Yesterday's Wall Street Journal (8/30/11) reported on P. C11 that a hedge fund manager named Mark Brodsky asked the International Swaps and Derivatives Association to rule that a "bankruptcy credit event" (which triggers a dealer's obligation to pay under a credit default swap) has occurred for a company that hasn't actually entered into bankruptcy proceedings. A lot may ride on the response to this request. Brodsky runs a hedge fund called Aurelius Capital Management LP, which holds credit default swaps for Texas Cooperative Electric Holdings Co. According to Aurelius Capital, Texas Cooperative Electric is insolvent and has admitted as much. Aurelius Capital would like to collect on its CDS's without having to wait for an actual bankruptcy filing (which would constitute a bankruptcy credit event triggering a dealer obligation to pay on the CDS's).
A decision by ISDA that the insolvency of Texas Cooperative Electric is enough to trigger the obligation to pay on the CDS's may transform the CDS market. CDS's have been regarded as similar to insurance contracts, which pay when discrete, well-defined events occur. If the debtor doesn't pay the underlying debt on time or files for bankruptcy, then the dealer that sold the CDS has to pay its customer. But insolvency is a much broader concept, and may depend on how one defines and assigns valuations to the debtor's "assets" and "liabilities." Lawyers and accountants can argue until pigs fly about whether or not a debtor is insolvent. It's not unreasonable to believe that just about all major American banks were insolvent in parts of 2008-09; and it's possible that one or more remain insolvent today. Perfectly sane people rationally entertain suspicions that Europe's major banks might now be insolvent. Very possibly, most industrialized nations of the world are insolvent. There are shiploads of CDS's outstanding with respect to the debt of all the major banks and just about all the world's industrialized nations.
If Aurelius Capital can collect on its Texas Cooperative Electric CDS's without an actual bankruptcy filing, a lot of market participants holding an exponentially larger quantity of bank and sovereign debt CDS's might be similarly entitled to collect because the relevant underlying debtors are insolvent. The major CDS dealers might become shaky at that point--assuming they can even figure out their net claims or liabilities, which could be a convoluted process given that we still don't have much transparency in the trading, settlement or clearance of CDS's, Dodd-Frank notwithstanding. Since the major CDS dealers are among the world's largest banks, a lot might be at stake.
Financial crises, like the debacle in 2007-08, tend to occur because something unexpected happens. In the case of the events in 2007-08, it was the drop in the real estate market on a national basis, something that hadn't happened in a very long time and therefore wasn't expected to happen again. Today, the European sovereign debt crisis could trigger another financial crisis because market participants continue to believe that there is no problem so great that some expedient muddling by EU governments can't forestall the denouement for yet a couple more months. Excessive expediency allows underlying problems to fester and fester--and then blow up when least expected.
A change in the way CDS's are interpreted, as requested by Aurelius Capital, could fluster a lot of people playing in the CDS market. That market might become less predictable, and then who knows what would happen. If there's one thing the CDS market hasn't expected, it would be a legal interpretive issue like this one, which could, in one fell swoop, affect the length and breadth of the market--and with it, the entire financial system. So keep an eye out for the outcome.
Wednesday, August 31, 2011
Monday, August 29, 2011
Stock Market Regresses
The stock market is behaving increasingly like a petulant teenager. It's moody, impulsive, flighty, delirious one moment, and despondent the next. Since the financial crisis of 2008, individual investors have fled while professional traders increasingly dominate. Today, computerized trading is a larger part of the market than trading by sentient human beings. Computerized trading to a large degree involves following trends (the stock market term is "momentum trading"). Does that remind you of high school?
Investing on fundamentals seems to be done more outside the market than in it. Look Warren Buffet's big deals--in negotiated transactions, he bought a railroad, and special preferred stock from Goldman Sachs and Bank of America. He doesn't bet big money (that is, big money for him) trading stocks.
The stock market has become a playground for professional traders, who use it for short term speculation. In that way, it has regressed back to the 19th Century. When the robber barons held sway, savers didn't put their money into common stocks. They made deposits in bank accounts and bought bonds. Common stock was viewed as a vehicle for gambling. The few stocks that savers might buy were those with a solid history of paying dividends, and perhaps preferred stock, which had rights to dividends superior to common stock but no voting rights. Either way, a stock's ability to deliver cash in the form of dividends was crucial to its attractiveness to savers.
The state of affairs today is comparable, with so much cash flowing into banks that at least one is charging large depositors for the privilege of making deposits. The U.S. Treasury market is rallying from the flow of funds out of stocks and into safe havens, in spite of S&P's downgrade. There remains some investor interest in stocks that are proven dividend payers. Otherwise, the thrill of capital appreciation is increasingly left to the Wall Streeters who let their computers do the trading.
The Federal Reserve's relentless campaign to crush all interest rates attempts to coerce savers to put their money into riskier assets, in the belief that if savers lose their life savings to market volatility, the economy will somehow recover. But the Fed seems to be missing a basic point about investing. It's done when savers have confidence in the investment. When savers think the putative investment is a tractor trailer laden with bullswaggle, they won't send in a buy order. Making savers feel poorer by taking away their only safe sources of interest income will make them more insecure, spend less and swear off stocks. People who can stash some of their savings in secure, income generating vehicles are more likely to risk other savings in stocks. People who are repeatedly frustrated in their quest for a port in today's financial storms won't unfurl the sails and hope that the gale will somehow propel them to calmer waters.
The Fed seeks a wealth effect by using lower interest rates to support and bolster stock prices. The problem is that lower interest rates make savers feel less wealthy, especially retirees who count on their savings. Has the Fed netted out the discouragement to savers it imposes against the encouragement it gives to stockholders? Since many people are both savers and stockholders, they'll net out the impact, understanding that you can never recoup interest that didn't accrue during a time of low rates, but that stock gains may be ephemeral. Then they'll boost spending--or not.
With the advent of derivatives, computerized trading and no end of structured financial products that are too complex for battered investors to truly understand, it's easy to overlook the regressing of the financial markets. But with that in mind, is it any wonder individual stock market investors are becoming an endangered species?
Investing on fundamentals seems to be done more outside the market than in it. Look Warren Buffet's big deals--in negotiated transactions, he bought a railroad, and special preferred stock from Goldman Sachs and Bank of America. He doesn't bet big money (that is, big money for him) trading stocks.
The stock market has become a playground for professional traders, who use it for short term speculation. In that way, it has regressed back to the 19th Century. When the robber barons held sway, savers didn't put their money into common stocks. They made deposits in bank accounts and bought bonds. Common stock was viewed as a vehicle for gambling. The few stocks that savers might buy were those with a solid history of paying dividends, and perhaps preferred stock, which had rights to dividends superior to common stock but no voting rights. Either way, a stock's ability to deliver cash in the form of dividends was crucial to its attractiveness to savers.
The state of affairs today is comparable, with so much cash flowing into banks that at least one is charging large depositors for the privilege of making deposits. The U.S. Treasury market is rallying from the flow of funds out of stocks and into safe havens, in spite of S&P's downgrade. There remains some investor interest in stocks that are proven dividend payers. Otherwise, the thrill of capital appreciation is increasingly left to the Wall Streeters who let their computers do the trading.
The Federal Reserve's relentless campaign to crush all interest rates attempts to coerce savers to put their money into riskier assets, in the belief that if savers lose their life savings to market volatility, the economy will somehow recover. But the Fed seems to be missing a basic point about investing. It's done when savers have confidence in the investment. When savers think the putative investment is a tractor trailer laden with bullswaggle, they won't send in a buy order. Making savers feel poorer by taking away their only safe sources of interest income will make them more insecure, spend less and swear off stocks. People who can stash some of their savings in secure, income generating vehicles are more likely to risk other savings in stocks. People who are repeatedly frustrated in their quest for a port in today's financial storms won't unfurl the sails and hope that the gale will somehow propel them to calmer waters.
The Fed seeks a wealth effect by using lower interest rates to support and bolster stock prices. The problem is that lower interest rates make savers feel less wealthy, especially retirees who count on their savings. Has the Fed netted out the discouragement to savers it imposes against the encouragement it gives to stockholders? Since many people are both savers and stockholders, they'll net out the impact, understanding that you can never recoup interest that didn't accrue during a time of low rates, but that stock gains may be ephemeral. Then they'll boost spending--or not.
With the advent of derivatives, computerized trading and no end of structured financial products that are too complex for battered investors to truly understand, it's easy to overlook the regressing of the financial markets. But with that in mind, is it any wonder individual stock market investors are becoming an endangered species?
Friday, August 26, 2011
Is This Any Way to Run a European Union?
The latest bailout for Greece has bogged down because one EU member, Finland, beset by domestic political opposition to more handouts to Greece, insisted on cash collateral for its portion of the bailout. In other words, cash loaned by other EU members to Greece would be given to Finland as collateral for Greece's obligation to repay Finland. Amazingly, Greece agreed to Finland's demand. Even though Finland's share of the bailout was only 2%, it would get better terms than other EU members. Greece violated a cardinal principle of negotiating a workout of its debts: that similarly situated creditors be treated equally.
When the word got around, several other EU members balked at participating in the bailout unless they, too, got cash collateral. Needless to say, the entire bailout package began swirling in the porcelain bowl, because funds Greece would receive from the EU's bailout mechanism wouldn't be used to repay current liabilities but instead recycled to other EU members as collateral. How, then, would Greece avoid defaulting on its current liabilities?
Germany and the Netherlands quickly planted an IED under the Finnish collateral proposal. That preserved the principle of equal treatment for all members. But it leaves Finland's political problem unresolved. Large numbers of Finnish voters want to tell Greece to take a hike. Without collateral, or some other protection, Finland may refuse to sign off on the bailout. Because EU rules require unanimity, Finland by its lonesome can torpedo the entire deal.
Germany, the most powerful member of the EU, stands by the unanimity requirement, even though a collapse of the EU from a failure of the bailout proposal could visit extremely painful consequences on Germany. The unanimity requirement protects Germany, too. Otherwise, it might be forced to relinquish a large part of its wealth bailing out more profligate EU members simply by a vote of the majority. Germany, too, wants eat its cake and have it too by preserving the option to blow up the bailout if the terms are too costly for Germany.
From a traditional creditor's viewpoint, Finland's position makes sense. Greece, for the most part, has been dealing with its sovereign debt problem by swapping maturing debt for longer term debt--i.e., rolling its obligations over. Swapping paper for more paper doesn't repay debt. It simply extends maturities. If Finland had collateral, it could seize the collateral in the event of nonpayment and step off the paper swapping merry-to-round. If Greece lost collateral, it would lose real value, and the prospect of such a loss might focus its attention on truly paying down its debts. As long as Greece has the option of swapping paper and holding onto its true wealth, it can continue to make promises instead of keeping them.
To appease the Finns and others, the EU is looking into some sort of collateral for the bailout. But how much of its wealth will Greece put into hock? Unless it pledges the Acropolis, Greece can't fully collateralize all its debts. Reality is that Greece, mostly for political reasons, simply cannot repay its debts in full. The EU won't confront this reality. Its rules, which protect its creditor members, enable this head in the sand outlook. Fully protecting creditors isn't how commercial creditors do a loan workout with a troubled borrower. They make concessions, take some losses, maybe take an equity interest to have some upside potential if the borrower survives, and hope for the best. The EU's pro-creditor governance structure makes a true workout of Greece's problems essentially impossible. Paper is swapped because it's the only way for everyone concerned to pretend they're doing something.
This is no way to run a continental union. Something has to give. The EU has no mechanism for kicking members out, even if they violate the rules. So it's stuck with Greece, which has no incentive to leave as long as it's rolling paper over. Germany isn't ready to walk, either, because it has so much to lose. Perhaps secession by other members will be next. Finland and other small member nations may conclude it's best for them to vamoose, reverting back to national currencies that may be strong against the Euro. The rest of the EU won't stop them. Europe lost tens of millions of people in two horrendous world wars in the last century. Secession wasn't accepted by the United States but 21st Century Europeans won't fight any Gettysburgs, Vicksburgs or Peterburgs. If a few small nations succeed on their own, then other prosperous EU members will be under enormous pressure to skedaddle. As more members hightail it, Germany won't be able to support the entire edifice by itself. The EU, poorly designed and too inflexible to deal with the risks of the real world, will then go the way of the Titanic.
The alternative will be for Germany to write checks to profligate EU members--big ones. West Germany did something like that once before, to finance unification with East Germany. Whether it will do that again, this time for non-German peoples, remains to be seen. But, if you're not the betting type, avoid long term investments denominated in the Euro.
When the word got around, several other EU members balked at participating in the bailout unless they, too, got cash collateral. Needless to say, the entire bailout package began swirling in the porcelain bowl, because funds Greece would receive from the EU's bailout mechanism wouldn't be used to repay current liabilities but instead recycled to other EU members as collateral. How, then, would Greece avoid defaulting on its current liabilities?
Germany and the Netherlands quickly planted an IED under the Finnish collateral proposal. That preserved the principle of equal treatment for all members. But it leaves Finland's political problem unresolved. Large numbers of Finnish voters want to tell Greece to take a hike. Without collateral, or some other protection, Finland may refuse to sign off on the bailout. Because EU rules require unanimity, Finland by its lonesome can torpedo the entire deal.
Germany, the most powerful member of the EU, stands by the unanimity requirement, even though a collapse of the EU from a failure of the bailout proposal could visit extremely painful consequences on Germany. The unanimity requirement protects Germany, too. Otherwise, it might be forced to relinquish a large part of its wealth bailing out more profligate EU members simply by a vote of the majority. Germany, too, wants eat its cake and have it too by preserving the option to blow up the bailout if the terms are too costly for Germany.
From a traditional creditor's viewpoint, Finland's position makes sense. Greece, for the most part, has been dealing with its sovereign debt problem by swapping maturing debt for longer term debt--i.e., rolling its obligations over. Swapping paper for more paper doesn't repay debt. It simply extends maturities. If Finland had collateral, it could seize the collateral in the event of nonpayment and step off the paper swapping merry-to-round. If Greece lost collateral, it would lose real value, and the prospect of such a loss might focus its attention on truly paying down its debts. As long as Greece has the option of swapping paper and holding onto its true wealth, it can continue to make promises instead of keeping them.
To appease the Finns and others, the EU is looking into some sort of collateral for the bailout. But how much of its wealth will Greece put into hock? Unless it pledges the Acropolis, Greece can't fully collateralize all its debts. Reality is that Greece, mostly for political reasons, simply cannot repay its debts in full. The EU won't confront this reality. Its rules, which protect its creditor members, enable this head in the sand outlook. Fully protecting creditors isn't how commercial creditors do a loan workout with a troubled borrower. They make concessions, take some losses, maybe take an equity interest to have some upside potential if the borrower survives, and hope for the best. The EU's pro-creditor governance structure makes a true workout of Greece's problems essentially impossible. Paper is swapped because it's the only way for everyone concerned to pretend they're doing something.
This is no way to run a continental union. Something has to give. The EU has no mechanism for kicking members out, even if they violate the rules. So it's stuck with Greece, which has no incentive to leave as long as it's rolling paper over. Germany isn't ready to walk, either, because it has so much to lose. Perhaps secession by other members will be next. Finland and other small member nations may conclude it's best for them to vamoose, reverting back to national currencies that may be strong against the Euro. The rest of the EU won't stop them. Europe lost tens of millions of people in two horrendous world wars in the last century. Secession wasn't accepted by the United States but 21st Century Europeans won't fight any Gettysburgs, Vicksburgs or Peterburgs. If a few small nations succeed on their own, then other prosperous EU members will be under enormous pressure to skedaddle. As more members hightail it, Germany won't be able to support the entire edifice by itself. The EU, poorly designed and too inflexible to deal with the risks of the real world, will then go the way of the Titanic.
The alternative will be for Germany to write checks to profligate EU members--big ones. West Germany did something like that once before, to finance unification with East Germany. Whether it will do that again, this time for non-German peoples, remains to be seen. But, if you're not the betting type, avoid long term investments denominated in the Euro.
Tuesday, August 23, 2011
Barack Obama's Lousy Vacation
President Obama has been vacationing in the tony confines of Martha's Vinyard, hiking, biking, and so on. An ordinary fully-employed American, let alone the millions of unemployed, can't afford a summer break on this exclusive isle. So the President has taken some heat for golfing while many Americans line up at food banks hoping for fresh produce in addition to canned green beans.
To make things worse for Obama, Washington was hit today by the largest earthquake in the mid-Atlantic region in over a century. The quake registered 5.8 on the Richter scale, relatively moderate as these things go, and little damage was done. But it sent tens of thousands of office workers into the streets, and then on to a long, slow, sweaty commute home. It didn't help the President's image that he could stay cool in gentle Atlantic breezes hundreds of miles away.
A Gallup poll added to the misery of the President's vacation. It now appears that the President is basically in a dead heat with four leading Republican contenders: Mitt Romney, Rick Perry, Ron Paul and Michelle Bachmann. That's a notable change from polls just a few weeks ago, which placed him ten percentage points or more ahead of any Republican challenger. Of course, any poll taken today has only limited value for predicting 14 months in the future. What it does do, however, is encourage disgruntled Democrats to find a more liberal prospect to challenge Obama in the Democractic primaries next year. The core of the Democratic Party has become increasingly disenchanted with Obama's expedient shifts to the middle, and would be quite interested in finding a credible primary challenger. The worse Obama does in the polls, the more credible potential challengers become.
But in adversity there is opportunity. Even as nature wrought the earthquake on the President, nature also brings the gift of a hurricane predicted to sweep up the East Coast this weekend. The President is currently scheduled to return to Washington at the beginning of next week. He should shorten his vacation and be back in the White House before the 'cane arrives. Then, he can arrange to be prominently photographed hunkering down and eating dinner straight out of a can of pork and beans, a victim just like all the other folks who have to suffer through the hurricane. It would give voters something to connect to. And that would do him a lot more good than another round of golf.
To make things worse for Obama, Washington was hit today by the largest earthquake in the mid-Atlantic region in over a century. The quake registered 5.8 on the Richter scale, relatively moderate as these things go, and little damage was done. But it sent tens of thousands of office workers into the streets, and then on to a long, slow, sweaty commute home. It didn't help the President's image that he could stay cool in gentle Atlantic breezes hundreds of miles away.
A Gallup poll added to the misery of the President's vacation. It now appears that the President is basically in a dead heat with four leading Republican contenders: Mitt Romney, Rick Perry, Ron Paul and Michelle Bachmann. That's a notable change from polls just a few weeks ago, which placed him ten percentage points or more ahead of any Republican challenger. Of course, any poll taken today has only limited value for predicting 14 months in the future. What it does do, however, is encourage disgruntled Democrats to find a more liberal prospect to challenge Obama in the Democractic primaries next year. The core of the Democratic Party has become increasingly disenchanted with Obama's expedient shifts to the middle, and would be quite interested in finding a credible primary challenger. The worse Obama does in the polls, the more credible potential challengers become.
But in adversity there is opportunity. Even as nature wrought the earthquake on the President, nature also brings the gift of a hurricane predicted to sweep up the East Coast this weekend. The President is currently scheduled to return to Washington at the beginning of next week. He should shorten his vacation and be back in the White House before the 'cane arrives. Then, he can arrange to be prominently photographed hunkering down and eating dinner straight out of a can of pork and beans, a victim just like all the other folks who have to suffer through the hurricane. It would give voters something to connect to. And that would do him a lot more good than another round of golf.
Monday, August 22, 2011
Merkel Has the Bazooka, Not Bernanke
The eyes of the financial markets are on Federal Reserve Chairman Ben Bernanke, who will give the Federal Reserve's unofficial annual Financial State of the Union Address at the Kansas City Fed's Jackson Hole conference on Friday, Aug. 26, 2011. Bernanke will almost surely announce one policy measure or another. QE3 is unlikely; QE2 has turned to be largely a bust. The Fed may well choose something like adjusting the mix of maturities of its bond portfolio, shifting toward greater emphasis on the long end in order to push down longer term interest rates. Such a shift may moderately reduce longer term rates. But those rates are already lower than a snake's belly. So the impact of a portfolio shift on economic growth isn't likely to be more than a sacrifice bunt.
Bernanke's problem is that the markets expect him to expend all ammunition. Primarily because of Bernanke's own predilection toward policy action, and his predecessor's issuance to the financial markets of the Greenspan put, the Fed no longer has the option of holding its fire. The markets expect the Fed to maintain its covering fire, and have priced continuing Fed activism into the market. In effect, the Fed has already fired all its ammo, and will be punished with a market rout if it fails to fire. Bernanke surely knows this and is mustering his now meager forces on the firing line.
Governmental action can give the markets a lift when it's unexpected. The one thing the markets don't expect is for Germany and France to sign off on the concept of Euro bonds. At the moment, the world's biggest economic problem isn't America, but the European Union and its spiraling debt crisis. Things have been going from bad to worse, and may lead to another financial crisis a la 2008. Perhaps the one clear way out of the mess would be for the EU to combine and issue Euro bonds, community-wide debt to replace the sickly sovereign debt of profligate members like Greece, Ireland and Portugal, and possibly Spain and Italy. But Euro bonds would amount to a massive transfer of wealth from Germany, and to a lesser degree France, to the weaker nations. The German electorate has yet to wrap their brains around this concept, and it may take a few centuries before they do. They can't simply hand over the wealth--that would feel like they were held up. But imposing strict fiscal controls over beneficiary nations would bring back images of storm troopers goose stepping into foreign capitals. For some reason, many European nations have a problem with this.
Nevertheless, Merkel holds the bazooka. She can surprise the markets by endorsing Euro bonds. It's doubtful she will. But if we're going to have a big upside surprise this August, it will come from Germany, not Jackson Hole.
Bernanke's problem is that the markets expect him to expend all ammunition. Primarily because of Bernanke's own predilection toward policy action, and his predecessor's issuance to the financial markets of the Greenspan put, the Fed no longer has the option of holding its fire. The markets expect the Fed to maintain its covering fire, and have priced continuing Fed activism into the market. In effect, the Fed has already fired all its ammo, and will be punished with a market rout if it fails to fire. Bernanke surely knows this and is mustering his now meager forces on the firing line.
Governmental action can give the markets a lift when it's unexpected. The one thing the markets don't expect is for Germany and France to sign off on the concept of Euro bonds. At the moment, the world's biggest economic problem isn't America, but the European Union and its spiraling debt crisis. Things have been going from bad to worse, and may lead to another financial crisis a la 2008. Perhaps the one clear way out of the mess would be for the EU to combine and issue Euro bonds, community-wide debt to replace the sickly sovereign debt of profligate members like Greece, Ireland and Portugal, and possibly Spain and Italy. But Euro bonds would amount to a massive transfer of wealth from Germany, and to a lesser degree France, to the weaker nations. The German electorate has yet to wrap their brains around this concept, and it may take a few centuries before they do. They can't simply hand over the wealth--that would feel like they were held up. But imposing strict fiscal controls over beneficiary nations would bring back images of storm troopers goose stepping into foreign capitals. For some reason, many European nations have a problem with this.
Nevertheless, Merkel holds the bazooka. She can surprise the markets by endorsing Euro bonds. It's doubtful she will. But if we're going to have a big upside surprise this August, it will come from Germany, not Jackson Hole.
Friday, August 19, 2011
Should We Bring Back the Leisure Suit?
The economy in America and Europe is stagnant. Gas prices have risen sharply in recent years, and the Bureau of Labor Statistics reports rising inflation. The job market stinks. Business investment has ground to a halt. America is unwinding from unpopular wars. Young people just entering the labor force believe they face a lifetime of limited opportunity and lower living standards. They envy their parents, who seem to have had it so good. Prospects for the future seem like a blurred swirl in a porcelain bowl. Whether you believe history repeats itself or simply rhymes, the times are looking a lot like the 1970s. Maybe we should bring back the leisure suit.
The leisure suit had many attributes. It was casual, a rejection of the stuffy old formality of the 1950s. It usually came in pastel colors, brightening things up as the lights dimmed for electricity conservation mandated by rising energy prices. It was made of polyester, which thankfully led us to rethink the whole idea of better living through chemistry. It was flashy, ideal for mindlessly dissipating evenings in artificially fogged discos. Considering today's pervasive gloom, a bit of self-referential, sartorial frivolity might be just the thing we need.
But thinking of the 1970s reminds us of how glad we were to escape the malaise of those times. What is worth examining is how we made the escape. The fundamental economic problem then was price inflation. Already a nagging problem in the 3% range at the beginning of the decade, inflation was aggravated by OPEC oil price fixing, which escalated it to 13% by the end of the decade. Wages tended to keep fairly close pace with inflation, but the value of savings was eroded as interest rates lagged (does this sound familiar?). The stock market stunk, worth much less after inflation than it was worth at the beginning of the decade.
As students of economic history know, then Fed Chairman Paul Volcker raised interest rates sharply at the beginning of the 1980s to stabilize prices. In the process, the U.S. economy belly flopped into recession, with unemployment rising above 10% and stocks falling. Despite a tidal wave of criticism from the left, right, Democrats, Republicans, and just about everyone else standing on or about a bully pulpit, Volcker held firm, like a latter day Rock of Chickamauga. And prevailed. The recession of 1981-82 wrung inflation out of the economy, and it has never returned at any level approaching the confidence sapping double digits of the 70s. With inflation whipped, real economic growth resumed, employment levels rebounded, and the stock market took off on an 18-year bull run. The bond market, even more amazingly, took off on a bull run that hasn't ended even today.
An essential, virtually forgotten lesson from the disco era is that real pain had to be endured before the economy could be set on the right track. Investors, workers, businesses, savers, and homeowners all made sacrifices. There was no easy way out. Inflation had created economic distortions that had to eliminated. The relatively lax Fed of the 1970s was replaced by a stern, unyielding inflation slayer who wielded a mighty halberd.
Such is the path America must take today if it is to end today's dreary replay of the 1970s. The economy is distorted by asset bubbles, the leverage that made them possible, the fantasy mortgage loans that can't be collected but haven't been written off by the banks, Fed-prescribed low interest rates that encourage speculation while discouraging savings, and the dependence of the private sector on federal stimulus. Private businesses won't hire or invest unless there is a prospect of more federal intervention. Everyone wants a risk-free environment, or absent that, a federal bailout. Free enterprise, which means taking risk, barely exists any more and can usually be found only in the small business sector, where federal manna is scarce.
If the Fed wants to stimulate risk taking, what it must do is reverse the tide of moral hazard and stop the endless stream of largely futile accommodations. It should force business executives to take risk, not force savers to gamble their hard-earned retirement funds on dodgy financial instruments. When businesses realize that they will have to make their profits the old fashioned way--by taking risks and managing those risks to attain profitability--then we will see organic economic recovery. No amount of Fed coddling of corporate interests, and no amount of Fed punishment of savers and holders of capital, will achieve the spontaneous and self-sustaining growth that produces lasting prosperity.
Before there was a Federal Reserve, there were recessions, and bad ones at that. There were also recoveries from those recessions that led to sparkling prosperity. It's not like America endured an unrelenting stream of recessions followed by more recessions until the clouds parted and the Federal Reserve System was handed down to someone on Mount Sinai. The Fed has a legitimate role in stabilizing the financial system, and has done yeoman's duty in that respect. But it isn't and can't be the progenitor of all prosperity in America. In a free enterprise system, private enterprise must take on that job, and if corporate interests hold back in hope of yet another federal bailout, they must be made to understand it won't be forthcoming.
America is becoming like Japan, moribund and without a vision of the future. We don't want to take risks any more, and we don't want to accept pain. Blame and culpability are denied by the most powerful, even though their responsibility is greatest. The less powerful and the powerless are made to suffer the worst consequences of the Great Recession, even though their ability to cope is the least. Capitalism requires that blame and responsibility be assessed, and that losses be imposed appropriately. Without right and wrong, there can be no morality. And without losses as well as gains, there can be no free enterprise. We can have all gains only if we become one big government enterprise (and those gains would ultimately prove ethereal). We can't escape our current predicament by having the federal government (and, even worse, the EU) artificially support or inflate assets that are in reality worthless. There won't be a revival of sustained economic growth as long as the government holds out the promise of yet another bailout, yet more accommodation. While there remains a legitimate role for government in taking on tasks for which the private sector isn't well-suited, like building and maintaining infrastructure, and funding and conducting basic research (recall that the Internet started off as a Defense Department project), the government should stop trying to alleviate general business risk.
Otherwise, we might as well bring back the leisure suit. A dose of self-delusion as we circle the drain will numb the process of decay and decline. If we're going to stop thinking about tomorrow, we might as well have fun while we can.
The leisure suit had many attributes. It was casual, a rejection of the stuffy old formality of the 1950s. It usually came in pastel colors, brightening things up as the lights dimmed for electricity conservation mandated by rising energy prices. It was made of polyester, which thankfully led us to rethink the whole idea of better living through chemistry. It was flashy, ideal for mindlessly dissipating evenings in artificially fogged discos. Considering today's pervasive gloom, a bit of self-referential, sartorial frivolity might be just the thing we need.
But thinking of the 1970s reminds us of how glad we were to escape the malaise of those times. What is worth examining is how we made the escape. The fundamental economic problem then was price inflation. Already a nagging problem in the 3% range at the beginning of the decade, inflation was aggravated by OPEC oil price fixing, which escalated it to 13% by the end of the decade. Wages tended to keep fairly close pace with inflation, but the value of savings was eroded as interest rates lagged (does this sound familiar?). The stock market stunk, worth much less after inflation than it was worth at the beginning of the decade.
As students of economic history know, then Fed Chairman Paul Volcker raised interest rates sharply at the beginning of the 1980s to stabilize prices. In the process, the U.S. economy belly flopped into recession, with unemployment rising above 10% and stocks falling. Despite a tidal wave of criticism from the left, right, Democrats, Republicans, and just about everyone else standing on or about a bully pulpit, Volcker held firm, like a latter day Rock of Chickamauga. And prevailed. The recession of 1981-82 wrung inflation out of the economy, and it has never returned at any level approaching the confidence sapping double digits of the 70s. With inflation whipped, real economic growth resumed, employment levels rebounded, and the stock market took off on an 18-year bull run. The bond market, even more amazingly, took off on a bull run that hasn't ended even today.
An essential, virtually forgotten lesson from the disco era is that real pain had to be endured before the economy could be set on the right track. Investors, workers, businesses, savers, and homeowners all made sacrifices. There was no easy way out. Inflation had created economic distortions that had to eliminated. The relatively lax Fed of the 1970s was replaced by a stern, unyielding inflation slayer who wielded a mighty halberd.
Such is the path America must take today if it is to end today's dreary replay of the 1970s. The economy is distorted by asset bubbles, the leverage that made them possible, the fantasy mortgage loans that can't be collected but haven't been written off by the banks, Fed-prescribed low interest rates that encourage speculation while discouraging savings, and the dependence of the private sector on federal stimulus. Private businesses won't hire or invest unless there is a prospect of more federal intervention. Everyone wants a risk-free environment, or absent that, a federal bailout. Free enterprise, which means taking risk, barely exists any more and can usually be found only in the small business sector, where federal manna is scarce.
If the Fed wants to stimulate risk taking, what it must do is reverse the tide of moral hazard and stop the endless stream of largely futile accommodations. It should force business executives to take risk, not force savers to gamble their hard-earned retirement funds on dodgy financial instruments. When businesses realize that they will have to make their profits the old fashioned way--by taking risks and managing those risks to attain profitability--then we will see organic economic recovery. No amount of Fed coddling of corporate interests, and no amount of Fed punishment of savers and holders of capital, will achieve the spontaneous and self-sustaining growth that produces lasting prosperity.
Before there was a Federal Reserve, there were recessions, and bad ones at that. There were also recoveries from those recessions that led to sparkling prosperity. It's not like America endured an unrelenting stream of recessions followed by more recessions until the clouds parted and the Federal Reserve System was handed down to someone on Mount Sinai. The Fed has a legitimate role in stabilizing the financial system, and has done yeoman's duty in that respect. But it isn't and can't be the progenitor of all prosperity in America. In a free enterprise system, private enterprise must take on that job, and if corporate interests hold back in hope of yet another federal bailout, they must be made to understand it won't be forthcoming.
America is becoming like Japan, moribund and without a vision of the future. We don't want to take risks any more, and we don't want to accept pain. Blame and culpability are denied by the most powerful, even though their responsibility is greatest. The less powerful and the powerless are made to suffer the worst consequences of the Great Recession, even though their ability to cope is the least. Capitalism requires that blame and responsibility be assessed, and that losses be imposed appropriately. Without right and wrong, there can be no morality. And without losses as well as gains, there can be no free enterprise. We can have all gains only if we become one big government enterprise (and those gains would ultimately prove ethereal). We can't escape our current predicament by having the federal government (and, even worse, the EU) artificially support or inflate assets that are in reality worthless. There won't be a revival of sustained economic growth as long as the government holds out the promise of yet another bailout, yet more accommodation. While there remains a legitimate role for government in taking on tasks for which the private sector isn't well-suited, like building and maintaining infrastructure, and funding and conducting basic research (recall that the Internet started off as a Defense Department project), the government should stop trying to alleviate general business risk.
Otherwise, we might as well bring back the leisure suit. A dose of self-delusion as we circle the drain will numb the process of decay and decline. If we're going to stop thinking about tomorrow, we might as well have fun while we can.
Wednesday, August 17, 2011
Steady is the Way to Save
Financial returns have gone to hell. Bond yields are evaporating, money market returns are zero, and stocks have gone negative more than most politicians. We're in an investment desert, with the prospect of retirement a cruel mirage. If you manage to retire, you fear that you'll run out of money before you run out of time on this planet. That would leave you with only Social Security. But the political right will ambush Social Security and if you plant a garden to survive, the white tail deer swarming America's suburbs will eat your food supply before you can harvest it. You're screwed. Unless you find a way to boost your net worth.
The most reliable way to build up your net worth is to save steadily, week after week, month after month, year after year. Then, if you compound your earnings (assuming there are earnings to compound), you leverage your returns (see http://blogger.uncleleosden.com/2009/09/if-you-love-compounding-compounding.html). How can you achieve a steady flow of cash into your saving and investment accounts? Here are a few ideas.
Pay yourself first. Participate in any 401(k) or other employer-sponsored retirement program available to you. A portion of your paycheck will be automatically credited to your retirement account before you can spend it. You can also arrange with your bank to automatically transfer each month a fixed amount from your checking account to a saving account, IRA account, or mutual fund account. The key to saving is to live below your means. Paying yourself first is a great way of doing that.
Shop for Loss Leaders. Many stores offer extra low prices on select items to get you in the door, in the hope that you'll pay full freight for other items. Grocery stores are notorious for advertising loss leaders, and nailing you with high prices on staples. A way around this pricing scheme is to identify a cluster of grocery stores that are within a few miles of each other, so that travel costs aren't a big factor, and buy the loss leaders at each. You'll probably find that different stores often have different items on sale each week. It's hard for stores to win the loss leader game if they mark down the same items. So they frequently mark down different items to avoid competing directly against each other. If the stores are close to each other, you can drive to all of them easily and buy the bargains. When you frequently shop the same cluster of stores, you'll also learn how their regular prices differ. One store will usually have cheaper meat, another cheaper bread, a third cheaper milk. With this knowledge, you can save even more. While this strategy may not work well in rural areas and urban areas poorly served by the big supermarket chains, it does work for the majority of Americans who live in the suburbs.
Cheap gas. There are websites that report on gas prices in your neighborhood. None have complete information. But take advantage of the bargains you find. Since gas is an important monthly expense for most Americans, the savings add up.
Drive like a millionaire. Studies of the well-to-do report that the typical millionaire drives, not a luxury or sports car, but a standard sedan or mid-range SUV. Most millionaires became well-off because, among other things, they didn't burn up their income on big depreciating assets like expensive cars. Buy as much car as you need. A family of five or six obviously needs more vehicle than a single person. But don't confuse looking prosperous with being prosperous. Choose a Honda over an Acura, or a Ford over a Lincoln, and you'll look more like a typical millionaire.
Eavesdrop on your fellow passengers. We all know that mass transportation will usually be cheaper than driving, and it's kinder to the environment. Okay, strap hanging with a lot of other people trying not to look like sardines may seem like eating bologna with processed American cheese food on white. But view the glass as half full. Almost every day in public transportation, you can hear other people over-sharing too loudly on their cell phones. You learn what idiotic, messed up, contorted, perverse, and incredibly lunatic lives they have, and you will be amused, entertained, appalled, disgusted, and grateful. Grateful because however boring, unrewarding, difficult, and warped your life may seem, someone else has traveled farther down the road toward disaster than you. Don't worry about being an eavesdropper; they voluntarily, if perhaps unwittingly, made spectacles of themselves. Laugh while you bank your savings in commuting costs.
Veg out for free. If you're going to rot your brain sitting in front of a television, consider what you like to watch and find the cheapest way to get it. Check out resources on the Internet. A lot of cable shows can be accessed through your PC for free or a lot less than monthly cable charges. If you are a public television fan, many PBS stations post copies of shows on their websites that you can access later without charge if you miss the broadcast. Broadcast TV still does exist, and there are more channels now than ever. Of course, if you need to slobber on the sofa with shopping shows playing nonstop, cable may be your best option. But you'd be spending money in order to spend money. That isn't the way to get rich.
A pox on credit card interest. You won't enrich yourself by enriching banks. As interest rates for savers have fallen, interest charges for credit card customers have risen. Do you think someone might be getting shafted? If you carry over a monthly balance on your credit card, that someone can be found in the mirror.
Make Your Life Fit Your Closet Space. If you look at the typical American home (be it a single family house, a condo or an apartment), you'll notice that the closet space seems rather limited. Think about your friends and family--most or all of them have filled their closets and other storage space to 150% of capacity, and then stacked stuff up against walls and in other stray spaces. Most of America's housing stock was built in the 1940s, 1950s, 1960s and 1970s, with enough closet space for the needs of the times. It's only been in the last few decades that the warehouse-size walk-in closets found in newer suburbs have felt barely adequate. During the halcyon years of the 1950s and 1960s, when Americans thought of themselves as glowingly prosperous, people lived with a lot less than they have today and felt damn good about it. You can save a lot of money by making your life fit your closet space. Buy what you need. Buy what you want. But don't make a landfill of your closet space.
The most reliable way to build up your net worth is to save steadily, week after week, month after month, year after year. Then, if you compound your earnings (assuming there are earnings to compound), you leverage your returns (see http://blogger.uncleleosden.com/2009/09/if-you-love-compounding-compounding.html). How can you achieve a steady flow of cash into your saving and investment accounts? Here are a few ideas.
Pay yourself first. Participate in any 401(k) or other employer-sponsored retirement program available to you. A portion of your paycheck will be automatically credited to your retirement account before you can spend it. You can also arrange with your bank to automatically transfer each month a fixed amount from your checking account to a saving account, IRA account, or mutual fund account. The key to saving is to live below your means. Paying yourself first is a great way of doing that.
Shop for Loss Leaders. Many stores offer extra low prices on select items to get you in the door, in the hope that you'll pay full freight for other items. Grocery stores are notorious for advertising loss leaders, and nailing you with high prices on staples. A way around this pricing scheme is to identify a cluster of grocery stores that are within a few miles of each other, so that travel costs aren't a big factor, and buy the loss leaders at each. You'll probably find that different stores often have different items on sale each week. It's hard for stores to win the loss leader game if they mark down the same items. So they frequently mark down different items to avoid competing directly against each other. If the stores are close to each other, you can drive to all of them easily and buy the bargains. When you frequently shop the same cluster of stores, you'll also learn how their regular prices differ. One store will usually have cheaper meat, another cheaper bread, a third cheaper milk. With this knowledge, you can save even more. While this strategy may not work well in rural areas and urban areas poorly served by the big supermarket chains, it does work for the majority of Americans who live in the suburbs.
Cheap gas. There are websites that report on gas prices in your neighborhood. None have complete information. But take advantage of the bargains you find. Since gas is an important monthly expense for most Americans, the savings add up.
Drive like a millionaire. Studies of the well-to-do report that the typical millionaire drives, not a luxury or sports car, but a standard sedan or mid-range SUV. Most millionaires became well-off because, among other things, they didn't burn up their income on big depreciating assets like expensive cars. Buy as much car as you need. A family of five or six obviously needs more vehicle than a single person. But don't confuse looking prosperous with being prosperous. Choose a Honda over an Acura, or a Ford over a Lincoln, and you'll look more like a typical millionaire.
Eavesdrop on your fellow passengers. We all know that mass transportation will usually be cheaper than driving, and it's kinder to the environment. Okay, strap hanging with a lot of other people trying not to look like sardines may seem like eating bologna with processed American cheese food on white. But view the glass as half full. Almost every day in public transportation, you can hear other people over-sharing too loudly on their cell phones. You learn what idiotic, messed up, contorted, perverse, and incredibly lunatic lives they have, and you will be amused, entertained, appalled, disgusted, and grateful. Grateful because however boring, unrewarding, difficult, and warped your life may seem, someone else has traveled farther down the road toward disaster than you. Don't worry about being an eavesdropper; they voluntarily, if perhaps unwittingly, made spectacles of themselves. Laugh while you bank your savings in commuting costs.
Veg out for free. If you're going to rot your brain sitting in front of a television, consider what you like to watch and find the cheapest way to get it. Check out resources on the Internet. A lot of cable shows can be accessed through your PC for free or a lot less than monthly cable charges. If you are a public television fan, many PBS stations post copies of shows on their websites that you can access later without charge if you miss the broadcast. Broadcast TV still does exist, and there are more channels now than ever. Of course, if you need to slobber on the sofa with shopping shows playing nonstop, cable may be your best option. But you'd be spending money in order to spend money. That isn't the way to get rich.
A pox on credit card interest. You won't enrich yourself by enriching banks. As interest rates for savers have fallen, interest charges for credit card customers have risen. Do you think someone might be getting shafted? If you carry over a monthly balance on your credit card, that someone can be found in the mirror.
Make Your Life Fit Your Closet Space. If you look at the typical American home (be it a single family house, a condo or an apartment), you'll notice that the closet space seems rather limited. Think about your friends and family--most or all of them have filled their closets and other storage space to 150% of capacity, and then stacked stuff up against walls and in other stray spaces. Most of America's housing stock was built in the 1940s, 1950s, 1960s and 1970s, with enough closet space for the needs of the times. It's only been in the last few decades that the warehouse-size walk-in closets found in newer suburbs have felt barely adequate. During the halcyon years of the 1950s and 1960s, when Americans thought of themselves as glowingly prosperous, people lived with a lot less than they have today and felt damn good about it. You can save a lot of money by making your life fit your closet space. Buy what you need. Buy what you want. But don't make a landfill of your closet space.
Monday, August 15, 2011
The Politics of Powerlessness
The Iowa straw vote and Tim Pawlenty's sudden withdrawal from the race for the Republican presidential nomination starkly highlights the pervasive feeling of powerlessness that drives politics today. Michelle Bachmann and Ron Paul finished a close first and second, with Pawlenty a distant third. Bachmann and Paul appeal to the far right, tapping into the anger of those that feel unconnected to the mainstream of American society. Pawlenty was very much the traditional conservative that the power brokers of the Republican Party would like as their candidate. He got clobbered.
Others who fit the profile preferred by the Republican power structure--Mitt Romney, Jon Huntsman, Rick Santorum, and Rick Perry--either stayed out or did poorly. Romney's campaign dropped hints to the press that his absence from the straw vote was strategic. But in politics, avoiding losses isn't the way to get elected. Romney may have deftly ducked a left jab from the far right. But his deliberate decision to stay out of the straw vote seems to quietly acknowledge his lack of appeal to the most powerful force in politics today: those that feel dispossessed.
A similar dynamic operates on the left. Union busting tactics in Wisconsin by recently elected Republican governor Scott Walker sparked an outpouring of liberal anger, weeks of demonstrations in Madison, and recall elections that weakened the Republican hold on the Wisconsin Senate. The demonstrators weren't powerful Democratic leeches sucking taxpayers dry. They were just moderate and middle income people trying desperately to hold onto their small portions of the national economic pie.
Middle class Americans are buffeted by enormous forces beyond their control. Wall Street created a financial crisis that threw the nation into a great recession. Workers are laid off through no fault of their own. They then lose their homes to foreclosure by human auto-pens. They see vast amounts of deficit spending by the federal government that doesn't seem to benefit them. Their children, raised to believe they could accomplish anything if they tried, now have little faith in the future. Both parents and children feel betrayed. A sovereign debt crisis in Europe that could wreck the international financial system, coinciding with an astonishingly inept process in Washington for raising the debt ceiling, knocks stocks down 15% in a few weeks. Daily volatility sweeps the financial markets, enriching firms whose computers trade in millionths of a second while trampling over Ma and Pa trying to patch up the holes in their 401(k) and IRA accounts. The homes they worked so hard to buy sink in value, but they still have to pay their debts in full with stagnating incomes.
The human survival instinct, normally well-concealed by the congeniality that prosperity allows, is the most powerful organic force on Earth. Humans have grown from a small number of short-lived hunter gatherers in Africa to a population of billions who control virtually every square mile of planet. When prosperity flags, and questions of survival begin to surface, adrenalin flows and emotions erupt. Many, many millions feel powerless against these gigantic forces beyond their control and see politics as the only outlet for their surging survival instincts. That is the force harnessed by Bachmann, Paul and the unions in Wisconsin. That is the force that will play a key role in the 2012 elections.
Paul won't win primaries; he has a track record in that respect. The mandarins of the Republican Party will quietly do everything they can to undermine Bachmann, in the belief that she might primaries, but can't win the general election. That belief is probably correct. The ghost of Barry Goldwater haunts the Republicans. A far right candidate is easy to demonize, and Democratic operatives are surely hoping that Bachmann will continue to fore check mainstream Republican candidates.
On the left, dissatisfaction with Barack Obama, now seen as too expedient a compromiser, has led to mutterings about a primary challenge. It's hard to see who would be a viable challenger. But in August 2007, few people considered Barack Obama a viable challenger to the presumed Democratic nominee, Hillary Clinton. So you never know. The ultimate in cool projected by Obama isn't the right teleprompter feed for this election cycle, and a more impassioned candidate may win over the Democratic left.
With the economy slowing and the chances of renewed recession rising, feelings of powerlessness will play an ever greater role in politics. Political doings in Washington could become even more unpredictable than they have been. And the stability of the financial markets, now determined by governmental action as much as the direction of the economy, is likely to suffer correspondingly.
Of course, voters' desperation and its political consequences would evaporate if the economy began to grow briskly. But what are the chances of that?
Others who fit the profile preferred by the Republican power structure--Mitt Romney, Jon Huntsman, Rick Santorum, and Rick Perry--either stayed out or did poorly. Romney's campaign dropped hints to the press that his absence from the straw vote was strategic. But in politics, avoiding losses isn't the way to get elected. Romney may have deftly ducked a left jab from the far right. But his deliberate decision to stay out of the straw vote seems to quietly acknowledge his lack of appeal to the most powerful force in politics today: those that feel dispossessed.
A similar dynamic operates on the left. Union busting tactics in Wisconsin by recently elected Republican governor Scott Walker sparked an outpouring of liberal anger, weeks of demonstrations in Madison, and recall elections that weakened the Republican hold on the Wisconsin Senate. The demonstrators weren't powerful Democratic leeches sucking taxpayers dry. They were just moderate and middle income people trying desperately to hold onto their small portions of the national economic pie.
Middle class Americans are buffeted by enormous forces beyond their control. Wall Street created a financial crisis that threw the nation into a great recession. Workers are laid off through no fault of their own. They then lose their homes to foreclosure by human auto-pens. They see vast amounts of deficit spending by the federal government that doesn't seem to benefit them. Their children, raised to believe they could accomplish anything if they tried, now have little faith in the future. Both parents and children feel betrayed. A sovereign debt crisis in Europe that could wreck the international financial system, coinciding with an astonishingly inept process in Washington for raising the debt ceiling, knocks stocks down 15% in a few weeks. Daily volatility sweeps the financial markets, enriching firms whose computers trade in millionths of a second while trampling over Ma and Pa trying to patch up the holes in their 401(k) and IRA accounts. The homes they worked so hard to buy sink in value, but they still have to pay their debts in full with stagnating incomes.
The human survival instinct, normally well-concealed by the congeniality that prosperity allows, is the most powerful organic force on Earth. Humans have grown from a small number of short-lived hunter gatherers in Africa to a population of billions who control virtually every square mile of planet. When prosperity flags, and questions of survival begin to surface, adrenalin flows and emotions erupt. Many, many millions feel powerless against these gigantic forces beyond their control and see politics as the only outlet for their surging survival instincts. That is the force harnessed by Bachmann, Paul and the unions in Wisconsin. That is the force that will play a key role in the 2012 elections.
Paul won't win primaries; he has a track record in that respect. The mandarins of the Republican Party will quietly do everything they can to undermine Bachmann, in the belief that she might primaries, but can't win the general election. That belief is probably correct. The ghost of Barry Goldwater haunts the Republicans. A far right candidate is easy to demonize, and Democratic operatives are surely hoping that Bachmann will continue to fore check mainstream Republican candidates.
On the left, dissatisfaction with Barack Obama, now seen as too expedient a compromiser, has led to mutterings about a primary challenge. It's hard to see who would be a viable challenger. But in August 2007, few people considered Barack Obama a viable challenger to the presumed Democratic nominee, Hillary Clinton. So you never know. The ultimate in cool projected by Obama isn't the right teleprompter feed for this election cycle, and a more impassioned candidate may win over the Democratic left.
With the economy slowing and the chances of renewed recession rising, feelings of powerlessness will play an ever greater role in politics. Political doings in Washington could become even more unpredictable than they have been. And the stability of the financial markets, now determined by governmental action as much as the direction of the economy, is likely to suffer correspondingly.
Of course, voters' desperation and its political consequences would evaporate if the economy began to grow briskly. But what are the chances of that?
Saturday, August 13, 2011
Where Europe is Heading
Italy has just called for the issuance of Euro bonds that would substitute for the sovereign debt of individual EU member nations. An EU-controlled entity would issue these bonds in exchange for the sovereign debts of each member nation, and could impose continent-wide taxes to pay off the Euro bonds. Greece, badly battered by the debt crisis, shouted a heartfelt "amen" to Italy's proposal.
The UK seconded the sentiment, proposing fiscal union for the EU. Fiscal union is about effectively the same as the Euro bond concept. Why would Italy, Greece and the UK publicly talk up European unity? Because they can see the handwriting on the wall. Unity is, in their view, the only alternative to the septic tank.
Germany, on the other hand, is reaching for as much garlic as it can find, in the hope of warding off fiscal union. It would have to pick up most of the tab for true European fiscal unity, and the German electorate has yet to wrap their heads around that concept.
Europeans basically have two options. One is to unite. They would become something similar to the United States, with a continent-wide government controlling fiscal policy and having taxation powers. The current nations would become more like America's states, controlling local matters but subordinate to the bureaucrats and legislators in Brussels. While Europe would probably never be as tightly united as America under the Constitution (that is, after the Civil War and the adoption of the 13th, 14th and 15th Amendments), its survival would require greater union than achieved by the original thirteen American states under the Articles of Confederation.
Europe's second option would be for Germany and maybe other fiscally strong northern EU nations to leave the EU and strike out on their own, issuing their own national currencies again. Germany would probably strengthen economic ties with Eastern Europe, the Baltic republics, and the southeastern portions of the former Soviet Union (such as Ukraine, Moldova, etc.). These nations are of historical German interest, dating back even to the excursions of the Teutonic Knights during the Middle Ages. Southern European nations would be left on sidelines, muttering something about dancing with the one you brung.
Germany's chancellor, Angela Merkel, and France's president, Nicholas Sarkozy, meet on Tuesday, Aug. 16, 2011. With all this talk of European union, the media will fixate over their every smile, frown, and arched eyebrow. Merkel, more than anyone, will be the decider. Although she has talked the talk on requiring southern European nations to pay their own way, she has reluctantly slid down the slippery slope toward comprehensive EU assumption of the sovereign debt of member nations. It would be politically impossible for her to reverse course now (although she won't openly support Euro bonds because that would be political suicide). A change of political control in Germany would required for option two. That's not yet likely, although it's possible. Political turmoil there would translate into more stock market volatility in Europe and America.
More than anything else, Europe's response to its sovereign debt crisis will dictate the direction of Europe's and North America's economies and stock markets. Europe's recent piecemeal ban on naked short selling of bank stocks is akin to shooting the messenger. But the EU approach to its debt crisis has certainly been lathered with expediency. Next week, the EU may stir up a good deal of market volatility. The U.S. Congress can't do its share to screw things up, since it's thankfully out of Washington for the August recess. Keep an eye on events across the pond.
The UK seconded the sentiment, proposing fiscal union for the EU. Fiscal union is about effectively the same as the Euro bond concept. Why would Italy, Greece and the UK publicly talk up European unity? Because they can see the handwriting on the wall. Unity is, in their view, the only alternative to the septic tank.
Germany, on the other hand, is reaching for as much garlic as it can find, in the hope of warding off fiscal union. It would have to pick up most of the tab for true European fiscal unity, and the German electorate has yet to wrap their heads around that concept.
Europeans basically have two options. One is to unite. They would become something similar to the United States, with a continent-wide government controlling fiscal policy and having taxation powers. The current nations would become more like America's states, controlling local matters but subordinate to the bureaucrats and legislators in Brussels. While Europe would probably never be as tightly united as America under the Constitution (that is, after the Civil War and the adoption of the 13th, 14th and 15th Amendments), its survival would require greater union than achieved by the original thirteen American states under the Articles of Confederation.
Europe's second option would be for Germany and maybe other fiscally strong northern EU nations to leave the EU and strike out on their own, issuing their own national currencies again. Germany would probably strengthen economic ties with Eastern Europe, the Baltic republics, and the southeastern portions of the former Soviet Union (such as Ukraine, Moldova, etc.). These nations are of historical German interest, dating back even to the excursions of the Teutonic Knights during the Middle Ages. Southern European nations would be left on sidelines, muttering something about dancing with the one you brung.
Germany's chancellor, Angela Merkel, and France's president, Nicholas Sarkozy, meet on Tuesday, Aug. 16, 2011. With all this talk of European union, the media will fixate over their every smile, frown, and arched eyebrow. Merkel, more than anyone, will be the decider. Although she has talked the talk on requiring southern European nations to pay their own way, she has reluctantly slid down the slippery slope toward comprehensive EU assumption of the sovereign debt of member nations. It would be politically impossible for her to reverse course now (although she won't openly support Euro bonds because that would be political suicide). A change of political control in Germany would required for option two. That's not yet likely, although it's possible. Political turmoil there would translate into more stock market volatility in Europe and America.
More than anything else, Europe's response to its sovereign debt crisis will dictate the direction of Europe's and North America's economies and stock markets. Europe's recent piecemeal ban on naked short selling of bank stocks is akin to shooting the messenger. But the EU approach to its debt crisis has certainly been lathered with expediency. Next week, the EU may stir up a good deal of market volatility. The U.S. Congress can't do its share to screw things up, since it's thankfully out of Washington for the August recess. Keep an eye on events across the pond.
Wednesday, August 10, 2011
The Fragility of the Financial System
Is the stock market crazy with its recent belly flops? In the past 5 weeks, it's dropped over 15%, with the Dow adding another 519 points today (over 4%). We're getting close to a bona fide bear market. While the trading may look like panic selling, maybe it's not. Over half the market is computerized trading. The firms that do this stuff leave it to the algorithms and machines. Many of the non-computerized sellers are institutional investors--mutual funds, pension funds, hedge funds, and so on. The money managers of these institutions presumably have the professional experience to stay focused even when under stress. Are they right to jump ship so quickly?
The heart of the world's economy is the financial system. Banks and other firms that comprise the financial system are unusually fragile. Even the biggest banks have Achilles heels where their commercial counterparts don't. A bank's principal asset is the confidence in which it is held by those that deal with it. Without that confidence, the bank would be overwhelmed by a flash mob of depositors, counterparties and creditors all trying to get their money out immediately. By contrast, the Apples, Googles, Microsofts, and even Fords of the world can't go under in a matter of a day or two or three, no matter how little confidence others have in them. They need months, and even years, to collapse.
Confidence in the big banks has been shaken. The European debt crisis is the biggest reason. Europe's big banks hold large amounts of EU sovereign debt. If the EU's debt crisis keeps metastasizing (and it likely will, by all indications), these banks will have greatly shortened half-lives. While the major U.S. banks hold only modest amounts of EU sovereign debt, they are bound by numerous interconnections to Europe's big banks (through the settlement and clearance process for checks, trade financings and the like, interbank lending, derivatives exposures and so on). If Europe's big banks become insolvent, America's big banks will be living in a world of ships (or something like that). Just a couple of days ago, Spain and Italy were the focus of domino-like rumors as the next shoes to drop in the EU crisis. Now, France is vigorously denying that it has problems. Many in the market are taking this as confirmation that France does have problems (on the theory that if you have to deny it, you're already toast). The EU debt crisis acts like a battering ram on confidence in the world's big banks.
Another confidence shaker was the S&P downgrade of U.S. Treasuries. The proximate connection of the downgrade to the big banks is they hold boatloads of U.S. Treasuries. Since the 2008 financial crisis, the big banks have played a sure-win game where they borrow from the Federal Reserve, for virtually nothing, and reinvest the money in U.S. Treasuries. The Treasury securities effectively give the big banks a wash with the federal government, except for a net positive interest payment. In effect, the Fed has been sending income to the big banks for free. There was also no credit risk, that is, until the downgrade. While Treasuries have momentarily risen in market value due to flight to quality buying, the rating downgrade highlights the risks of the concentration of bank assets in Treasury securities.
Taken together, the large holdings of EU sovereign debt by EU banks, and the large positions of U.S. banks in U.S. Treasuries, make the international banking system unusually sensitive to difficulties with sovereign debt. And lately there have been difficulties galore. Hence, the financial system looks shakier and stock values less certain.
To make the situation worse, the Fed's relentless campaign to drive down interest rates along the length and breadth of the yield curve has, perversely, weakened the banks. Banks, in a nutshell, make their money by borrowing on a short term basis, usually at the low rates available at the short end of the curve, and lending longer term at the higher rates usually available for longer maturities. This strategy works when long term interest rates are sufficiently higher than short term rates (i.e., the yield curve is sufficiently upward sloping). The flatter the yield curve gets (i.e., the lower long term rates go, relative to short term rates), the less profitable lending is for banks. The Fed's various policy measures, most recently QE2, have flattened the yield curve quite a bit. Recent flight to quality has flattened it even more. Perhaps one reason why the Fed hasn't yet announced QE3 is because it doesn't want to further stifle the profitability of bank lending by making the yield curve resemble the horizon.
Thus, the Fed's interest rate policies are probably adding to the fragility of the banking system. Folk wisdom on the Street holds that when the yield curve inverts (i.e., the short end rises above the long end), a recession is likely. Today, it's hard to apply this thesis, since the Fed artificially prescribes rates. But if we could extrapolate somehow to what a more normal, less government controlled market would look like, we'd have to be concerned that prospects for the economy are far from rosy.
Last, but certainly not least, the real estate/mortgage crisis still haunts the banking system. Recently, the robo-signing foreclosure debacle has operated like a pipe bomb in bank balance sheets, with escalating costs that the banks have been desperately trying to cap through court settlements. Once the banks are able to foreclose again, they'll have to book losses by writing down a lot of loans currently held in suspension because foreclosures remain in limbo. It will be years and many more losses before the real estate disaster is cleaned up.
So have investors been freaking out and selling in a panic? Or does it make sense that the sudden flaring of the EU sovereign debt crisis over the past few months, coupled with the debt ceiling dance of governmental dysfunction, and the nine lives of the real estate/mortgage crisis, would reveal the ethereal foundations of stock market valuations? This isn't necessarily a situation where the market must be crazy. Maybe the world really is screwed up, and market valuations are adjusting to reflect that reality.
The heart of the world's economy is the financial system. Banks and other firms that comprise the financial system are unusually fragile. Even the biggest banks have Achilles heels where their commercial counterparts don't. A bank's principal asset is the confidence in which it is held by those that deal with it. Without that confidence, the bank would be overwhelmed by a flash mob of depositors, counterparties and creditors all trying to get their money out immediately. By contrast, the Apples, Googles, Microsofts, and even Fords of the world can't go under in a matter of a day or two or three, no matter how little confidence others have in them. They need months, and even years, to collapse.
Confidence in the big banks has been shaken. The European debt crisis is the biggest reason. Europe's big banks hold large amounts of EU sovereign debt. If the EU's debt crisis keeps metastasizing (and it likely will, by all indications), these banks will have greatly shortened half-lives. While the major U.S. banks hold only modest amounts of EU sovereign debt, they are bound by numerous interconnections to Europe's big banks (through the settlement and clearance process for checks, trade financings and the like, interbank lending, derivatives exposures and so on). If Europe's big banks become insolvent, America's big banks will be living in a world of ships (or something like that). Just a couple of days ago, Spain and Italy were the focus of domino-like rumors as the next shoes to drop in the EU crisis. Now, France is vigorously denying that it has problems. Many in the market are taking this as confirmation that France does have problems (on the theory that if you have to deny it, you're already toast). The EU debt crisis acts like a battering ram on confidence in the world's big banks.
Another confidence shaker was the S&P downgrade of U.S. Treasuries. The proximate connection of the downgrade to the big banks is they hold boatloads of U.S. Treasuries. Since the 2008 financial crisis, the big banks have played a sure-win game where they borrow from the Federal Reserve, for virtually nothing, and reinvest the money in U.S. Treasuries. The Treasury securities effectively give the big banks a wash with the federal government, except for a net positive interest payment. In effect, the Fed has been sending income to the big banks for free. There was also no credit risk, that is, until the downgrade. While Treasuries have momentarily risen in market value due to flight to quality buying, the rating downgrade highlights the risks of the concentration of bank assets in Treasury securities.
Taken together, the large holdings of EU sovereign debt by EU banks, and the large positions of U.S. banks in U.S. Treasuries, make the international banking system unusually sensitive to difficulties with sovereign debt. And lately there have been difficulties galore. Hence, the financial system looks shakier and stock values less certain.
To make the situation worse, the Fed's relentless campaign to drive down interest rates along the length and breadth of the yield curve has, perversely, weakened the banks. Banks, in a nutshell, make their money by borrowing on a short term basis, usually at the low rates available at the short end of the curve, and lending longer term at the higher rates usually available for longer maturities. This strategy works when long term interest rates are sufficiently higher than short term rates (i.e., the yield curve is sufficiently upward sloping). The flatter the yield curve gets (i.e., the lower long term rates go, relative to short term rates), the less profitable lending is for banks. The Fed's various policy measures, most recently QE2, have flattened the yield curve quite a bit. Recent flight to quality has flattened it even more. Perhaps one reason why the Fed hasn't yet announced QE3 is because it doesn't want to further stifle the profitability of bank lending by making the yield curve resemble the horizon.
Thus, the Fed's interest rate policies are probably adding to the fragility of the banking system. Folk wisdom on the Street holds that when the yield curve inverts (i.e., the short end rises above the long end), a recession is likely. Today, it's hard to apply this thesis, since the Fed artificially prescribes rates. But if we could extrapolate somehow to what a more normal, less government controlled market would look like, we'd have to be concerned that prospects for the economy are far from rosy.
Last, but certainly not least, the real estate/mortgage crisis still haunts the banking system. Recently, the robo-signing foreclosure debacle has operated like a pipe bomb in bank balance sheets, with escalating costs that the banks have been desperately trying to cap through court settlements. Once the banks are able to foreclose again, they'll have to book losses by writing down a lot of loans currently held in suspension because foreclosures remain in limbo. It will be years and many more losses before the real estate disaster is cleaned up.
So have investors been freaking out and selling in a panic? Or does it make sense that the sudden flaring of the EU sovereign debt crisis over the past few months, coupled with the debt ceiling dance of governmental dysfunction, and the nine lives of the real estate/mortgage crisis, would reveal the ethereal foundations of stock market valuations? This isn't necessarily a situation where the market must be crazy. Maybe the world really is screwed up, and market valuations are adjusting to reflect that reality.
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