people think. The chart at http://www.nowandfutures.com/key_stats.html reveals that M3 has grown by a mind-boggling 19.5% over the past 12 months, but as was the case during the early 1990s it appears that this broad measure of money supply is currently giving a 'major league' FALSE signal.
Mish: I 100% agree with the notion that M3 is giving a false signal. That is the very premise behind my post MZM, M3 Show Flight to Safety.
Saville: Our preferred measures of money supply are TMS (True Money Supply) and what we call TMS+ (TMS plus Retail MMFs). TMS and TMS+ currently have year-over-year (YOY) growth rates of around 3% and 6%, respectively. In other words, our assessment is that the current US inflation (money-supply growth) rate is 3-6%. Inflation is still occurring, but at a much slower rate than it was during the early years of this decade.
Mish: I do not agree with adding MMFs to TMS as Saville does. I agree with the formulation of TMS and gave my reasons in Money Supply and Recessions.
Furthermore, and it is hard to say who is right or wrong given massive backward revisions in some Fed reporting and delays in other Fed reporting, but the latest M'/TMS numbers that I come up with (more accurately Bart at Now and Futures on my formulation) are as follows.
click on chart for sharper image
The above chart is as of April 18, 2008 as reported in MZM, M3 Show Flight to Safety.
Presumably it is the same as TMS. If it's not, one or more data series discrepancies may be at play, and given numerous backdated changes by the Fed as well as delays in reporting sweeps, I am not going to assume which series is correct. Close analysis will show near perfect correlation over time.
Finally, and this is key: Saville failed to mark credit to market! It is the marking to market process by which I state that deflation is here and now.
Please see Deflation In A Fiat Regime? and Now Presenting: Deflation! No one has rebutted the arguments presented in those links.
Saville: On a side note, the wrongness of M3's current signal is validated by the happenings in the financial world. Inflation-fueled booms generally continue until there is a deliberated or forced slowdown in the inflation rate, that is, the booms continue until the central bank takes steps to rein-in the inflation or until inflation slows under the weight of market forces.
Mish: I agree. Those looking at MZM are barking up the same incorrect tree.
Saville: It is also worth noting that although inflation is a major driving force behind the commodity bull market, commodity prices are generally still very low in REAL terms. Therefore, while we are anticipating a commodity shakeout over the next few months we think the long-term upward trend in the commodity world has a considerable way to go.
Mish: I fail to see how this fits into the debate. Commodity prices may indeed be very low in real (CPI adjusted) terms. Exactly what does that have to do with credit contraction/expansion other than perhaps propose the next bubble may very well be in commodities? If that is indeed the point, then I agree.
Saville: In conclusion, it is clear that inflation is still occurring in the US (and pretty much everywhere else, for that matter), albeit at a reduced rate. Furthermore, if it hasn't already done so it is likely that the inflation rate will bottom-out over the coming few months and then embark on its next major upward trend. It is possible that consumers are 'tapped out' and that the commercial banks are about to reduce the rate at which they lend, but the government will never be 'tapped out' and the central bank will always be able to monetise debt.
Mish: In conclusion, I do not see evidence supporting Saville's conclusion!
I feel he's failed to mark credit to market, to state why credit will not contract greater than central banks' attempt to inflate, to account for global wage arbitrage, walk-aways, boomer retirement and a shift away from consumption, $500 trillion of derivatives that can never be paid back and a secular shift from consumption to saving.
I see no explanation of how consumers and businesses are going to pay back debts in a world of declining real wages, wealth concentration at the extreme high end of the spectrum, global wage arbitrage, declining home prices, rising unemployment, overcapacity at every corner, and insane overbuilding of both commercial and residential real estate.
On the other hand, my thesis is simple: The Fed can address liquidity issues not solvency issues, and we are facing a solvency issue. And because of the enormous amount of debt in relation to the pool of real savings, there is no way that debt can be paid back. Debt that cannot be paid back will be defaulted on.
Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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But they are probably betting on the never ending story of creative accounting from the government level ( Pre-Revision CPI: 9%, Disappearing Economic Indicators, Unemployment Soars, Jobs Collapse etc ) to mask the real damage. At least the officials haven´t gotten so far as the pentagon ( Behind Analysts, the Pentagon's Hidden Hand )..... :-)
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The BBC is reporting Banks warned over lending fears.
The Bank of England has warned that banks' fears of a financial meltdown may become a self-fulfilling prophecy. Banks previously over-willing to lend are now too reluctant, even with credit-worthy borrowers, it suggests.My Comment: The psychology of deflation sets in. Banks are unwilling or unable to lend.-left: 30px; margin-right: 0; margin-top: 0; margin-bottom This increased fear of risk has itself undermined confidence in financial institutions and made them reluctant to lend to each other, the Bank adds.My Comment: This is what happens when banks have a bloated balance sheet and deteriorating assets.Its financial stability report suggests the credit exposure not declared by UK banks may be near to £100bn. The quarterly report says that there is a "significant increase" in the risk that a major bank collapse or reluctance to lend will disrupt the financial system.My Comment: That suggests that banks may have insufficient capital to lend whether someone is a good credit risk or not.In its quarterly Financial Stability Report, the Bank of England warns that there are potentially large exposures that have still not been declared by financial institutions.
However, the Bank points out that the freezing up of markets has meant that these estimated losses may be inflated because of the difficulty of pricing the complex securities which are now very difficult to value.My Comment: Market conditions may not return to "normal" for decades, if "normal" means anything like we have seen for the past 5 years. Otherwise, normal is likely to be years. Whatever "normal" means, talk of reduced loan losses is fantasy.It says that "credit losses from the turmoil are unlikely ever to rise to levels implied by current market prices unless there is a significant deterioration in fundamentals."
And it estimates that total sub-prime losses could be reduced from $400bn to $200bn once market conditions return to normal.
The Bank of England judges that there is a risk that "the currently elevated risk premia in some markets will persist".My Comment: The risk is the BOE and the Fed manages to encourage more foolish lending. The more banks lend now, the bigger the defaults will be later. In a world awash in overcapacity, I fail to see the need for massive amounts of lending."This could lead to a self-fulfilling adverse cycle in which persistent market illiquidity and falling asset prices further undermine confidence in banks and results in a sharper tightening of credit conditions."
Lending drying upMy Comment: Tightening credit is the smart thing to do. Banks that tighten the most will lose the least.The Bank's quarterly survey of credit conditions shows that lenders are tightening up credit sharply not just on home loans, but also on household lending and commercial loans to companies.
And the sources of future loans in wholesale money markets have also contracted sharply.
The market for "asset-backed securities" such as sub-prime and other mortgages has collapsed - with the value of such assets issued going from $700bn a quarter in the middle of 2007 to just $100bn in the first quarter of 2008.
The Bank of England argues that to rebuild financial confidence, it will continue to allow UK banks to swap illiquid assets with safe UK government securities.My Comment: Swaps accomplish nothing. What is swapped today has to be swapped back later. Except in some make believe pretend world, virtually nothing is accomplished by swapping.
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I've had time to look at it a bit more closely - and it's much weaker than the headline number suggests (and MUCH weaker than the previous quarter, even though the growth rate was the same.)
It's not just that final sales fell, so that the economy grew only because of inventory accumulation.
If you look at consumer spending, purchases of goods actually fell substantially. Only service purchases rose - and much of that was housing and medical care.
As Michael Mandel at Business Week has pointed out, those aren't "really" consumer decisions: housing "consumption" is largely imputed rents on owner-occupied homes, and medical care is mostly paid for by insurance.
So this really does look like an economy at stall speed, not an economy skirting past the edge of recession (whatever recession means).
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Last modified: March 12, 2019
Keep running enormous trade deficits, a government operating with an annual deficit, and a national debt that consumes 15% of the federal governments revenue and I promise the price of oil will continue to increase even without the very real increases in global demand and the dawning realization by more and more people that peak oil has been reached and production will slowly decline.
One, Two, Three Strikes and You're OUT!
- Posted by Gene L Payne