Economics

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15
Dec 10

Market Discipline and Sustainable Growth

Many of the Federal Reserve maneuverings are well documented and analyzed: asset purchases of junk value mortgage backed securities, QE1 and QE2. Many of these strategies exceed the Fed statutory mandate of ensuring stable prices and full employment raising  political and even constitutional problems.

Less discussed are two economic consequences:  destruction of market discipline and weakening sustainable growth.  Administration economic policies have prompted unlimited and bogus guarantees to various enterprises.  Moreover, these policies have intruded in the marketplace, backstopping and buttressing private companies that ought not to be supported.

Destruction of Real Risk Taking

In A Desperate Fed – QE2.0 is a Hail Mary Toward the Wrong End Zone, Atlantic Capital Management (ACM) brilliantly dissects QE2. (Note-the report should be read in its entirety at Zero Hedge).  ACM posits that the Fed’s objective is to create negative real interest rates, thus making safe investments expensive.  Worse, the Fed hopes to promote spending over saving, and risk taking over liquidity in order to “stimulate” the real economy.  ACM characterizes this policy as “forced distortions of normal economic functioning.”

The ACM report breaks down and details the harm:

  • Growth in household spending will be more difficult through increases in energy and food prices more than offsetting the effect of lower mortgage payments through lowered interest rates.
  • QE2 may aid US exports, but at the same time will lower the value of the US dollar.  But who will buy our goods?  Imported Chinese goods will be more expensive, without American goods or services being sold to the Chinese middle class.  Moreover, our largest import, energy, will become more expensive.    Exporting to Europe seems a long shot with the EU’s current budgetary problems.  And the threat of a currency war remains, as all nations simultaneously seek to devalue their currencies.
  • Without much final demand, most of our “recovery” has focused on inventory building, with little corresponding pull from consumers purchasing goods.
  • The government controlled auto industry and financial arm, Ally Bank, has again fostered auto industry inventory buildup with lack of the “pull” of final sales.  The suspicion is that building inventory is related to the highly publicized and promoted GM IPO to justify government intervention.
  • Zero interest rate policies have discouraged new bank loans.  Instead, banks make profits from borrowing short term at a virtual zero cost and purchasing longer dated Treasury securities.  Similarly, smaller banks are reducing their loan portfolios and not making perceived risky loans to businesses and consumers.

In sum, the economy is devoid of the real risk taking that produces a sustainable recovery and a thriving business environment.

Destruction of Market Discipline

ACM’s prescription for the ailing economy: market discipline.  What is needed to dispel the economic uncertainty which discourages productive investment and real risk taking:

…is for businesses and investors alike to know without any sliver of a doubt that government and businesses and consumers are being forced to regulate themselves.   With the threat of illiquidity and bankruptcy never far away, economic actors will behave as if their survival depends on maintaining sound and sustainable habits. And that brutal market discipline is what makes investors less uncertain about investing, makes banks less uncertain about lending to households, makes businesses less uncertain about future growth.  Discipline leads directly to long-term sustainability and high quality wealth. See A Desperate Fed – QE 2.0 is a Hail Mary Toward the Wrong End Zone

The Fed and the government have opted for QE2, government guarantees, zero interest rate lending to favored banks, and nationalization of businesses over market discipline.  They have removed market enforcement “in favor of political hocus pocus, ‘nobody loses’ nonsense.”  Market discipline would be even a greater economic tonic than increased government regulation.

Sustainability

Separately, economist John Hussman attacks the Fed also on the grounds of undermining a sustainable recovery:

From my perspective, an “economic recovery” that requires a tripling in the Fed’s balance sheet, continues to average 450,000 new unemployment claims weekly, and relies on fiscal stimulus to counter utterly stagnant personal income, is ipso facto (by the fact itself) not a “standard” economic recovery. We have swept an enormous volume of bad debt under rugs, behind dams, and in back of curtains (not to mention in off-balance sheet vehicles such as Maiden Lane that were created by the Federal Reserve). But it is all effectively still there, festering. Meanwhile, our policy makers are trying to reignite financial bubbles in order to create an illusory “wealth effect” to propagate spending patterns that were inappropriate in the first place.  See The Cliff

Hussman believes that the stock market is richly valued with possible peak earnings.  Against a backdrop of higher inflation and diminishing ability of the government to intervene in markets, current corporate earnings are not sustainable.

A Seriously Unbalanced Economy

ACM and Hussman paint a portrait of a seriously unbalanced economy.  Government interventions and policy gimmickry only worsen our economic problems.  This could end one of two ways: our policy makers like Dr. Bernanke come to their senses, or external forces impose market discipline.

Perhaps the recent dramatic decline in the 10-year Treasury note is just such a market warning sign.  Until then smart investors should be very cautious when investing in the financial markets.

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24
Nov 10

Who Pays?

Early in my career I learned a valuable lesson.  In the course of a transaction, a question arose as to how much in pension assets were to be transferred to the buyer’s plan.  The pensions for employees transferring with the business were guaranteed and never in jeopardy.  The only question was who would pay to fully fund the pension plan, the buyer, one large company or the seller, another large company?

Much disinformation exists about the roots and causes of our current financial crisis.   Republicans blame Democrats, and vice versa.  Banks blame government policy, and vice versa.  Homeowners blame lenders, and vice versa.   The US government faults the failure of the Chinese to let the yuan rise in value.  The blame game is endless.

Government and its supporters have promised financial salvation in little understood programs such as TARP, TALF, QE1 and QE2.  By design these programs are meant to confuse and mislead legislators and the public.  The pseudo science of Federal Reserve and Treasury Keynesian technocrats has produced few if any promised results.  I believe that these programs have been deliberately designed to hide their designers’ true agendas: socializing losses among taxpayers, and allowing malefactors to keep profits and undeserved, out-sized executive bonuses.  Non-stop government propaganda again supports keeping the truth from the public.  See 1984 in 2010. What is missing from the discussion is the proper allocation of both blame and responsibility.  And logically flowing from that absent conversation would be the fundamental question now:  who should pay?

Ireland’s current financial crisis foreshadows what could happen here.

Ireland Pays and Pays

After steadfastly considering a bailout, the Irish government stated that it intended to negotiate a bailout package with the EU and the IMF.  Reports indicate the package could exceed $85 billion Euros ($149b).  The government would take over one bank and take a majority stake in another bank.  Report Asia One News

The central bankers have extracted financial concessions from the Irish government.  Ireland must operate under an austerity budget with increased property and taxes on the wealthy coupled with a ten percent or more budget cut each year for the next four years.  It is expected that the current government will be dissolved and new elections held.

How Did Ireland Get Into This Mess?

Like many economies, Ireland’s recent prosperity was built on a real estate boom.

Much of its growth was built around the property market, but since 2008 this has suffered a dramatic collapse.

House values have fallen by between 50% and 60%, and bad debts – mainly in the form of loans to developers – have built up in the country’s main banks. This almost wrecked the institutions, leaving them needing bailing out by the government at a cost of 45bn euros (£39bn; $60.1bn).

This has opened a huge hole in the Irish government’s finances – which will see it run a budget deficit equivalent to 32% of GDP this year. See BBC Q&A: Irish Republic Finances

When the property market collapsed the government stepped in to save its banks:

As several of the banks have been part-nationalised, most of their massive debt is now actually government debt.

And the great majority of this debt is owed to foreign lenders, which the Irish banks (and therefore the Irish government) simply cannot afford to default on. See BBC Q&A: Irish Republic Finances

Thus, the government saved foreign holders of Irish debt and the private Irish bank bondholders.  The losers are the Irish taxpayer and their economy.

The US Taxpayer Also Pays and Pays

Seemingly innocuous words and phrases such as “bailout,” “government guarantee,” “quantitative easing” or “Troubled Asset Relief Program” hide the true nature of the governmental objective.  Whether it is Bank of America, General Motors, General Electric, Citicorp or Chrysler, these are enormous businesses that made bad decisions.  The litany is long and undistinguished: lending irresponsibly (no income, no job loans); using too much leverage (Bear and Lehman); selecting the wrong products (SUVs during the oil price crisis) or misleading accounting (GE pension accounting).  All of these were private businesses pursuing profits.  Shareholders and bondholders of these enterprises willingly invested, hoping for share appreciation, dividends and interest payments. They understood the risk that businesses could go bankrupt, or dividends and interest suspended.

The rallying cry of “save the banks” or “save GM” is really a way of transferring losses from the business and its investors to the taxpayer.  With QE2 we face the prospect of the taxpayer/consumer paying the hidden tax of higher inflation.  Just after QE2 was announced the Fed revealed its true purpose:  saving the banks yet again by requiring a second round of bank stress tests.

A Moment of Morality

Karl Denninger provides an unvarnished view of the morality of the Irish bailout, the parallels to the US and what must happen:

Looting becomes impossible to sustain eventually.  Now the Irish Government thinks that the Irish people should pay for being robbed!

It’s not enough to get ripped off – now the government wants to tax the people to pay for the stealing that they allowed to happen in the first place.

This is no different than what happened in Greece or the United States for that matter, and it will continue to happen until the people stand up and refuse to accept it.

Further, and far more importantly, shifting the bad debt around doesn’t get rid of it.  It simply tries to impose the cost on the nation as a tax – a tax that cannot be paid, and won’t be paid.

To the Irish people: You must choose between putting a stop to this – no matter what it takes to enforce that demand – and literal debt peonage and servitude imposed upon you for the sins of a handful of rich bastards that robbed all of you. See Another Lie Exposed: Ireland

Behind all these fancy financial terms and maneuverings there is a moral dimension.   Judeo-Christian theology is based on concepts of reward and punishment.  Capitalism follows the same path.  Rewarding financial elites who misbehaved, and punishing hardworking, prudent taxpayers, runs contrary to a moral core.  The programmatic maneuverings blur the distinction between right and wrong.  Further, from an economic viewpoint it encourages moral hazard, that is, risk taking without fear of punishment.  Ultimately, the populace refuses to accept this new burdensome status quo and real trouble starts.

Until now, we in the US have accepted the status quo that we must save banks, auto companies and insurance outfits and further burden taxpayers.   Has anyone in authority explained why, or offered any other alternatives?  If we don’t ask these questions soon, we face a weekend like Ireland is experiencing right now:  looking down the gun barrel of austerity and increased taxes or worse.

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17
Nov 10

Unintended Consequences of QE2

In several previous posts we have discussed why QE2 is wrong-headed and potentially disastrous.  Let’s look at some of the unintended consequences since its announcement on November 3.

Bond Market

The stated goal of QE2 was to lower interest rates to stimulate spending.  The methodology was the purchase of intermediate term (5-15 years) Treasury securities.  Looking at last month’s performance of the Treasury market we see the following: five-year (current yield – 1.46%; one month ago 1.13%); ten-year (current yield -2.83%; one month ago – 2.51%); 30-year (4.23%; one month ago – 3.95%).  Source – Yahoo Finance, November 17th. Similarly, QE2 has triggered a crash in the municipal bond market. Yields have risen one-half percent since November 5th.  See Tax- Exempt Muni Bonds Tumble; Munis Continue Collapsing.   Increases in interest rates only favor banks over the real economy.  See Bond Market to Bernanke: F@&k You

The G-20 Meeting

QE2 has set off a currency war.  Our trading partners recognize that the Federal Reserve is flooding the world with US dollars.  To avoid importing inflation, these countries are contemplating erecting protectionist measures such as controls on imported capital.  Writing for the Asia Times, David Goldman captures the international turmoil:

…Never before has the world displayed the sort of public contempt for American policy that Germany, China and others expressed last week. Wolfgang Schaueble’s Spiegel interview last week describing quantitative easing as “clueless,” followed by Federal Chancellor Angela Merkel’s open attack on it during the G20 meetings, is entirely new, as is the Chinese and other Asian threat to simply keep dollars out.

The rest of the world is right and the Fed is wrong. QE2 is turning into Titanic I. The Fed has been exporting inflation through excess money creation; holders of dollars buy foreign currency, which forces foreign central banks to intervene on foreign exchange markets by selling their own currency. The foreign central banks create new local currency in order to buy the unwanted dollars and stabilize their exchange rates, which adds to inflationary pressures in their countries. They use the dollars they have bought to buy Treasuries.  See Exchange Controls and Deflation

Since countries such as Japan and China are major purchasers of US Treasury securities, alienating these purchasers will have the unintended consequence of further driving up US interest rates.  Mr. Goldman advises investors to avoid financial markets and stick to cash during this turbulent period.  In a disingenuous defense of QE2 William Dudley, President of the New York Federal Reserve Bank, claimed that: “I don’t think we knew that the dollar would necessarily weaken.”  Before implementing a controversial policy as QE2, shouldn’t Professor Bernanke and his cohorts have considered a falling dollar and rising commodity prices?

Cost Push Inflation

Living through the 1970’s, cost push inflation, where input prices compressed profit margins, was a major cause of the steep bear market in stocks.  Carefully massaged  current government inflation statistics need to be taken with a grain of salt.   In the real world companies as diverse as Kraft, Dean Food, Kimberly Clark and Campbell Soup have cited cost pressures, and reported poor quarterly results.  Kimberly Clark’s announcement cited its “highest-ever cost inflation…” And So it Begins… (Cost-Push Margin Compression)

The already beleaguered consumer is experiencing real world inflation at the checkout counter:

There might not have been a second round of quantitative easing, if Federal Reserve Chairman Ben Bernanke shopped at Walmart.

A new pricing survey of products sold at the world’s largest retailer showed a 0.6 percent price increase in just the last two months, according to MKM Partners. At that rate, prices would be close to four percent higher a year from now, double the Fed’s mandate. See Walmart: Inflation is Up

Stocks are now priced for perfection, the market’s way of telling us that investors have not considered rising inflation.  Declining profit margins will result in price earnings multiple shrinkage and a falling stock market.  See The Cliff

Misallocation of Capital

Since the US does not have exchange controls, the Federal Reserve cannot control where its newly created dollars are invested.  We have identified commodity speculation as one area for these funds.  See 1984 in 2010.  Further, money is being invested in emerging markets instead of the US economy.

Despite the belief that the Federal Reserve can create unlimited amounts of dollars, any society has limited capital resources.  These can either be invested wisely in new productive enterprises or squandered through speculation.  QE2 encourages the latter.  By artificially attempting to suppress interest rates the following occurs:

You get asset and credit bubbles – every time. The reason is simple: You have paid someone to perform an uneconomic activity.  That is, an activity which would not be performed by free actors in a free market system because it would inevitably lead to loss becomes profitable due to intentional interference in the market.

Maintenance of such a thing over time requires that “someone” be given incentives to perform non-economic activities.  This in turn fuels asset bubbles and that, in turn, leads to cycles of booms and busts. See Dishonesty All Around – Monetary and Security

Constant intervention in the economy will only lead to an inevitable bust.

Real Solutions

We are headed down a dangerous path: not only dangerous to our financial portfolios, but dangerous to our security.  Currency wars and protectionism lead to real wars.  The history of the 1930s is a dramatic example.

The ways out of this quagmire are painful.  They involve writing down debt, losses to bondholders, a failure of several “too big to fail banks” and a shock to the equity markets.  The pain will be great, but swift.   Remaining on our current course will be worse.

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6
Nov 10

Who Elected Ben Bernanke?

Everyone was focused this week on the mid-term election results.  Instead, we need to focus on another event just as crucial, but less understood by the American public.  Our unelected Federal Reserve Chairman, Ben Bernanke, launched QE2, the outright government purchase of US treasury securities.  The highlights:

-          The Fed is buying $600 billion of Treasuries (in the 5-10 year part of the curve) through mid-2011 and another $250-300 billion via coupon reinvestments, which they were going to do anyway.

-          The key “number” for the markets is that $600 billion figure, which is about $75 billion per month. See Rosenberg Joins Chorus of those Accusing Bernanke of Asset (Read Stock) Price Targeting

In Ben Bernanke’s self-justifying op-ed in the Washington Post, he explained his main goal:

This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion. What the Fed did and Why: Sustaining the Recovery and Supporting Price Stability

Dr. Bernanke remained confident he could reverse this policy at the appropriate time.

Nowhere in the Federal Reserve’s mandate is the elevation of stock prices.  Why not target wages and house prices?  Further, the Fed will be continuing to purchase tainted and suspect mortgage backed securities.  These securities are the heart of the current Foreclosuregate controversy.  The Fed is paying full value for a security that may be worth pennies on the dollar.

Unintended Consequences of the Policy

Focusing on stock prices is a little like ordering dessert before focusing on the nutritional value of the main course.  Before now, profits, dividends, discounted cash flow and future growth prospects determined what happened to a company and its stock price.  Now will we have Federal Reserve whim determine stock prices?  QE2 sets the markets up for another enormous bear market when the Fed stops QE2, or when stock-dislocating events overtake the Fed.

The unintended consequences are both legion and wealth destroying:  a weak dollar with surging import prices; soaring inflation in critical commodities such as oil and grain; compressed profit margins caused by higher input costs; further punishment of savers and retirees; trade wars with other nations whose economies wilt under a weakened dollar; and market-wide unstable speculation.

Karl Denninger in Bernanke’s Folly: The End Game explains that the Fed policy is essentially a gigantic hidden tax on businesses and consumers.   The end result will be a downward spiraling economy with businesses forced to lay off more workers to offset higher input costs – anything but the virtuous cycle Dr. Bernanke so fervently seeks.

The Constitution and the Election

Economic blogs are abuzz with QE2 analysis.  One particular area has been overlooked:  the break down in our political system and Constitutional protections.  Dr. Bernanke has usurped the taxing and budgeting authority of Congress.  QE1 and 2 put the taxpayer squarely on the hook for all Federal Reserve losses.  The Treasury is required to make good on Fed losses. So without writing a bill or holding a hearing, Dr. Bernanke launched his quantitative easing campaign and effectively dismantled the legislative process.  John Hussman warns of the danger of this reckless usurping of Congress’ role:

Now, since standing behind insolvent debt in order to make it whole is strictly an act of fiscal policy, one would think that under the Constitution, it would have been subject to Congressional debate and democratic process. But the Bernanke Fed evidently views democracy as a clumsy extravagance, and so, the Fed accumulated $1.5 trillion in the debt obligations of these insolvent agencies, which effectively forces the public to make those obligations whole, without any actual need for public input on the matter.” See Lessons from a Lost Decade

The Farce of the Mid-Term Elections

Tea Party activists are publicly miserable about out of control federal spending, bank bailouts and economic stimulus.  Before the new Congress convenes, Dr. Bernanke has unilaterally established economic policy for both Congress and the Administration.  Where is the outrage?  The Tea Party is so worried about liberty and free market capitalism, why have they not protested the dubious economic policies of an unelected new economic Czar, Dr. Bernanke? After all Dr. Bernanke and the Federal Reserve Governors have the same methods and goals as the former Soviet State Planning Committee.

More practically, why has Congress not held hearings and asked Dr. Bernanke some pointed questions:

  • Why did QE1 not work?
  • When you stopped QE1 in March of this year the markets fell and the economy retreated.  Is there a reasonable possibility that you can ever stop the QE policy without a market crash?
  • Have we just signed on to perpetual QE? If not, explain your exit strategy.
  • What will be the effect on our trading partners and will your policy lead to a currency war?
  • Please outline other risks in your policy and weigh these against the benefits.
  • How much of QE2 will go into foreign market speculation?
  • QE did not work in Japan for the last 20 years. Why will it work here?

Academic Theory

Dr. Bernanke is an academic theoretician. He taught at Princeton and now heads the Federal Reserve.  He has never run a business in the real world.  Quantitative easing is a theory and like all theories needs to be tested and proven.  We do not approve introduction of a new drug without stringent tests and proofs.  Dr. Bernanke is not playing with one drug; he is playing with our entire economy and political system.  QE1 in the United States and QE in Japan for twenty years  proved to be failures.  Why are we repeating failed strategy?

If he is going to target stock prices, then I still have some underwater stock options from a former employer.  Perhaps the good doctor could salvage my company’s stock too.  When one usurps normal market mechanisms, why not?

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29
Oct 10

Is the US Economy an Impaired Asset? Part II

In Part I we defined impaired assets and posited that the United States could be compared to a corporation so burdened.   Has ill-advised investment in multiple critical areas led US INC to be over-indebted with too limited income to repay that debt?   If the answer is yes, it also leads to other impediments to a genuine economic recovery.

Impediments to Economic Recovery

-          Discouraging savings – Productive enterprise springs from investment. Investment is predicated on a pool of savings to tap.  Zero interest rates and high taxes impede savings and investment.

-          Workplace regulations – We have overregulated the workplace.  Worker protections have been taken to an extreme.  We protect workers against a myriad of discriminatory behaviors: race, age, sex, national origin, pregnancy, gender, disability, union membership, marital status, veteran’s status and others.  While all noble goals, fearing expensive litigation, companies build costly compliance complexes and hesitate to discipline or discharge a poorly performing employee because of their protected status.

-          Environmental regulations – While initially a worthy goal, the overlapping state and federal (EPA) enforcement regimes and expensive compliance impose significant costs on American companies.   Foreign competitors face little pressure in this area and thus enjoy a competitive advantage.

-          Unionization – Through a myriad of seniority and work rules, breaks, and generous wage and benefit demands, unions impose a significant employer expense. These limit employer flexibility to respond to changed economic conditions.  The Administration has an avowed policy of trying to make unionization easier.

-          Litigation – Besides employment, environmental and labor litigation, employers face significant litigation risk in product liability and securities areas.  States with pro-plaintiff orientations have encouraged expensive and prolonged class action litigation.

-          Public Sector – Expanded public sector employment creates a dual problem.  First, the private sector is at a competitive disadvantage competing for talent against the higher paid, secure employment in the public sector.   Second, an expanded public sector imposes greater tax burdens across all levels of government, all of which costs are ultimately levied against private enterprise.

-          A Culture of Entitlements – Public policy over the past seventy years has built an expensive safety net of personal entitlements: social security, Medicare, Medicaid, unemployment, disability insurance, family leave, medical leave and others.  The Obama health care initiative only adds to these burdens.

The US is much like the mid-1990s telecom environment.   We are burdened by too many legacy costs.  We have too much debt, overvalued assets and insufficient income to pay back our debts or support our regime of entitlements and regulatory burdens.

Solutions

Technology and poor economic policy have earned US INC the dubious status of impaired asset.   One way the markets have been expressing this concern is through the decline of the dollar.  Moving up the economic chain, the next move would be for foreign governments to refuse to purchase US Treasury securities.

Looking at government attempts to export our way out of this problem through depreciating the dollar, Doug Noland of Prudent Bear comments:

Having de-industrialized and failed to invest sufficiently in productive capacity during our prolonged Credit Bubble, there will be no near-term exporting our way out of trade deficits.  And there is little evidence that help is on the way from the current elixir of massive non-productive government debt expansion and ultra-ultra-loose monetary policy.  While extreme government stimulus has stabilized incomes, consumption and imports, it has done little to promote the type of productive investment necessary to rebalance our maladjusted economy. See Rebalancing the World

It is time to end extend and pretend.  If US INC was subject to private business accounting rules, the banks would be forced to write down their “assets” (loans) to fair market value.  Yes, this would involve hardship upon the equity and bond holders of banks.  But failure to remedy this problem will only prolong the economic agony.

Further, any good business person would look at the cost side of the enterprise and try to reduce expenses.  We probably have gone as far as we can in cutting employment expense through layoffs.  We need to move up the chain to look at societal costs being imposed on business.  We are not about to throw out all environmental, workplace and other protections  However, we need to see how a more sensible regulatory scheme could reduce costs and minimize employer litigation costs.    Further, public policy needs to reduce public sector employment numbers and cut back entitlements.

We need to take these steps before our foreign investors and competitors impose them upon us.

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18
Oct 10

Ben Bernanke is a Dinosaur

Ben Bernanke and I are almost the same age.  In this age of public confessions, I have one.  Ben Bernanke and I are dinosaurs.  Ben and I went to school during the 60s and 70s.  During that period inflation was the major economic problem.   In 1973, the Arab oil embargo kicked inflation into high gear, and wages soared.  It was not until Paul Volcker pushed interest rates to nose bleed levels did the Great Inflation subside.  Mr. Bernanke seeks to solve 2010 problems with remedies that may have worked in 1973.  Since he is fighting the last war, I do not think he will be successful.

The New Reality

That was then.  We need to look at now:

  • Consumers are Deleveraging -  That means people are paying their debts, leaving less for discretionary purchases. Deleveraging is emblematic of a solvency problem, not liquidity.  Adding liquidity through QE2 (quantitative easing) does not remedy the solvency issue.
  • Demographic Trends – As the large number of Baby Boomers near retirement the trend shifts from spending to savings.  In a zero interest rate environment savings become vital.
  • Global Overcapacity – Overcapacity exists in key industries such as electronics, autos and steel.
  • Depressed Housing Prices – Housing prices remain depressed, removing a major asset which consumers borrowed against to enable personal spending.
  • High Unemployment – With so many people looking for work, employers feel little wage pressure (except for awarding large Wall Street bonuses).
  • Price Deflation – We see free or cheaper goods and services.  Can’t afford a movie ticket?  Choose from free movies on broadcast television or the internet.  Don’t want to spend money on a personal seat license, tickets and parking for an NFL football game? Stay home and watch it on television.  Want to see your favorite Broadway show? Wait for the tickets to be half price at TKTS.
  • The Internet as a Deflationary Force – From the time I began blogging and said the internet was a deflationary force,  its impact has only intensified.   Amazon and other online sellers are only exacerbating the decline in commercial real estate values.
  • Endless Amounts of Commercial and Industrial Space – The confluence of the depression in the FIRE (finance, insurance, real estate) economy; manufacturing and service jobs being moved offshore and the rise of online retailing has depressed the commercial and industrial real estate market.  A short trip around my relatively prosperous hometown reveals vacancies in everything from retail, apartment, warehousing, office, medical and manufacturing space.  New for sale and for lease signs seem to sprout up each week.

Rosenberg and Deflation

One thesis espoused in this blog is that we have inflation in everything we need (gasoline, basic foodstuffs) and deflation in everything we do not need (plasma televisions, vacation homes).  David Rosenberg debunks the fear mongering of inflationists.  See Rosenberg Still Sees Deflation Despite Consistent Speculative “Limit Up” Opens in Pretty Much Everything

Despite a speculative equity market binge, a weakening U.S. dollar, an economy that seemingly avoided a double-dip recession last quarter, and a renewed boom in commodity prices, what continues to prove elusive in this questionable recovery is pricing power in the broad retail sector.

How apropos it was for Ben Bernanke to utter the word “deflation”, not once, but twice, in his Boston speech this morning. Because fifteen minutes later, the September consumer price index data were released and showed a goose-egg — that is 0% — on the key core CPI measure (which excludes food & energy), for the second month in a row. In the past, this has happened but 7% of the time, so it is a rare enough…event to at least mention.

The headline rate of inflation, despite everything that has been thrown at it in terms of unprecedented monetary, fiscal and bailout stimulus, sits at 1.1% today. The core rate, proven to be the key driver for bond yields, which is why it is a focal point, is now running at a mere 0.8% year-over-year rate, the lowest since March 1961 when Ben Bernanke was in grade school.

While QE1 may have worked in terms of bringing mortgage and corporate spreads out of orbit and preventing an all-out contraction in the money supply, it has not managed to stop the economy from sputtering, the unemployment rate from remaining near 10%, and underlying inflation from grinding lower. Consider for a moment that when the Fed first hinted at QE1 in December 2008, the jobless rate was 7.4% and the core inflation rate was 1.8%. See Rosenberg Still Sees Deflation Despite Consistent Speculative “Limit Up” Opens in Pretty Much Everything

Rosenberg supports the thesis that inflation in discretionary purchases has declined or remain unchanged.

While commodity prices have been firming of late with the downdraft in the dollar, what is key is that we are seeing discernible deflationary trends evolve in many segments of the service sector. Movies, personal care services, hotels, delivery services, and education all deflated last month — education deflated at its fastest pace ever…

Moreover, despite what the price of cotton is doing, clothing prices are still in decline, and other “goods” such as furniture, appliances, audio-video equipment, motor vehicles and home improvement all posted price declines last month as well.  See Rosenberg Still Sees Deflation Despite Consistent Speculative “Limit Up” Opens in Pretty Much Everything

The Last Voyage of QE2

Ben Bernanke is determined to institute a second round of quantitative easing (QE2) through direct purchases of Treasury securities.  The goal is to induce inflation, but the evidence clearly does not support that outcome.   Good luck, Dr. Bernanke.

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11
Oct 10

You Say You Want a Revolution Part II

In my last blog we described the seeds of the next American revolution.  See You Say You Want a Revolution Part I. Paul Farrell outlined the incompetence of the Republican and Democratic parties and the greed of Wall Street.  One institution targeted for dissolution is the Federal Reserve:

…the Fed cannot survive. Why? Not because the Fed is at the center of America’s economic problems, beyond repair, a dying institution. But because the Fed is a pawn of Wall Street’s Happy Conspiracy, which is incapable of seeing the train wreck that it set up.

This out-of-control, conspiracy of greedy Wall Street bankers, corporate CEOs, corrupt politicians and Forbes 400 billionaires will, in the near future, trigger the third catastrophic meltdown of the 21st century, a collapse that paradoxically can transform America into a new, stronger post-capitalist economy … but only after a revolution and brutal class warfare. But few will talk about what’s coming.  The Fed is Dead, Maybe by 2012

You Should Always Tell the Truth

Nassim Taleb, author of The Black Swan, believes that the Federal Reserve will not exist in 25 years.   Mr. Farrell demurs, warning that it will happen much sooner as fallout from the second American Revolution.

It’s inevitable: Wall Street banks control the Federal Reserve System; it’s their personal piggy bank. They’ve already done so much damage, yet have more control than ever.

Warning: That’s a set-up. They will eventually destroy capitalism, democracy, and the dollar’s global reserve-currency status. They will self-destruct before 2035 … maybe as early as 2012 … most likely by 2020.  The Fed is Dead, Maybe by 2012

Taleb uses two simple formulas to determine the veracity and competence of our politicians, business leaders and academicians: do they tell the truth (not half truths or other deceptions) and prior to 2008 did they foresee the financial crisis?

Taleb’s view is that you cannot trust anyone in government. He cites two US Treasury Secretaries:  Timothy Geithner and Henry Paulson.  Geithner cherry picks dates and misleads about the economic recovery.  Paulson warned President Bush about the financial crisis in 2006, but failed to warn the public.  Worse, Paulson’s public declarations in 2007 and 2008 led the investing public to believe in the strength of the US economy and that the housing bubble was well contained.  The Fed Chairman, Ben Bernanke, made the same deceptive statements.

Turning to economists, Taleb focuses on Paul Krugman who never anticipated the financial crisis.  Moreover, his economic proscription of exchanging private debt for public debt only creates moral hazard. Our grandchildren will be burdened with our debt.

He heaps special scorn upon President Obama and the Senate for reappointing Bernanke after his miserable track record.  Bernanke remains in his position despite failing to revive the economy.  Taleb believes that Bernanke is a shaman, “whose methods make ‘homeopath and alternative healers look empirical and scientific.”  The Fed is Dead, Maybe by 2012

A Recipe for Collapse

Charles Hugh Smith in The Recipe for Collapse,  supports Mr. Farrell’s proposition that we are heading for another collapse.  The following mixture all but assures a coming collapse: central planning (the Federal Reserve); encouraging speculation through reducing the safe return on capital to below the inflation rate (zero interest rate policy); creating bubbles in real estates, stocks, bonds and commodities (e.g., nine million vacant homes); corrupting the power elites to continue financial skimming and speculation (watering down the financial reform bill); concentrating wealth and power in a small elite; promoting debt and leverage so that the economy will collapse with ever increasing amounts of debt; continuing to promote failed economic remedies (stimulus, zero interest rates); making corruption, cronyism, embezzlement, insider trading and fraud endemic; concentrating media in a few hands; devoting an increasing share to internal security or military adventures; making an ever greater number of laws hampering productive enterprise, and raising the hopes of the general population that they can get rich quickly (housing, stocks) only to have their dreams deflated or dashed.

So You Want a Revolution

The Administration, the media and the financial elite are unwittingly marching down the path to revolution.  What I find most disturbing is that we re-cycle and give prominence to the same public figures that got us into this mess:  Ben Bernanke at the Federal Reserve, Timothy Geithner formerly of the Federal Reserve Bank of New York and now Treasury, Barney Frank in Congress, Paul Krugman at the New York Times and a host of others.   We need some new thinking and directions, not a repetition of the same tired nostrums which have not, and probably never, worked.

So we are at the crossroads of a revolution.  Revolutions do not have to be violent.  But it would take revolution to upset the smug, intellectually and morally bankrupt status quo.  We need some leaders who regularly speak truth.  Only when we make a complete break from the past, do we have the possibility of a brighter future.

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6
Oct 10

Why is Charles Schwab the Only One Concerned About Zero Interest Rates?

Charles Schwab, father of discount brokerage, again raised the insanity of a zero interest rate policy.  Writing in the Weekend Edition of the Wall Street Journal, Enough with the Low Interest Rates, Mr. Schwab succinctly states his views:  the Federal Reserve’s experiment with near-zero interest rates,  begun after the credit crisis of 2008, has now become counterproductive.

As a temporary fix it served its purpose. It was an emergency antibiotic appropriate for the illness. But continuing with the experiment is disfiguring the economy and fueling doubt. Healthy economies find their own equilibrium based on market forces of supply and demand. When people don’t think market forces are driving the economy and believe instead that it is being driven by excessive government intervention, they don’t take the risks an economy requires.

It’s time to stop the experiment and return to monetary normalcy.

Interestingly, Mr. Schwab wrote an op-ed piece six months ago for the Journal on low interest rates; Low Interest Rates are Squeezing Seniors.  His argument: “[t]oday’s historically low interest rates may be feeding banks’ profitability, but they are financially starving our seniors.” Despite his first article, the interest rate on the benchmark 10-year Treasury bond has declined from just under 4% to just under 2.5%.  Source Yahoo Finance.  Perhaps in order to achieve a better result, Mr. Schwab should write on weekdays when Mr. Bernanke can read the Journal at his Federal Reserve office.

In the most recent op-ed, Mr. Schwab makes the following points:

  • Near zero interest rates weigh on both business and consumer confidence.
  • Banks are able to make money through the carry trade (borrowing short term money at low interest rates and buying higher yielding, longer dated treasury securities).
  • The carry trade impedes making loans in the real economy and slows the velocity of money.
  • Savers, especially retirees are hurt, with diminished spending power.
  • Society is driven to seek out riskier investments to try to improve yield.
  • Job growth, consumer spending, business investments are not improving.
  • Small business is unable to borrow since banks merely “sit on” excessive reserves.
  • Banks are afraid to lend for 30-year mortgages since they are fearful of a future increase in interest rates once this “temporary” zero interest rate regime ends.

Mr. Schwab believes that the economy is ready to heal, if institutions just let interest rates find their market-based level.

It Is More Than Confidence

Mr. Schwab identifies that low interest rates are a problem.  He views the problem as one of confidence.   That is, the Federal Reserve, by keeping interest rates artificially low, signals to the markets that the economy is weak and in need of the perpetual stimulus of low interest rates.  In contrast, I believe that we have a different problem, constant government tinkering and meddling in the economy.  The economy could heal if the Administration and the Federal Reserve would stop picking the economic winners and losers, and let market forces perform their historical function of allocating capital and punishing the profligate.  Instead, the Federal Reserve has chosen the following path:

  • Favoring banks over savers
  • Preventing creditors from suffering any losses, not permitting the bankrupt to go bankrupt
  • Artificially propping up the housing market
  • Artificially propping up the stock market
  • Depressing the yield on virtually all debt instruments

This is not just supposition; it is confirmed in an October 4 speech by Brian Sack, Executive VP of the Markets Group at the NY Federal Reserve Bank.  Through manipulating interest rates, Mr. Sack believes that he has found the magic cure for the economy: “[t]hese effects on Treasury yields appear to have been transmitted into lower rates on private credit instruments and higher asset prices more broadly.”   Managing the Federal Reserve’s Balance Sheet. The Federal Reserve believes that it can levitate stock market and housing prices with no consequence.

Hubris

“Whom the gods would destroy, they would first make mad.” Medea by Euripides

On Monday October 4, Mr. Bernanke made two speeches and Mr. Sack made one.   It is not a matter of confidence impeding the economy as postulated by Mr. Schwab.  First, it is the hubris of the Federal Reserve that it can control a $14 trillion economy and $50 trillion dollars of US assets through zero interest rates or asset purchase programs.  They may have better luck trying to control the tides.  Second, it is crony capitalism, where politically connected financial institutions, public sector unions and unionized industries such as auto manufacturing are favored to the detriment of savers and Main Street.   Finally, it is the refusal to allow debt to be written off, homeowners default, banks and companies fail, or the stock market to fall to cleanse the system.

As we have discussed before, all irrational structures fail.  See Why Do all Irrational Structures Fail? Unfortunately in capitalism there is no free lunch; artificially bolstering the markets will fail too.   Hardships occur. But the self correctives of lower prices for housing, stocks and bonds and higher interest rates are the only way to re-start the economy.  More than financial chicanery, a return to the basics will restore the confidence that Mr. Schwab seeks.  Mr. Schwab should not be the only one criticizing Federal Reserve policy.

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13
Sep 10

One Year of Blogging

After one year of blogging on economic, corporate, social and political issues, I thought I would try to make sense out of trends:

  • The rule of law has taken a major hit in the United States.  Some examples of this phenomenon are the unlimited guarantees to Fannie Mae and Freddie Mac, guarantees to banks and favored companies, and Federal Reserve purchases of mortgage backed securities. See Shredding the Social Fabric
  • We have exposed monetarist and Keynesian economic solutions as intellectually bankrupt.   Amazingly, the decision makers who believe in these theories have not been fired.   More amazingly, with all the evidence that we are still mired in a deep recession, we keep trying the same tired strategies.
  • Obama’s economic acumen and performance has been disappointing.  His monomaniacal focus on a health care bill that the country cannot afford hampers new hiring.  Worse, it enriches the insurers and big pharmaceutical companies.  And worst, he has wasted important political capital.   Further, with his tepid financial reform bill he missed a real opportunity to address citizens’ concerns about the excessive power of Wall Street.
  • Congress should be tried for malpractice.   Members of Congress did not read the financial reform or the health care bill.  Nancy Pelosi had the temerity to implore Congress to pass these bills so she and the public could find out what is inside.
  • The Executive Branch and Congress appear to be for sale to the highest corporate bidder.  Industry lobbyists essentially control Congress and the executive branch.
  • Where has leadership gone?  Congress used to produce real leaders: Everett Dirksen, Hubert Humphrey, Robert Taft, William Fulbright, Sam Nunn, Henry Jackson and others.  We may not have agreed with their views, but they were serious, well-respected, independent minded individuals.   We never doubted that these leaders put the country’s interests first.  The Executive Branch also produced great leaders.  Compare past Secretaries of the Treasury– Andrew Mellon, Douglas Dillon and Lloyd Bentsen– to the flawed and unworthy Timothy Geithner.
  • Political clout, not reason and merit, determine current policy.   GM, GE, the banks, municipalities and others were saved from extinction because of campaign contributions and union ties.  Picking winners and losers based on political considerations generates cynicism and undermines the guarantee of equal protection under our laws.
  • Zero interest rate policies encapsulate everything that is wrong with our current system.  We have impoverished the thrifty and the prudent and rewarded the profligate and the incompetent.   On the backs of savers, we have bailed out the banks.  This is particularly heinous because the victims of this policy are the retired and elderly who have watched their savings dwindle and their retirement lifestyles vanish.  An economic policy which encourages savers to speculate in the stock market or buy junk bonds is unconscionable.
  • Promises of better corporate behavior after passage of Sarbanes-Oxley have been false.  Congressional pressure on the Financial Accounting Standards Board to suspend mark to market accounting has created the “extend and pretend” economy.  We no longer properly recognize losses; banks know this and refuse to lend knowing they can obfuscate the true state of their balance sheets.  More damaging, the true financial condition of the banks leads investors to purchase equities essentially under false pretenses.  Many of the bank stocks have declined significantly from their peaks.
  • Culturally, extend and pretend has permeated beyond our financial culture.  BP and the government hid many facts about the Gulf oil spill.     Even now we probably do not know the full extent of the damage and independent researchers have been denied access to information.
  • Corporate Boards of Directors are still not paying attention. In the case of Mark Hurd the violation of corporate financial policies was rewarded with a generous severance package.  (Trust in a corporation is predicated on the integrity of their financial policies.)   His unemployment did not last very long, as Oracle recently named him co-president.  Did character matter to Oracle or its Board?  Does anyone have any shame anymore? Was the HP Board afraid to fire Hurd for cause?
  • We are becoming a divided country.  The government protects the rich and the poor.  The middle class is being economically squeezed by inflation in basic goods, unemployment or the threat of it, rising health care and education costs and diminished retirement savings.   All these things plant the seeds of political upheaval.
  • Finally, blogging serves an important purpose in presenting an alternative viewpoint to mainstream media.  Blogging is the antidote to endless economic cheerleading by paid media and government officials. Blogging has become the new millennium’s populist forum. For example, bloggers steadfastly maintained that we have not emerged from the recession/depression and there were never any “green shoots” of recovery.  The mainstream media now feigns surprise at reports of economic weakness and prognostications of a double dip recession.

Watching the passing parade of economic and political folly is both depressing and exhilarating.  Depressing because we believed there would be a change in business-as-usual Washington.  Exhilarating because the public is awakening to the fact that they have been misled.  And that augers a change in the status quo and perhaps a better tomorrow.

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6
Sep 10

Labor Day 2010

In an earlier and different time in America, Labor Day was celebratory, a transition from the leisurely light-hearted summer to the more serious autumn, and a return to the busy rhythm of school.   This year, Labor Day is a grim reminder of an American economy that cannot produce new jobs.  How did we get here and how do we get out of this mess?

Lies and Statistics

Friday, the stock market rallied on a better than expected unemployment report.  But behind the statistics there was little reason for optimism.  Mike Larson of Money and Markets analyzes Friday’s Labor Department report:

  • The economy shed another 54,000 jobs in August after losing a similar number in July and 175,000 in June. If you strip out the impact of the Census, you see that private industry created a paltry 67,000 jobs last month. That’s far, far too low to bring down unemployment.
  • Speaking of unemployment, it rose to 9.6 percent in August from 9.5 percent in July, a three-month high. And if you include all unemployed and UNDERemployed workers, you get a whopping 16.7 percent of American workers who are discouraged, only able to find part-time work because full-time work isn’t available, and who have just given up looking entirely!
  • Then look at who’s hiring and who’s not! Education and health care continues to see reasonable growth, with 45,000 jobs added. But hiring health care workers to take care of an aging population isn’t going to drive your economy long term. See America’s Unemployment Nightmare

The problem is that higher paying economic sectors are either not growing or continuing to lay off workers:

Economically sensitive sectors are showing virtually no growth, with only 13,000 jobs added in leisure and hospitality and 19,000 in construction. Manufacturing shed 27,000 workers … trade and transport lost 9,000 jobs … and financial firms cut workers for the fourth month in a row. In fact, the “diffusion” index which tracks how many industries are adding jobs versus how many are cutting jobs sank to 53 from 56.7.

And let’s step back and look at the big picture for a minute. We’ve added just 650,000 jobs in the first seven months of 2010. We lost 8.4 million jobs in the recession that started in December 2007. It would take several YEARS to get back to even at this pace. See America’s Unemployment Nightmare

A Look at the Real World

Much reporting of the Great Recession (Depression) comes from New York, Los Angeles or Atlanta based media.  Few of these outlets examine what is really going on in most of the country. Michael Panzer in Financial Armageddon looks at who is really being hurt:

  • Two million workers over age 55 are looking for work.  Over a million have been out of work for six months or longer.  The unemployment rate in this age group is 7.1%, the highest rate since the 1940’s.
  • A sector of the work force denominated as “middle-skill, middle-wage” has been decimated.  These are entry level white collar jobs such as administrator or secretary, or blue collar jobs such as assembler or machine operator.   Instead of finding good paying jobs, these workers are taking massive pay cuts to work as wait staff or other service personnel, or health aides in homes or health care facilities.
  • Among young blue collar workers employment has fallen 18%.
  • Middle class and upper middle class managers and professionals are seeking assistance from social service agencies due to unemployment or underemployment.   Former donors to these agencies have become recipients of their services.
  • A recent Rutgers study found “that 73% of Americans have either been unemployed themselves (14%) or saw an immediate family member (12%), another member of their family (30%) or a close friend (17%) lose a job.” See Another Installment of ‘Scenes from a V-Shaped Recovery’

Why Intractable Unemployment?

Explanations of “we couldn’t see this coming” or “it was just bad luck” mask several reasons for our current state of unemployment:

  1. Technology is a “game changer.”  Technology will replace many lower skilled administrative and manufacturing jobs (postal workers, telephone operators, computer operators, etc).  See e.g. 23 Occupations That Will Never Recover from the Great Recession
  2. Outsourcing – Closely allied to technology is the outsourcing of jobs to other countries.  With high speed telecommunications, sophisticated software, larger faster ships and lax foreign labor and environmental standards, American companies will continue to outsource jobs.
  3. Financial Excess- The combination of financial engineering of mortgage back securities,  subprime loans and a zero interest rate policy misallocated capital to the housing sector.  With the inevitable housing bust, we destroyed construction jobs and supporting professions such as law, mortgage banking, appraisal, insurance brokers and real estate brokerage.  Moreover, until bad debt is completely recognized and restructured or defaulted upon, the banks will continue limiting new loans.
  4. Government Policy – Small business owners are the growth engines for new jobs.  Faced with new health care mandates and the prospect of heavy fines, new business owners are reluctant to expand.  A full description of the problem is outlined in “Angel Heart” and Obamacare.

Many of these issues were identified in The New Reality: Permanent Job Loss and Why This May Be Worse than the Great Depression.

Wall Street spokespeople and the Obama Administration have been less than candid with the American public about what the real prospects are for reducing unemployment.  While there is a certain inevitability about technological progress, poor government policy is not necessary.  We need to stop some of the self-inflicted wounds of zero interest rates, poor tax policy, wasted stimulus and new mandates, all of which impede economic growth and stymie new hiring.

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