Archive for May, 2008

From Imperialist to Third World?

Friday, May 30th, 2008

Full story here.

I love thought-provoking commentary. I will put in my 2 cents about the concept “Third World”. You may think, no plumbing and unsanitary. Well, that’s one aspect. More generically, imagine your nice house and plumbing, but a busted public works system, bankrupted or hyperinflated out of existence. You can have all the pipe in the world, but if it doesn’t go anywhere…you get the idea. Same for the garbage man never showing up. Other characteristics of Third World are: a small elite, controlling most of the prime resources and wealth of the country; a non-democratic gov’t or sham-vote democracy, perpetuating a familial or tight group rotation as leader/generalissimo; poor civil rights; bribery/payoffs to get work done, contracts approved, political favors, etc; no public schools, or ones of such poor quality or limited scope that private schooling is vital to true education; a proportionally large amount of GDP invested in military activities; suppression/scapegoating of minority ethnic or religious groups;

When you look at it that way, you may find a lot more places aren’t as fabulous as billed.

“A good comment by Philip Stephens in the Financial Times, “Uncomfortable truths for a new world of them and us,” is a polite and understated wake-up call to the fading former imperialist of the West. He notes that the countries currently dominant in major international organizations assume that life will continue more or less as now, except the rising powers will have a few more votes. Stephens argues that the advanced economies are psychologically ill prepared for the shift in power and economic might that is in motion and are too often assigning responsibility to third world countries for phenomena where the West is far from blameless.

As uncomfortable as this message is, there is an even grimmer way to cast Stephens’ data. For the first time since the Great Depression, a major financial crisis is centered in first world countries. And the irony, mentioned here before, is that the US’s status is very much like that of Indonesia or Thailand circa 1997, except we have the reserve currency and nukes.

But the ugly fact is that the US (and the UK) has the potential to go from first world to third world on a relative basis. We’ve already have one developing economy trait: the emergence of a super-rich cohort that lives in splendid isolation, often with considerable security.

If you think that’s impossible, remember that Argentina had a spectacularly rapid fall. Bad leadership can destroy an economy in a surprisingly short period of time. Again, the US will hopefully escape that fate, but no matter what happens, our economic strength is ebbing as others are moving forward. A severe crisis in the advanced economies could lead to a bad outcomes even in emerging economies, but that scenario has perils of its own.

From Stephens:

Globalisation belonged to us; financial crises happened to them.

The world has been turned on its head. Consumers in the wealthiest nations are struggling with the consequences of the credit crunch and with the soaring cost of energy and food. In China, retail sales have been rising at an annual 15 per cent. I cannot think of a better description of the emerging global order.

The trouble is that the politics of globalisation lags ever further behind the economics… the west still wants to imagine things as they used to be. In this world of them and us, â??theyâ? are accused by Democratic contenders in the US presidential contest of stealing â??ourâ? jobs. Now, you hear Europeans say, â??theyâ? are driving up international commodity prices by burning â??ourâ? fuel and eating â??ourâ? food.

The other day I listened to an eminent central banker offer a lucid explanation of the collapse of confidence that last summer paralysed international credit markets…

The crisis, this banker told a conference hosted by the Weidenfeld Institute for Strategic Dialogue, flowed from the coincidence of a global savings glut with the explosion in financial innovation made possible by ever more sophisticated information technology. This had engendered among all those highly paid investment bankers and traders an insouciant indifference to risk. It was always going to end in tears.

The savings had come largely from the fast-growing Asian economies and from the burgeoning incomes of oil and gas producers, though some could be traced to a disinclination to investment in developed nations after the bursting of the dotcom bubble. As risk premiums had fallen and spreads narrowed, central bankers and regulators had warned of the dangers. What they had not foreseen was that the explosion in subprime mortgage lending in the US would be the catalyst for such a sudden bust.

None of the above, I suppose, is any great revelation to those in the banking business now counting the bonuses lost to irrational exuberance. What struck me, though, was how this crisis (no one is sure it is over) provides a perfect metaphor for the new geopolitical landscape.

Think back to the financial shocks of the 1980s and 1990s. For those of us in the west, these were unfortunate events in faraway places: Latin America, Russia, Asia, Latin America again. There was a risk of contagion, but in so far as rich nations paid a price, it lay largely in the cost of bailing out their own feckless banks. The really unpleasant medicine, prescribed by the International Monetary Fund, had to be taken by the far less fortunate borrowers.

The parameters of globalisation were set by the west. Liberalisation of trade and capital flows was a project owned largely by the US. It was not quite an imperialist enterprise, but, while everyone was supposed to gain from economic integration, the unspoken assumption was that the biggest benefits would flow to the richest. The rules were set out in something called, unsurprisingly, the Washington Consensus.

Against that background, the westâ??s present discomfort is replete with irony. A sizeable chunk of the excess savings that inflated the credit bubble were a product of the Washington Consensus. Never again, the victims of the 1997 east Asian crisis said to themselves after being forced to take the IMFâ??s medicine in 1997. This would be the last time they were held hostage to western bailouts. Instead they amassed their own huge foreign currency reserves.

So the boot is now on the other foot. The IMF is forecasting that the advanced economies will just about keep their heads above water. With luck, growth this year and next will come in at a touch above 1 per cent. If they do avoid recession â?? and most of my American friends think it unlikely as far as the US is concerned â?? they will have to thank robust growth rates in Asia and Latin America. The forecast for China is growth of about 9 per cent in both years, for India 8 per cent and for emerging and developing economies as a whole something more than 6 per cent.

The old powers have not grasped this new reality….. More seats, maybe, at the World Bank, the United Nations and, yes, on the board of the IMF. But the assumption is that the rising powers will simply be accommodated within the existing system….Missing is a willingness to see that this is a transformational moment that demands we look at the world entirely afresh.

One of the reasons for such reticence has been the emergence of another â??them and usâ? â?? this time within western societies. The â??usâ? in this case are the well educated and well positioned who have been able to extract sizeable rents from the process of global economic integration. The â??themâ? are the under-educated and less fortunate who have seen their jobs lost or their incomes depressed by big shifts in comparative advantage flowing from technological innovation and open economies.

The response of governments thus far has lain somewhere between despair and denial: there is nothing to be done in the face of global market forces; or the benefits of globalisation will eventually trickle down. The active education and welfare policies necessary to ease the adjustment have been conspicuous by their absence. How do you tell your electorates that all the old assumptions about welfare capitalism must be rethought?

Difficult. But these two sets of pressures â?? between nations and within them â?? cannot indefinitely be ignored. That way lies an inexorable slide into the beggar-thy-neighbour protectionism that would make the recent financial storm seem like a summer squall. However it is handled, the adjustment process to the new world order will be wrenching. The US and Europe, after all, have between them have enjoyed the best part of two centuries of effortless political and economic hegemony.

There is no reason they should not continue to prosper in a world where power is more evenly spread. Globalisation need not be a zero-sum game. But if the west is going to adapt, it must recognise that it can no longer expect to write the rules.”

Waiting for the other shoe to drop

Wednesday, May 28th, 2008

Full story here. Use ShadowTraders now, and avoid the heartbreak of finding out that 30 years worth of pension got flushed down the toilet…

Walk On the Wild Side

I decided to take a look at the largest pension pool in the U.S. â?? the 240 billion Calpers [California Public Employees Pension Fund] – we can see the breakout of their Fixed Income Investments. The following is from their most recent June 30, 2007 Annual Investment Report:

FIXED INCOME REPORTS – Calpers

For the purposes of saving you readers a bit of time, represented above are 245 individual asset backed securities, 564 mortgaged backed securities of varying descriptions, 66 individual currency and interest rate swaps and two entries in the high yield category totaling more than 400 million in reported market value.

Selected Calpers Equity Highlights:

Having glanced through the equities portion of the same Calpers report, we see no less than 641 thousand shares of Bear Stearns with a reported market value of 140 bucks per share, more than 22 million shares of B of A with a reported value of 48+ bucks, 23 million shares of Citibank with a reported value of 51+ dollars per share, 565 thousand shares of AMBAC with a reported value of 87+ bucks per share, 948 thousand shares of MBIA valued at 62 bucks+ per share and for a bit of international diversification, letâ??s not forget 819 thousand shares of good ole Northern Rock valued at 17.70 per share.

Calpers is soon due to release their updated June 2008 Annual Investment Report. Anyone want to place a friendly wager on the extent of losses that are going to be reported?

Run for the Roses?

Isnâ??t it amazing that some folks REALLY DO KNOW when theyâ??ve had too much of good thing?

The Rats [or at least some of the smart ones] Are Jumping Ship:

CalPERS resignations not connected – turmoil denied
Sam Zuckerman, Chronicle Staff Writer
Wednesday, April 30, 2008

The resignation of the CEO of California’s public employee retirement system, announced Monday, was its second high-level departure in less than a week, prompting speculation about turmoil at the $240 billion pension fund.

It seems Calpers is not alone â?? misery really does love company, eh?”

Why gold will get whacked again

Wednesday, May 28th, 2008

Full story here.

“Gold has recovered from its previous two â??whacksâ? rather nicely this past week and the Friday before, but it will very likely be whacked again very soon, possibly as early as this coming Monday.

Why?

Because gold is rising while the Dow/US stocks are in ultra-dangerous territory.

That is the one thing the â??powersâ? cannot tolerate. Confidence in the dollar is apparently no longer a necessity for those who operate our economy from behind the scenes. In fact, a falling dollar is utterly desirable for them, for reasons to be discussed below.

A primary stock market collapse, alone, is also not to high on their list of no-nos, but a collapsing stock market alongside a collapsing bond market alongside rising gold prices cannot, must not be tolerated.

If such were to come to pass, investors would have no place else to go but to foreign stocks â?? and to precious metals stocks.

After breaking its resistance line in April during what looked to many as a â??powerful rallyâ?, the Dow has betrayed the fundamental weakness of its recent, post-Bear Stearns, recovery by shying away from its 200-day moving average twice, breaking its recent uptrend, and falling below even its 60-day moving average. It is now about halfway between its resistance and its level 1 support…

The engineered nature of this phony uptrend was revealed by the fact that it consisted largely of huge one or two-day rises which were inevitably followed by a series of smaller drops that at first capped and frequently eventually all but negated the previous rises.

Normal, healthy uptrends just don’t look that way.

I would venture a prediction that, as soon as the Dow hits or crashes through support level 1, gold will be whacked again. If not, the Dow threatens to fall through its level 2 support, which would bring it below the January 200 high of 11,750 â?? and that would finally reveal that every bit of the Dow’s recovery since then was contrived.

The NYSE looks very similar, except that it briefly managed to break above its 200-day MA before succumbing to its fundamental weakness, and except for the fact that its support level #2, going back to January 2000, lies far below current levels, namely at 7000. Which only means that, once it breaks below support level 1, it has along, long ways to go before it finds support.

The fundamental picture supports these chart views. Inflationary expectations are high, oil prices are high and climbing with no end in sight, US economic activity is declining, and the dollar is dropping out of sight, which makes investing in US assets far less profitable for foreigners with stronger currencies.

Under these conditions, profits are hard to come by for US companies, so their stocks tend to be weak.

At the same time US bonds have passed their historic peaks and are now engaged in a secular decline. If we’re lucky, that decline will show itself only gradually, but it is very possible that it will come abruptly. That means US interest rates will be rising in spite of the Fed’s frantic attempts to keep them low so as to â??re-igniteâ? the economy.

Unfortunately, the only thing the Fed will set on fire is its paper currency â?? and that’s why ultimately, gold will not be suppressed for long. We are now approaching June. By the end of August or early September, the next leg up in gold’s price will begin. That’s only three months away.

Yet, for right now, gold is still vulnerable. Indians are no longer buying much and have started to sell. Jewelers are having a hard time because their gilded adornments are getting too expensive for cash-strapped customers. Investment demand is up world wide, but the word still hasn’t gotten around to western mainstream investors quite yet â?? and that is what must be avoided at all cost, even if such avoidance amounts to nothing more than delays.

Gold has only surpassed short term trend lines 1 and 2. Number 3 is still a ways off, which means gold has not yet surpassed its most recent high. At the same time it is struggling to stay above its 50-day moving average. The more vulnerable gold is, the easier it is for the powers to effect a swift and severe downward move. In view of the current Dow-situation, their window of opportunity is very small.

Expect them to first try another artificial boost to the Dow by extensive futures buying on Monday morning. Maybe some concocted news of concocted economic data will be published. Most likely, that won’t work, though.

That’s why gold will be whacked, again…”

 I encourage you to not get caught in suckers’ rallies, just like when gold broke thru $1000, never to see the earth again. We know how that turned out. Personally, I don’t mind if you invest in this stuff or not. It is helpful to see how the manipulations correlate and what it means to futures trading. The good part about precious metals is that you can have them in your hot little hands. The bad news is that you have them and someone bigger and badder may want to take it away.

If I were an evil overlord and wanted to make sure the plebs didn’t keep gold, I’d try my best to really, really crash it, let’s say down to $500/oz to put so much doubt into the public’s mind that they figure it is again worth the risk to go into stocks and mutual funds. Then those can fly to the sky, while I, as evil overlord, dump my holdings at the top and pick up cheap gold and hoard it all in my evil overlord fortress. This sounds like a James Bond movie, hurray! I thought it’d be a boring Wednesday.

Former Fed economist: Fed using the wrong playbook

Wednesday, May 28th, 2008

Full story here. From the nakedcapitalism.com site, another recent favorite of mine.

Former Fed Economist: Central Bank Using Wrong Playbook

Listen to this article 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.”

Weekly Commentary May 26-30

Sunday, May 25th, 2008

What a difference a week makes. On Monday, the S&P 500 was at 1435. On Friday…1385. So what happened? In a word…Crude. Crude went to $135 a barrel and drove gasoline above $4.00 in many parts of the country. This is going to be the least driven Memorial Day weekend in a very long time. And surprisingly, the week before the holiday, crude oil inventories were down 5 million barrels. Where did the oil go? For the past 4 weeks, crude oil inventory had been rising, then suddenly, 5 million barrels are gone. How is that possible? (more…)

More on the real reason behind high oil prices

Thursday, May 22nd, 2008

Full story here. More from F. William Engdahl on the machinations of oil-based geopolitics. I suggest you read his other offerings as well (the one on Monsanto and GMO seeds will make your hair stand up on end). (more…)

EU to ‘protect’ citizens from capitalism?

Thursday, May 22nd, 2008

Full story here. Use ShadowTraders to protect yourself from busybody bureaucrats, sleazy brokers and any of the other pitfalls of capitalism. (more…)

Moody’s error gave Aaa rating to debt products

Wednesday, May 21st, 2008

Full story here. (more…)

It’s a numbers racket

Wednesday, May 21st, 2008

Full story here. A snippet of a Wizard of Oz theme writing up a new book by Kevin Phillips, which I’d recommend reading. If only we could click our heels and be back in Kansas, but the ruby slippers got repo’d. (more…)

The Shape of US Populism

Wednesday, May 21st, 2008

Another in a series of articles by economist Henry CK Liu. It reads almost like a detective novel, which is what it takes to discern an answer from people who speak with forked tongues. Use ShadowTraders to make your money fast, and don’t get ‘forked’.

“…The Fed intervention was in fact done amid confusion. Information since available on the details of the Sunday, March 16, rescue suggests that the Fed failed to notify Bear Stearns of its abrupt decision over the weekend to make discount window borrowing accessible to investment banks.

Had Bear Stearns been armed with knowledge of the availability of that critical option, it might have gone to the Fed discount window for funds rather than to negotiate with JP Morgan, which as a commercial bank had ready access to the discount window. The Fed insistence on JP Morgan capping the offer price of $2 per share to Bear Stearns was to bring home the impression that the rescue was not a bail-out of Bear Stearns, but a move to prevent a market meltdown from counterparty effects from a Bear Stearns default.

But the deal neglected the fact that Bear shareholder approval was necessary for the proposed transaction with JP Morgan and that such approval was unlikely at an offered price below what Bear shareholders could get in a bankruptcy filing. In the end, JP Morgan had to offer a new price of $10 per share to acquire 40% of the voting shares to ensure Bear shareholder approval, thus diluting the Fed effort to avoid any appearance of bailing out Bear Stearns shareholders. It was anything but a deal “done very well”.
Back in 1987, when the Dow Jones Industrial Average dropped by more than 22% on October 19, then Federal Reserve Board chairman Alan Greenspan and E Gerald Corrigan, at the time president of the New York Federal Reserve, executed a cleaner deal in strong-arming all the major banks not to withhold payments for fear of counterparty default because then the number of counterparties was small and their identities were known. In 2008, the number of counterparties was huge and their identities obscured by complex structured finance.

In 2008, Greenspan’s successor, Ben Bernanke, and present NY Fed president Tim Geithner executed a messy deal of questionable need. The Fed as a lender of last resort is mandated to support commercial banks and deposit-taking institutions that are critical parts of the retail payment mechanism if failing to do so threatens serious negative externalities in the entire market through contagion effects, such as classic bank run by depositors, even then only if the banks in question are otherwise solvent.

Other institutions are also deemed too important to fail because they play a key role in the wholesale payments, clearing and settlement system and if their failure would cause systemic consequences. Institutions are provided with liquidity on non-market terms or bailouts by the Fed when they face a cashflow problem, but not insolvency, because their failure would trigger a systemic chain-reaction of contagion effects on the entire market.
Bear Stearns did not fall within these criteria. It was not a deposit-taking institution. It played no role in the retail payment mechanism and was of no significance to the proper functioning of the wholesale payments, clearing and settlement system. There was no case for a Fed rescue for Bear Stearns except the risk of systemic contagion effects, in which case the Fed should have nationalized the investment bank at zero price per share and prevented it from defaulting any counterparty obligations. At most, the Fed could grant Bear Stearns shareholders the right to post-receivership claims on surplus value after the Fed as trustee had satisfied all Bear obligations.

Geithner told a US Senate banking committee: “On the evening of Thursday, March 13, 2008, I took part in a conference call with representatives from the Securities and Exchange Commission, the Board of Governors of the Federal Reserve and the Treasury Department. On that call, the SEC staff informed us that Bear Stearnsâ?? funding resources were inadequate to meet its obligations and that the firm had concluded that it would have to file for bankruptcy protection the next morning. Absent a forceful policy response, the consequences would be lower incomes for working families, higher borrowing costs for housing, education and the expenses of everyday life, lower value of retirement savings and rising unemployment.”

Under questioning by committee chairman Senator Christopher J Dodd, Democrat of Connecticut, both Fed chairman Bernanke and Geithner said they played no role in setting the price, which was one of the most controversial elements of the deal…”