A fundamental reason why EU bailouts repeatedly belly flop is that the EU is trying to work against market forces, rather than harnessing them to its advantage. The most recent 100 billion Euro "bailout" of Spain consisted of a press release promising a large sounding amount of money, with no details about where the money would come from or on what terms. Evidently, the idea was to use a big number to impress the bond vigilantes into simmering down. But the BVs are much better poker players than the EU's top ministers, and sniffed out the bluff in one trading day.
The baseline reason why the EU is in debt hell is that it's growing too slowly to service the outstanding amounts of its sovereign and quasi-sovereign debt (the latter including bank liabilities which national governments are legally or de facto obligated to cover). The simple solution to this problem is to boost economic growth. The time-honored way of fostering growth is to increase the nation's international competitiveness and thereby rev up its domestic production. This would be done by devaluing the currency and lowering wages. Governments would cut back on deficit spending, so as to begin the process of deleveraging. These adjustments are economically painful and politically difficult. But they put debtor nations in the position of using market forces to their advantage. This generally leads toward the path to recovery.
The EU's policies to date have focused on fighting bond market forces with "bailouts" that consisting of c0mbatting debt with more debt. Profligate nations are told to adopt policies aimed at austerity. But the European Central Bank won't devalue the Euro, so part of the normal path to recovery isn't being taken. Profligate nations are told to attempt dramatically painful cuts in government benefits and pay, without the assistance of a devalued currency. But too much drama is offputting and we are seeing the consequences in anti-austerity movements across much of the EU. These protest movements, in Greece, France and elsewhere, could lead to the break-up of the EU, as German taxpayers are likely to balk at ponying up the hundreds of billions of Euros it would cost to preserve the EU. The bond markets aren't fooled, and private sector money is gradually staging a run on Euro-denominated debt owed by any nation whose creditworthiness is in question. Only massive purchases of sovereign debt by debtor nation banks (which in turn may need bailouts themselves if things get stinkier) are keeping the credit markets open for some of the bigger spenders in the EU.
By trying to flimflam the bond markets while not effectively making the underlying economic adjustments that would lead to renewed growth, the EU continues to run off the road into the ditch. As we learned in the 2007-08 collapse of the real estate and mortgage markets in America, when conditions become extreme enough, basic economic forces prevail over government band-aids. To preserve the EU, everyone has to make painful sacrifices. People in profligate nations must accept lower wages and government benefits, along with much greater control over their governments' spending by the bureaucrats in Brussels. People in wealthy nations like Germany must accept significantly increased tax burdens to help their struggling neighbors through the crisis. The entire EU must accept the notion that the Euro should be devalued, by a lot and quickly.
The EU can't declare de facto bankruptcy because so much of its sovereign debt is held by its own banks that defaults would send its banking system swirling down the porcelain goddess. Of course, that wouldn't actually happen because national governments in Europe would bail out their banks. But the bailouts would require a new round of sovereign debt, thus perpetuating the not at all virtuous cycle.
The citizenry of Europe were told that the European Union would bring prosperity. These political promises now hinder effective resolution of the problem. Once promised prosperity, the citizens won't allow the politicians to take it away. But economic cycles have not been (and cannot be) repealed. Every society built on promises of permanent prosperity will eventually be hoisted by its own petard (see Soviet Union, Communist China for further reading). China and its much lower wages represent a path that won't be acceptable to Europe's bourgeoisie. The United States, with its bona fide national identity, will be difficult for Europeans, who are provincial deep down, to emulate. Indeed, it took a bloody civil war for America to truly become one nation. Europe won't go that far, not after the two world wars in the 20th Century.
The breakup of the Soviet Union may well illustrate what will happen to the EU. The Soviet Union was a historical experiment in fighting market forces, and it failed spectacularly. The EU won't fair any better in the end.
Wednesday, June 13, 2012
Wednesday, June 6, 2012
Over There at the EU Crisis
Paralysis now grips Europe. The EU has no solution for its sovereign debt-banking-economic crisis. Greece is in a political netherworld, with a second election to be held this month to determine, perhaps, if the electorate can choose a government.
But Greece is a side show. Spain now occupies center stage, with a banking crisis that the country itself cannot solve. Although Spain's sovereign debt is, proportionately speaking, no greater than Germany's, enormous losses from a collapsed real estate market have overwhelmed Spain's banks. The government, directly and indirectly, is in the process of taking over its banking system. But it cannot handle the shipload of liabilities it is assuming. So it has turned to the EU.
The EU, in its familiar, inimitable fashion, wallows in dysfunction as it squirms around to find someone to pick up the tab. The European Central Bank, by holding interest rates steady today, has signaled its firm intention not to take responsibility for the messes made by politicians. Most of Europe's politicians have raised their eyebrows in the direction of Germany. But the Germans fear, not irrationally, that they are being asked to pick up the tab not only for the table, but for the entire restaurant. Any bailout of Spain's banks would surely entail greater EU (read, German) control over Spain's banks. That may or may not be acceptable to the Spanish, since German control over Spain's credit spigots means German control over Spain's economy.
Not surprisingly, hints and even calls for American action have grown. It's not at all crazy for Europe to look westward. In 1917 and 1941, the United States called its men to arms in order to end world wars emanating from Europe's endemic political dysfunction. Over 400,000 Americans made the supreme sacrifice in Europe during these two wars and American taxpayers coughed up many, many billions of dollars to stop Europeans from killing each other. In 1947, America adopted the Marshall Plan, an extraordinary act of generosity that propped up a Europe devastated by war and prevented much of the continent from falling under Soviet control. Surely, it's quite rational for Europe to expect America to step up again and reach for the tab. We've fostered the greatest case of moral hazard in human history, and now have to live with the consequences.
But America has its own problems. The vituperative animosity between Republicans and Democrats, well-exemplified by the bitterness of Wisconsin's recall election, prevents the President and Congress from taking effective action before this fall's presidential election. Action thereafter, even if possible, may be too late.
That leaves the Federal Reserve. Market players twitch their ears around, hoping for any sound of Chairman Bernanke warming up his helicopter. We know from the 2008 financial crisis that Bernanke's default setting is to act. That setting isn't going to change in the foreseeable future. Whether or not the Fed can do anything effective is a different question. More QE might temporarily support the stock markets--and, naturally, that's Wall Street's underlying motive in encouraging an activist Fed. Never mind the spectacle of America's capitalists par excellence looking for more government intervention. But there's little reason to think that QE III will save Europe. The sources of the badness in Europe's bad debt won't be cured by Fed purchases of dollar denominated debt.
Is there any way the Fed could have an impact in Europe? The answer is maybe, but it would involve replacing the Euro with the U.S. dollar. Since the Fed can (and perhaps will) printed unlimited quantities of dollars, it could buy up Euro-denominated debt if the sellers would accept dollars. Because the EU crisis involves the heart of the European financial system (banks, central banks and sovereign debt), the result would be to make the dollar Europe's continental currency. Not necessarily for all daily spending at the supermarket and the gas station, but at least for all significant central banking, interbank and monetary policy transactions. With the dollar the only financial asset in the world that is readily available to provide a measure of stability to Europe, conversion from the Euro to the dollar may be the one card the Fed might effectively play.
Europeans wouldn't readily cotton to such a notion, because it would recreate the 1950s and 1960s, when the dollar played such a role and the United States exercised extra-sovereign power over Western Europe. But it might be the way the Fed, being the only central bank in the world with the inclination and capacity to act, could prop up Europe.
In essence, the EU faces a choice between dissolution, German dominance, or in this perhaps far fetched scenario, American dominance. Given the history of the past century, in which America was the most generous and benevolent of super powers, what do we think Europeans might prefer? Germany's stubborn insistence on its world view during the current crisis has, however unfairly, brought back in many European minds images of jackbooted stormtroopers and civilian killings by screaming Stuka dive bombers. But American intervention, if it occurs, would stir memories of raw, inexperienced GIs by dint of sheer determination and courage pushing their way through murderous German fire onto the heights overlooking Omaha Beach, and continuing from there to liberate a continent. A European return to the dollar may be the only real choice left. Time will tell.
But Greece is a side show. Spain now occupies center stage, with a banking crisis that the country itself cannot solve. Although Spain's sovereign debt is, proportionately speaking, no greater than Germany's, enormous losses from a collapsed real estate market have overwhelmed Spain's banks. The government, directly and indirectly, is in the process of taking over its banking system. But it cannot handle the shipload of liabilities it is assuming. So it has turned to the EU.
The EU, in its familiar, inimitable fashion, wallows in dysfunction as it squirms around to find someone to pick up the tab. The European Central Bank, by holding interest rates steady today, has signaled its firm intention not to take responsibility for the messes made by politicians. Most of Europe's politicians have raised their eyebrows in the direction of Germany. But the Germans fear, not irrationally, that they are being asked to pick up the tab not only for the table, but for the entire restaurant. Any bailout of Spain's banks would surely entail greater EU (read, German) control over Spain's banks. That may or may not be acceptable to the Spanish, since German control over Spain's credit spigots means German control over Spain's economy.
Not surprisingly, hints and even calls for American action have grown. It's not at all crazy for Europe to look westward. In 1917 and 1941, the United States called its men to arms in order to end world wars emanating from Europe's endemic political dysfunction. Over 400,000 Americans made the supreme sacrifice in Europe during these two wars and American taxpayers coughed up many, many billions of dollars to stop Europeans from killing each other. In 1947, America adopted the Marshall Plan, an extraordinary act of generosity that propped up a Europe devastated by war and prevented much of the continent from falling under Soviet control. Surely, it's quite rational for Europe to expect America to step up again and reach for the tab. We've fostered the greatest case of moral hazard in human history, and now have to live with the consequences.
But America has its own problems. The vituperative animosity between Republicans and Democrats, well-exemplified by the bitterness of Wisconsin's recall election, prevents the President and Congress from taking effective action before this fall's presidential election. Action thereafter, even if possible, may be too late.
That leaves the Federal Reserve. Market players twitch their ears around, hoping for any sound of Chairman Bernanke warming up his helicopter. We know from the 2008 financial crisis that Bernanke's default setting is to act. That setting isn't going to change in the foreseeable future. Whether or not the Fed can do anything effective is a different question. More QE might temporarily support the stock markets--and, naturally, that's Wall Street's underlying motive in encouraging an activist Fed. Never mind the spectacle of America's capitalists par excellence looking for more government intervention. But there's little reason to think that QE III will save Europe. The sources of the badness in Europe's bad debt won't be cured by Fed purchases of dollar denominated debt.
Is there any way the Fed could have an impact in Europe? The answer is maybe, but it would involve replacing the Euro with the U.S. dollar. Since the Fed can (and perhaps will) printed unlimited quantities of dollars, it could buy up Euro-denominated debt if the sellers would accept dollars. Because the EU crisis involves the heart of the European financial system (banks, central banks and sovereign debt), the result would be to make the dollar Europe's continental currency. Not necessarily for all daily spending at the supermarket and the gas station, but at least for all significant central banking, interbank and monetary policy transactions. With the dollar the only financial asset in the world that is readily available to provide a measure of stability to Europe, conversion from the Euro to the dollar may be the one card the Fed might effectively play.
Europeans wouldn't readily cotton to such a notion, because it would recreate the 1950s and 1960s, when the dollar played such a role and the United States exercised extra-sovereign power over Western Europe. But it might be the way the Fed, being the only central bank in the world with the inclination and capacity to act, could prop up Europe.
In essence, the EU faces a choice between dissolution, German dominance, or in this perhaps far fetched scenario, American dominance. Given the history of the past century, in which America was the most generous and benevolent of super powers, what do we think Europeans might prefer? Germany's stubborn insistence on its world view during the current crisis has, however unfairly, brought back in many European minds images of jackbooted stormtroopers and civilian killings by screaming Stuka dive bombers. But American intervention, if it occurs, would stir memories of raw, inexperienced GIs by dint of sheer determination and courage pushing their way through murderous German fire onto the heights overlooking Omaha Beach, and continuing from there to liberate a continent. A European return to the dollar may be the only real choice left. Time will tell.
Tuesday, May 29, 2012
The Bank Run Deposit Insurance Doesn't Protect Against
A slow motion run on banks in Greece, Spain and other distressed Euro bloc nations has been taking place ever since the sovereign debt crisis blew up two years ago. Recent news reports indicate it has accelerated, particularly in Greece. The top 1% and others in distressed nations have been moving money to banking havens such as Switzerland and Luxembourg, and stable nations like Germany and the UK.
Depositors have two reasons to flee banks in troubled countries. One, those holding deposits exceeding the 100,000 Euro limit on deposit insurance in the Euro bloc have much to lose if their local bank collapses. Two, depositors in any nation that potentially may depart the Euro bloc confront the risk of compelled conversion of their deposits into a new, depreciated currency. Greece presents a vivid example of the latter problem. Conversion back to the drachma could sharply reduce the value of Greek bank deposits. There is no deposit insurance that protects against losses sustained when one's home nation drops out of the Euro zone and adopts a depreciated national currency. Some Greeks have been withdrawing Euros from ATMs (presumably to pad their mattresses). Others have been moving Euros electronically to safe haven nations.
The capital mobility created by the adoption of the Euro facilitates such bank runs. Since the Euro bloc, by definition, eliminates the problems of currency conversion, moving funds from one Euro bloc nation to another is easier than in the bad old days of national currencies. The upside of increased capital mobility is that money was supposed to go where it could earn the highest return, which was thought to promote economic efficiency and greater overall prosperity. The downside is that capital can more readily flee ugly situations, even if it's needed to help finance a nation's way out of ugliness.
The European Central Bank might be able to stop the burgeoning bank runs. The core mission of central banks is to promote depositor confidence. The ECB seems to have been lending many billions of Euros to Greek and Spanish banks. But it won't print money, and that limits its options if the run quickens. The Euro bloc, a 21st Century financial innovation, may have laid the foundation for an old-fashioned 19th Century financial panic. Time will tell.
Depositors have two reasons to flee banks in troubled countries. One, those holding deposits exceeding the 100,000 Euro limit on deposit insurance in the Euro bloc have much to lose if their local bank collapses. Two, depositors in any nation that potentially may depart the Euro bloc confront the risk of compelled conversion of their deposits into a new, depreciated currency. Greece presents a vivid example of the latter problem. Conversion back to the drachma could sharply reduce the value of Greek bank deposits. There is no deposit insurance that protects against losses sustained when one's home nation drops out of the Euro zone and adopts a depreciated national currency. Some Greeks have been withdrawing Euros from ATMs (presumably to pad their mattresses). Others have been moving Euros electronically to safe haven nations.
The capital mobility created by the adoption of the Euro facilitates such bank runs. Since the Euro bloc, by definition, eliminates the problems of currency conversion, moving funds from one Euro bloc nation to another is easier than in the bad old days of national currencies. The upside of increased capital mobility is that money was supposed to go where it could earn the highest return, which was thought to promote economic efficiency and greater overall prosperity. The downside is that capital can more readily flee ugly situations, even if it's needed to help finance a nation's way out of ugliness.
The European Central Bank might be able to stop the burgeoning bank runs. The core mission of central banks is to promote depositor confidence. The ECB seems to have been lending many billions of Euros to Greek and Spanish banks. But it won't print money, and that limits its options if the run quickens. The Euro bloc, a 21st Century financial innovation, may have laid the foundation for an old-fashioned 19th Century financial panic. Time will tell.
Sunday, May 20, 2012
Winners and Losers in the Facebook IPO
WINNERS
Billionaires and Millionaires. Some Facebook investors and employees had a very good day. A few of them became billionaires and quite a few became millionaires.
Facebook. The fact that there wasn't much of a pop in the stock after trading began means that Facebook left little money on the table when it priced the offering at $38 per share.
Selling shareholders. More than half the stock offered was sold by investors and employees who had gotten their stock privately before the IPO. The lack of a big pop means they, too, left little money on the table when they sold.
California. The State of California stands to collect something like $2 billion in taxes from sales of Facebook stock by state residents. With the state's finances in the fiscal ICU, that's like manna from heaven.
Short sellers. The fact that the stock closed barely above the offering price indicates that many shareholders are looking at Facebook as a short term play. Like wolves scanning a herd of caribou for any animal displaying signs of weakness, short sellers are always on the alert for flagging shareholder interest. They may find a juicy target in Facebook.
LOSERS
Nasdaq. The opening of trading in Facebook was delayed for "technical" reasons that are now being poked into by the SEC. Press reports indicate that order execution for many investors was sloppy and slow. Not the kind of publicity Nasdaq needed from the highest profile IPO of the year.
Morgan Stanley. MSCO got the highly coveted lead underwriter position. Then it had to earn its fee when the stock began threatening to drop below the $38 IPO price. MSCO may have bought a shipload of stock toward the end of Friday, when trading opened, in order to keep the price above $38. Tomorrow, the second trading day for Facebook, could bring more challenges.
Money managers. Mutual fund managers and other money managers like IPOs with big opening day pops. They use their market connections to score a big allotment of the IPO, and sell some of it into the pop, getting a fast buck that's needed. Most money managers don't match the S&P 500, and non-typical gains like IPO pops are important to help them stand out from the crowd. Facebook wasn't a good IPO for them.
Tech companies planning IPOs. The tepid Facebook pop may put a damper on IPOs planned by other tech companies. The "technical" problems encountered by Nasdaq, market of choice for tech companies, won't add to anyone's enthusiasm. If investors don't have a good time with a high profile IPO like Facebook, they'll be wary of other, less glamorous ones.
Mark Zuckerberg. Billionaire, just married, he's got to feel like he's at the top of the world. The market will disabuse him of that notion in a couple of trading days, at most. He'll learn that public company stocks are traded short term, which means that he's expected to deliver, every quarter on the quarter end. Whatever his long term goals for the company, the short term performance will have to be gorgeous, and then more gorgeous the next quarter, or the stock price will be hung, drawn and quartered (pun intended). It gets personal, too. One lousy press release from the company, and bad things will be done to his effigy. He'll be made to understand, not in a fun way, that short sellers will be a permanent presence in his life, trying to financially actualize schadenfreude. Sooner or later, one or more of Facebook's officers, directors and employees will leak inside information to family and/or friends, and embarrass the company when federal authorities swoop in. He'll feel betrayed, but he won't be able to prevent it. He'll feel every uptick and downtick of the stock's price, because shareholders will make sure he feels ticks. Any significant failings by the company will lead to his introduction to the most prominent class action plaintiffs lawyers in America. As SEC rules compel him to make disclosures about his compensation, perks, transactions with the company, holdings of company stock and a variety of other things, he might end up feeling like he has less privacy than the most effusive of Facebook users. Surely, Zuckerberg has already been counseled by his advisers about all of the foregoing. But the reality of his new life running a public company won't sink in until he lives the full, graphic experience. There's a price to pay for going public, and the bill collectors are gathering.
Billionaires and Millionaires. Some Facebook investors and employees had a very good day. A few of them became billionaires and quite a few became millionaires.
Facebook. The fact that there wasn't much of a pop in the stock after trading began means that Facebook left little money on the table when it priced the offering at $38 per share.
Selling shareholders. More than half the stock offered was sold by investors and employees who had gotten their stock privately before the IPO. The lack of a big pop means they, too, left little money on the table when they sold.
California. The State of California stands to collect something like $2 billion in taxes from sales of Facebook stock by state residents. With the state's finances in the fiscal ICU, that's like manna from heaven.
Short sellers. The fact that the stock closed barely above the offering price indicates that many shareholders are looking at Facebook as a short term play. Like wolves scanning a herd of caribou for any animal displaying signs of weakness, short sellers are always on the alert for flagging shareholder interest. They may find a juicy target in Facebook.
LOSERS
Nasdaq. The opening of trading in Facebook was delayed for "technical" reasons that are now being poked into by the SEC. Press reports indicate that order execution for many investors was sloppy and slow. Not the kind of publicity Nasdaq needed from the highest profile IPO of the year.
Morgan Stanley. MSCO got the highly coveted lead underwriter position. Then it had to earn its fee when the stock began threatening to drop below the $38 IPO price. MSCO may have bought a shipload of stock toward the end of Friday, when trading opened, in order to keep the price above $38. Tomorrow, the second trading day for Facebook, could bring more challenges.
Money managers. Mutual fund managers and other money managers like IPOs with big opening day pops. They use their market connections to score a big allotment of the IPO, and sell some of it into the pop, getting a fast buck that's needed. Most money managers don't match the S&P 500, and non-typical gains like IPO pops are important to help them stand out from the crowd. Facebook wasn't a good IPO for them.
Tech companies planning IPOs. The tepid Facebook pop may put a damper on IPOs planned by other tech companies. The "technical" problems encountered by Nasdaq, market of choice for tech companies, won't add to anyone's enthusiasm. If investors don't have a good time with a high profile IPO like Facebook, they'll be wary of other, less glamorous ones.
Mark Zuckerberg. Billionaire, just married, he's got to feel like he's at the top of the world. The market will disabuse him of that notion in a couple of trading days, at most. He'll learn that public company stocks are traded short term, which means that he's expected to deliver, every quarter on the quarter end. Whatever his long term goals for the company, the short term performance will have to be gorgeous, and then more gorgeous the next quarter, or the stock price will be hung, drawn and quartered (pun intended). It gets personal, too. One lousy press release from the company, and bad things will be done to his effigy. He'll be made to understand, not in a fun way, that short sellers will be a permanent presence in his life, trying to financially actualize schadenfreude. Sooner or later, one or more of Facebook's officers, directors and employees will leak inside information to family and/or friends, and embarrass the company when federal authorities swoop in. He'll feel betrayed, but he won't be able to prevent it. He'll feel every uptick and downtick of the stock's price, because shareholders will make sure he feels ticks. Any significant failings by the company will lead to his introduction to the most prominent class action plaintiffs lawyers in America. As SEC rules compel him to make disclosures about his compensation, perks, transactions with the company, holdings of company stock and a variety of other things, he might end up feeling like he has less privacy than the most effusive of Facebook users. Surely, Zuckerberg has already been counseled by his advisers about all of the foregoing. But the reality of his new life running a public company won't sink in until he lives the full, graphic experience. There's a price to pay for going public, and the bill collectors are gathering.
Monday, May 14, 2012
J.P. Morgan's Big Problem
The baseline problem underlying J.P. Morgan's recently announced $2 billion loss on a credit default swap bet gone bad is that big banks face virtually all economic risks. Banking, as conducted by major money center banks, cuts across essentially all economic sectors, all lines of commerce, all financial instruments, and all asset classes. There are some exceptions. For example, big banks rarely dabble in penny stocks or business startups. And they tend to limit their exposure to junk bonds. But they directly or indirectly play in almost all sandboxes in the economy.
The essential conceit of contemporary financial engineering is that risk somehow can be controlled. It is believed that if you find a clever enough math whiz with an MBA from a sufficiently fancy school, s/he can fashion a derivative for any purpose that will magically (albeit for a fee) transport risk to a distant land from which it will never return. With such magical powers, one need not be prudent and limit exposure to risky assets. One need only have a smart enough financial engineer to fashion a seemingly appropriate hedge.
Derivatives can work, and work well, when the risk they're meant to mitigate is narrow and well-defined. For example, futures contracts for red winter wheat serve salutary purposes when appropriately used by farmers, grain companies and speculators.
But when derivatives are deployed to mitigate wide-ranging and vaguely defined risks, their limitations come into play. Press reports indicate that J.P. Morgan's management directed its chief investment office to mitigate the risks of economic deterioration in Europe. This, to say the least, is a rather large, complex and wide ranging problem. Things in Europe can go downhill for a variety of reasons, not all of which are easily defined or predicted. The murkier a situation, the more difficult it becomes to fashion appropriate hedges. And if the hedges aren't entirely appropriate, their imperfections may have be hedged in turn. Reports in the financial press indicate the mandate from J.P. Morgan's management seems to have morphed into a net position that bet on improved financial health for a number of major corporations. Such a bet wouldn't seem the intuitively obvious way to hedge against a downturn in Europe.
As with all financial firms, J.P. Morgan's most important asset is its reputation. Since the 2007-08 financial crisis, its reputation has been golden. J.P. Morgan avoided unduly large real estate risks. It bought Bear Stearns at the government's behest, quelling incipient panic in the financial system. Its earnings were relatively stable, compared to its competitors. While the latter downsized to ditch hinky assets and offload risk, J.P. Morgan became the largest bank in America.
But such golden reputations become a burden, because the market expected J.P. Morgan to remain golden. Given that big money center banks face virtually all economic risks, this becomes a harder and harder job as time passes. Skilled risk managers and corporate executives might be able to anticipate most risks most of the time. But no one can predict all risks all the time, and a financial institution facing the length and breadth of economic risks borne by major money center banks will stumble sooner or later. Indeed, the longer a bank's winning streak, the greater the chance the next quarter will be a bad one.
Management sitting on a winning streak will understandably want to keep the streak going. But they must consider whether or not they can. Not all risks can be hedged or managed. Much of the "hedging" that goes on in the financial markets consists of using apples to hedge oranges. The two sides of the hedge are not mirror images of each other, but approximations. If the approximations are pretty close, a well-capitalized firm can get by. But that "if" gets bigger and bigger as derivatives positions get larger and as some derivatives are used to hedge risk factors in other hedges (which may have been the case at J.P. Morgan). When risk managers and management fail to recognize that the magic doesn't work in all situations, they get a morass.
Recognizing one's limits is an ancient and highly effective means of risk management. Not taking a risk, or offloading it, eliminates the possibility that it will later bite your butt. Being the biggest bank doesn't necessarily mean that you're the best bank. Appreciate that derivatives are imperfect financial instruments, and because of their newness, their imperfections are imperfectly understood. Given the inability to comprehend all risks or hedge them, having a shipload of capital may be best way for a bank to safeguard its future.
Banks typically trade at comparatively low multiples of earnings per share. That's because of the plethora of risks financial firms typically face. The siren call of the derivatives market is that, for a fee, a bank can hedge its way out of problems instead of having to manage them. These sirens have claimed a number of victims since the 2007-08 financial crisis, and now they appear to have lured J.P. Morgan onto a rocky coast.
The essential conceit of contemporary financial engineering is that risk somehow can be controlled. It is believed that if you find a clever enough math whiz with an MBA from a sufficiently fancy school, s/he can fashion a derivative for any purpose that will magically (albeit for a fee) transport risk to a distant land from which it will never return. With such magical powers, one need not be prudent and limit exposure to risky assets. One need only have a smart enough financial engineer to fashion a seemingly appropriate hedge.
Derivatives can work, and work well, when the risk they're meant to mitigate is narrow and well-defined. For example, futures contracts for red winter wheat serve salutary purposes when appropriately used by farmers, grain companies and speculators.
But when derivatives are deployed to mitigate wide-ranging and vaguely defined risks, their limitations come into play. Press reports indicate that J.P. Morgan's management directed its chief investment office to mitigate the risks of economic deterioration in Europe. This, to say the least, is a rather large, complex and wide ranging problem. Things in Europe can go downhill for a variety of reasons, not all of which are easily defined or predicted. The murkier a situation, the more difficult it becomes to fashion appropriate hedges. And if the hedges aren't entirely appropriate, their imperfections may have be hedged in turn. Reports in the financial press indicate the mandate from J.P. Morgan's management seems to have morphed into a net position that bet on improved financial health for a number of major corporations. Such a bet wouldn't seem the intuitively obvious way to hedge against a downturn in Europe.
As with all financial firms, J.P. Morgan's most important asset is its reputation. Since the 2007-08 financial crisis, its reputation has been golden. J.P. Morgan avoided unduly large real estate risks. It bought Bear Stearns at the government's behest, quelling incipient panic in the financial system. Its earnings were relatively stable, compared to its competitors. While the latter downsized to ditch hinky assets and offload risk, J.P. Morgan became the largest bank in America.
But such golden reputations become a burden, because the market expected J.P. Morgan to remain golden. Given that big money center banks face virtually all economic risks, this becomes a harder and harder job as time passes. Skilled risk managers and corporate executives might be able to anticipate most risks most of the time. But no one can predict all risks all the time, and a financial institution facing the length and breadth of economic risks borne by major money center banks will stumble sooner or later. Indeed, the longer a bank's winning streak, the greater the chance the next quarter will be a bad one.
Management sitting on a winning streak will understandably want to keep the streak going. But they must consider whether or not they can. Not all risks can be hedged or managed. Much of the "hedging" that goes on in the financial markets consists of using apples to hedge oranges. The two sides of the hedge are not mirror images of each other, but approximations. If the approximations are pretty close, a well-capitalized firm can get by. But that "if" gets bigger and bigger as derivatives positions get larger and as some derivatives are used to hedge risk factors in other hedges (which may have been the case at J.P. Morgan). When risk managers and management fail to recognize that the magic doesn't work in all situations, they get a morass.
Recognizing one's limits is an ancient and highly effective means of risk management. Not taking a risk, or offloading it, eliminates the possibility that it will later bite your butt. Being the biggest bank doesn't necessarily mean that you're the best bank. Appreciate that derivatives are imperfect financial instruments, and because of their newness, their imperfections are imperfectly understood. Given the inability to comprehend all risks or hedge them, having a shipload of capital may be best way for a bank to safeguard its future.
Banks typically trade at comparatively low multiples of earnings per share. That's because of the plethora of risks financial firms typically face. The siren call of the derivatives market is that, for a fee, a bank can hedge its way out of problems instead of having to manage them. These sirens have claimed a number of victims since the 2007-08 financial crisis, and now they appear to have lured J.P. Morgan onto a rocky coast.
Tuesday, May 8, 2012
Fools Among the Holders of Greek Debt
A couple of months ago, most holders of Greek government debt reluctantly agreed to a deal to take a loss (called a "haircut" by the financial cognoscenti) of about 75% of the nominal (i.e., face) value of the debt as part of the second bailout package offered to Greece by the EU. Another aspect of that deal was the Greek government would institute austerity measures in order to reduce its future need for debt. The coalition government then governing Greece, a pushmi-pullyu shotgun marriage of two opposing parties, solemnly agreed to the austerity measures.
Just a couple of days ago, Greek voters gave the coalition government something like a machine gun divorce, placing bootprints on the behinds of the coalition parties and effectively putting a Communist politician in the position of calling the shots. It's been decades since Communists in any democratic nation have had a scintilla of political power. But there's never a dull moment with the ongoing economic and financial crisis.
Needless to say, the Communist leader, Alexi Tsipras, isn't of a mind to embrace austerity. He does say he wants Greece to remain in the Euro zone. And why not? Since the beginning of the EU sovereign debt crisis, Greek governments have made promises about fiscal probity and austerity, gotten promises of bailouts, not quite fully lived up to their promises to throttle back spending, and gotten bailed out anyway because the wealthy EU nations always blinked first. The Greek Communists might as well play the same game, and take credit for any blinks they can induce.
Meanwhile, back at the ranch, those holders of Greek debt who agreed to the 75% haircut must be wondering how foolish they now look to the people on whose behalf they manage money. It's well understood that there is political risk associated with speculating in sovereign debt. Politicians will, when push comes to shove, favor their constituents over money managers in the top 1%. Nevertheless, professional financiers dabbling in sovereign debt are supposed to be able to assess political risk astutely. Just two months after the second bailout deal, they've lost the benefit of their bargain because of a political risk that was staring them in the face when they agreed to the haircut.
Private investors will be reluctant to play in the EU sovereign debt sandbox in the future. It's not a winning strategy to take a big haircut and then find out two months later that you have to deal with a newly risen Communist politician.
With the evaporation of private investment interest in the sovereign debt of weaker EU nations, the European Union will have a problem. A fairly large one, in fact. Its member nations can't function without debt. But, with natural investors unwilling to lend their savings, EU sovereign debt (at least for the weaker member nations) would have to be financed by the European Central Bank. The ECB would protest that this violates the letter and spirit of its charter. But what choice will it have? The EU doesn't have a mechanism for defenestrating a member nation, however badly it behaves. And its undercapitalized banking system is up to its ears in the sovereign debt of weak EU nations and can't afford to keep booking losses.
But if the ECB starts to monetize the debt of weaker EU nations (which it already is doing in shadow form with its three-year loans to large member banks), the debt of the wealthier EU nations will become less attractive to private investors. A big money print by the ECB will inflate the Euro in Germany just as it inflates it in Greece, and no creditor wants to hold debt denominated in a potentially inflationary currency. If private investors step back from German sovereign debt, the EU game will be up.
In the end, the wealthier nations will probably leave the EU, and possibly create a smaller currency union with each other. Or they may just go it alone. Either path will garner the interest of private holders of capital. And that would be the way to restore true financial stability.
Just a couple of days ago, Greek voters gave the coalition government something like a machine gun divorce, placing bootprints on the behinds of the coalition parties and effectively putting a Communist politician in the position of calling the shots. It's been decades since Communists in any democratic nation have had a scintilla of political power. But there's never a dull moment with the ongoing economic and financial crisis.
Needless to say, the Communist leader, Alexi Tsipras, isn't of a mind to embrace austerity. He does say he wants Greece to remain in the Euro zone. And why not? Since the beginning of the EU sovereign debt crisis, Greek governments have made promises about fiscal probity and austerity, gotten promises of bailouts, not quite fully lived up to their promises to throttle back spending, and gotten bailed out anyway because the wealthy EU nations always blinked first. The Greek Communists might as well play the same game, and take credit for any blinks they can induce.
Meanwhile, back at the ranch, those holders of Greek debt who agreed to the 75% haircut must be wondering how foolish they now look to the people on whose behalf they manage money. It's well understood that there is political risk associated with speculating in sovereign debt. Politicians will, when push comes to shove, favor their constituents over money managers in the top 1%. Nevertheless, professional financiers dabbling in sovereign debt are supposed to be able to assess political risk astutely. Just two months after the second bailout deal, they've lost the benefit of their bargain because of a political risk that was staring them in the face when they agreed to the haircut.
Private investors will be reluctant to play in the EU sovereign debt sandbox in the future. It's not a winning strategy to take a big haircut and then find out two months later that you have to deal with a newly risen Communist politician.
With the evaporation of private investment interest in the sovereign debt of weaker EU nations, the European Union will have a problem. A fairly large one, in fact. Its member nations can't function without debt. But, with natural investors unwilling to lend their savings, EU sovereign debt (at least for the weaker member nations) would have to be financed by the European Central Bank. The ECB would protest that this violates the letter and spirit of its charter. But what choice will it have? The EU doesn't have a mechanism for defenestrating a member nation, however badly it behaves. And its undercapitalized banking system is up to its ears in the sovereign debt of weak EU nations and can't afford to keep booking losses.
But if the ECB starts to monetize the debt of weaker EU nations (which it already is doing in shadow form with its three-year loans to large member banks), the debt of the wealthier EU nations will become less attractive to private investors. A big money print by the ECB will inflate the Euro in Germany just as it inflates it in Greece, and no creditor wants to hold debt denominated in a potentially inflationary currency. If private investors step back from German sovereign debt, the EU game will be up.
In the end, the wealthier nations will probably leave the EU, and possibly create a smaller currency union with each other. Or they may just go it alone. Either path will garner the interest of private holders of capital. And that would be the way to restore true financial stability.
Sunday, May 6, 2012
A Farewell to European Union
The stock market's penchant for taking the short term view has never been so evident as tonight, with Japanese stocks down over 2% and U.S. stock futures down around 1% following anti-austerity elections in France and Greece. These election results are hardly a surprise; they've been predicted for weeks. Yet, the market is acting like it is shocked--shocked--that electorates would put their personal well-being ahead of the bond market's interests.
The market, as it so often does, allowed itself to be lulled into complacency by the EU's bailouts, which were just kicks of the can down the road with maximum PR effort. Press release politics, it was, and the market took the press releases at face value.
But the problem with the EU sovereign debt crisis is that debt must ultimately be repaid. It can be repaid by debtor remittances to bond holders. Or it can be repaid by forcing bondholders to take partial losses, with debtors kicking in a few pennies for the sake of principle (or principal, if you will). And most typically for the EU, it can be repaid by rolling the debt over, with the help of bailouts from wealthier nations. The last was the EU's first choice, although Teutonic imposition of austerity policies was the EU's way of trying to make debtor nations share some of the burden.
Austerity by itself is likely to produce only economic deceleration. It reduces spending and therefore economic stimulus. The workable form of austerity--austerity along with currency devaluation--can work. It was a formula for recovery by various Asian nations following the 1997 financial crisis there, albeit with substantial short term pain. But Greece's and France's citizens aren't willing to bear the pain of austerity, and the ECB and Germany aren't willing to devalue the Euro. So the EU's brand of austerity isn't destined for success.
The absence of true political union within the EU made it too easy for member nations to ask, not what they could do for the EU, but what the EU could do for them. Europe's political leaders bear much responsibility, presenting the EU as an great opportunity, while downplaying the risks. If the EU were selling securities in the U.S., the SEC would have serious questions about the completeness of its disclosures.
A true currency union can't realistically be a goal by itself. It must be accompanied by true political union. Witness America's Civil War, which not only unified the United States. It also made the U.S. dollar America's sole currency, when federal legislation in 1863 taxing state issued currencies--and federal victory over the Confederacy two years later--effectively eliminated all competing legal tender.
But Europe is too diverse for true political union. Unity requires a willingness to share burdens, to pay an economic price so that political unity can be maintained. Europeans don't have enough in common to contemplate such generosity with any degree of equanimity. So the EU as it now exists cannot survive. Some nations will exit. Those sufficiently similar in outlook and economic strength may stay together in a smaller currency union. But the recent collapse of the Dutch government, due to the growing strength of the right in the Netherlands, raises doubts about the potential for even a smaller currency union.
In one sense, the Euro was part of Europe's effort to prevent another world war. Both world wars of the 20th Century imposed almost unimaginable costs on Europeans. Postwar leaders sought economic union in order to diminish national differences that had fostered the hostilities. But Europeans remain tribal, something that economic interests and market forces have not overcome. And European tribalism will take its toll on the financial markets.
The market, as it so often does, allowed itself to be lulled into complacency by the EU's bailouts, which were just kicks of the can down the road with maximum PR effort. Press release politics, it was, and the market took the press releases at face value.
But the problem with the EU sovereign debt crisis is that debt must ultimately be repaid. It can be repaid by debtor remittances to bond holders. Or it can be repaid by forcing bondholders to take partial losses, with debtors kicking in a few pennies for the sake of principle (or principal, if you will). And most typically for the EU, it can be repaid by rolling the debt over, with the help of bailouts from wealthier nations. The last was the EU's first choice, although Teutonic imposition of austerity policies was the EU's way of trying to make debtor nations share some of the burden.
Austerity by itself is likely to produce only economic deceleration. It reduces spending and therefore economic stimulus. The workable form of austerity--austerity along with currency devaluation--can work. It was a formula for recovery by various Asian nations following the 1997 financial crisis there, albeit with substantial short term pain. But Greece's and France's citizens aren't willing to bear the pain of austerity, and the ECB and Germany aren't willing to devalue the Euro. So the EU's brand of austerity isn't destined for success.
The absence of true political union within the EU made it too easy for member nations to ask, not what they could do for the EU, but what the EU could do for them. Europe's political leaders bear much responsibility, presenting the EU as an great opportunity, while downplaying the risks. If the EU were selling securities in the U.S., the SEC would have serious questions about the completeness of its disclosures.
A true currency union can't realistically be a goal by itself. It must be accompanied by true political union. Witness America's Civil War, which not only unified the United States. It also made the U.S. dollar America's sole currency, when federal legislation in 1863 taxing state issued currencies--and federal victory over the Confederacy two years later--effectively eliminated all competing legal tender.
But Europe is too diverse for true political union. Unity requires a willingness to share burdens, to pay an economic price so that political unity can be maintained. Europeans don't have enough in common to contemplate such generosity with any degree of equanimity. So the EU as it now exists cannot survive. Some nations will exit. Those sufficiently similar in outlook and economic strength may stay together in a smaller currency union. But the recent collapse of the Dutch government, due to the growing strength of the right in the Netherlands, raises doubts about the potential for even a smaller currency union.
In one sense, the Euro was part of Europe's effort to prevent another world war. Both world wars of the 20th Century imposed almost unimaginable costs on Europeans. Postwar leaders sought economic union in order to diminish national differences that had fostered the hostilities. But Europeans remain tribal, something that economic interests and market forces have not overcome. And European tribalism will take its toll on the financial markets.
Monday, April 30, 2012
What's Good About the Bad Goldilocks Economy
Like welfare queens at the corner store swiping a government sponsored debit card for a pack of smokes and a forty of malt liquor, many day traders and other short term speculators on Wall Street complain that we have a Bad Goldilocks economy. It's not growing fast enough to reduce unemployment, boost consumer demand, and spur on the bull market. It's also not so sluggish as to induce the Fed to run its monetary printing presses overtime. In other words, there's no easy money to be made, nor is there a government handout to be had. Life stinks, because getting money may require hard work.
And that's the good thing about the Bad Goldilocks economy. There are no shortcuts or bailouts. The private sector will have to make it on its own, the old-fashioned way, by working and taking risk. That's what we need. No economy grows organically from never-ending government support. Repeated infusions of government bailouts promote dependency and capital hoarding, rather than investment and hiring. Many major American corporations are sitting on shiploads of cash, waiting for another gift from Uncle Ben, and not spending because they don't see a sure bet. Nothing could be more detrimental to America's economic future than this kind of cash hoarding. It doesn't finance innovation, create jobs, or produce operating profits.
The Fed's dilemma with the Bad Goldilocks economy isn't just the risk of recession if it doesn't act and the risk of inflation if it prints more money. In the past four years, the Fed has taken the most morally hazardous route in its history. Its repeated interventions have reduced many on Wall Street and in corporate America to Pavlovian passivity, waiting for the next wave of money printing. Such is not the stuff of which prosperity is made.
Bad Goldilocks gives the Fed an opportunity--to cut the money printing umbilical cord it affixed to the economy and the stock market in 2008. The private sector needs to learn that its next profit opportunity won't come from another round of government intervention. It needs to re-learn how pull up on its bootstraps. The best Fed may be a low profile Fed (if that's not an oxymoron). If the economy seems headed for a major belly flop, further intervention may be needed. But Goldilocks is good, giving the Fed a chance to ween the private sector off bailouts and handouts. We're not talking about doing anything radical like raising interest rates or reducing the Fed's Brobdingnagian balance sheet. We're just suggesting a gradual nudging of attitudes away from expecting the central bank to come by every night on a sleigh drawn by reindeer and drop down the chimney with gifts for all.
And that's the good thing about the Bad Goldilocks economy. There are no shortcuts or bailouts. The private sector will have to make it on its own, the old-fashioned way, by working and taking risk. That's what we need. No economy grows organically from never-ending government support. Repeated infusions of government bailouts promote dependency and capital hoarding, rather than investment and hiring. Many major American corporations are sitting on shiploads of cash, waiting for another gift from Uncle Ben, and not spending because they don't see a sure bet. Nothing could be more detrimental to America's economic future than this kind of cash hoarding. It doesn't finance innovation, create jobs, or produce operating profits.
The Fed's dilemma with the Bad Goldilocks economy isn't just the risk of recession if it doesn't act and the risk of inflation if it prints more money. In the past four years, the Fed has taken the most morally hazardous route in its history. Its repeated interventions have reduced many on Wall Street and in corporate America to Pavlovian passivity, waiting for the next wave of money printing. Such is not the stuff of which prosperity is made.
Bad Goldilocks gives the Fed an opportunity--to cut the money printing umbilical cord it affixed to the economy and the stock market in 2008. The private sector needs to learn that its next profit opportunity won't come from another round of government intervention. It needs to re-learn how pull up on its bootstraps. The best Fed may be a low profile Fed (if that's not an oxymoron). If the economy seems headed for a major belly flop, further intervention may be needed. But Goldilocks is good, giving the Fed a chance to ween the private sector off bailouts and handouts. We're not talking about doing anything radical like raising interest rates or reducing the Fed's Brobdingnagian balance sheet. We're just suggesting a gradual nudging of attitudes away from expecting the central bank to come by every night on a sleigh drawn by reindeer and drop down the chimney with gifts for all.
Thursday, April 19, 2012
Predicting China's Economic Performance From Political Scandal
China's political scandal du jour is the downfall of Bo Xilai, former top government official in the southwestern city of Chongjing. (That's the modern spelling of Chungking, the capital of free China during World War II.) Bo, formerly an upwardly mobile political star, was abruptly removed from power when his wife, Gu Kailai, was arrested on suspicion of murdering a British businessman named Neil Heywood. Heywood reportedly was a close associate of Bo and Gu, but apparently had a falling out and may have been eliminated because he knew too much and might reveal it. Good airport novel stuff, and there no doubt already are at least several commissioned (and numerous uncommissioned) film scripts about the scandal being written in Hollywood.
Bo appears like a throwback to Maoist days, promoting populist programs such as affordable housing for the masses and government directed spending to build infrastructure, thus fostering job creation. He also encouraged the singing of revolutionary songs from the Communist era, ordered students and government employees to work stints in rural areas (shades of the Cultural Revolution) and made the local TV station stop running commercials and broadcast revolutionary programming. Bo wasn't a pure Communist. He encouraged foreign investment and tried to attract manufacturing away from its established bases on China's coastline. But his overall approach revived notions of egalitarianism, and his popularity among average Chinese blossomed.
That made Bo a dangerous man--dangerous to the central government in Beijing, which is in the process of trying to engineer a transfer of power to a new generation of leaders. It's unclear that the differences between Bo and his adversaries are ideological; many of his policies are consonant with Beijing's expressed priorities. One suspects that this fight is over power. Bo is the son of Bo Yibo, one of the most exalted doyens of the Communist Party in its early days, and seemed destined by family legacy to rise to national prominence. As his popularity among the masses increased, his ascendency to top leadership could have become inexorable. Evidently, there were some people in Beijing who didn't cotton to that notion.
One of the oddest things about the Bo Xilai scandal is how it's being publicized by the Chinese government. This is basically a bare-fisted brawl in the smoke-filled rooms and back alleys of China's political power structure. In the past, such struggles were conducted in the utmost secrecy. Even today, the civil war that was the Cultural Revolution remains heavily shrouded in mystery. But the Beijing government has publicly announced Gu Kailai's arrest. And interesting details of the scandal--the kind of information that would likely be known by government investigators--seem to have found their way into the Western press. Why would the Party air its dirty laundry?
Most likely, to sway public opinion in China. Democracy, as the term is understood in the West, doesn't exist in China. But Chinese governments since the times of the earliest dynasties have understood that they need the loyalty of the populace. Emperors who lost the support of the people risked being overthrown by peasant rebellions, which had a tendency to flare up if government officials were corrupt and overbearing, and harvests were bad. In such circumstances, charismatic leaders would rise up, acquire popular followings and inspire uprisings. Often, they would embellish their appeals by harking back to the supposed moral uprightness and economic security of earlier times. The bad harvests, they would pronounce, were a sign that the emperor had lost the mandate of heaven, which justified rebellion.
Today's equivalent of a bad harvest is an economic downturn. And the economy has been slowing in China. Employment levels have fallen as Chinese exports faltered after the 2008 financial crisis. Real estate values are beginning to drop, and price inflation is disquieting. China's rapid shift to capitalism has removed most of the social safety net that existed in Communist days, leaving hundreds of millions who grew up with the security of the Iron Rice Bowl in the uncomfortable of role of fending for themselves in the mystifying harshness of the capitalist system.
Bo Xilai might have become a rallying point for China's discontented. Indeed, the press has reported that many in Chongqing continue to support him, if not for attribution. The Party's public destruction of Bo's political career would appear to be a message to the Chinese people that there ain't gonna be no change in the mandate of heaven, at least not if the power brokers in Beijing have anything to say about it (and they have a lot to say about it).
Why would they feel so threatened by Bo? Very possibly because they know that China's economy is headed for a downturn, one that could destabilize the fragile political compromise that holds China together today. Most Chinese don't care for Communism. But they also aren't ardent about fostering Western style democracy. They just want economic stability and an opportunity for a better life. As long as the government in Beijing delivers good harvests, most Chinese won't rock the boat. But if the economy starts to circle the drain, a charismatic leader like Bo Xilai, particularly if located far from the dour bureaucrats in the capital, could take advantage of the hard times in a gambit to seize power. Beijing's public exploitation of the scandal is, among other things, a pretty good indication that it expects China's economy to weaken. Hedge your bets if you're invested in the Central Kingdom.
Bo appears like a throwback to Maoist days, promoting populist programs such as affordable housing for the masses and government directed spending to build infrastructure, thus fostering job creation. He also encouraged the singing of revolutionary songs from the Communist era, ordered students and government employees to work stints in rural areas (shades of the Cultural Revolution) and made the local TV station stop running commercials and broadcast revolutionary programming. Bo wasn't a pure Communist. He encouraged foreign investment and tried to attract manufacturing away from its established bases on China's coastline. But his overall approach revived notions of egalitarianism, and his popularity among average Chinese blossomed.
That made Bo a dangerous man--dangerous to the central government in Beijing, which is in the process of trying to engineer a transfer of power to a new generation of leaders. It's unclear that the differences between Bo and his adversaries are ideological; many of his policies are consonant with Beijing's expressed priorities. One suspects that this fight is over power. Bo is the son of Bo Yibo, one of the most exalted doyens of the Communist Party in its early days, and seemed destined by family legacy to rise to national prominence. As his popularity among the masses increased, his ascendency to top leadership could have become inexorable. Evidently, there were some people in Beijing who didn't cotton to that notion.
One of the oddest things about the Bo Xilai scandal is how it's being publicized by the Chinese government. This is basically a bare-fisted brawl in the smoke-filled rooms and back alleys of China's political power structure. In the past, such struggles were conducted in the utmost secrecy. Even today, the civil war that was the Cultural Revolution remains heavily shrouded in mystery. But the Beijing government has publicly announced Gu Kailai's arrest. And interesting details of the scandal--the kind of information that would likely be known by government investigators--seem to have found their way into the Western press. Why would the Party air its dirty laundry?
Most likely, to sway public opinion in China. Democracy, as the term is understood in the West, doesn't exist in China. But Chinese governments since the times of the earliest dynasties have understood that they need the loyalty of the populace. Emperors who lost the support of the people risked being overthrown by peasant rebellions, which had a tendency to flare up if government officials were corrupt and overbearing, and harvests were bad. In such circumstances, charismatic leaders would rise up, acquire popular followings and inspire uprisings. Often, they would embellish their appeals by harking back to the supposed moral uprightness and economic security of earlier times. The bad harvests, they would pronounce, were a sign that the emperor had lost the mandate of heaven, which justified rebellion.
Today's equivalent of a bad harvest is an economic downturn. And the economy has been slowing in China. Employment levels have fallen as Chinese exports faltered after the 2008 financial crisis. Real estate values are beginning to drop, and price inflation is disquieting. China's rapid shift to capitalism has removed most of the social safety net that existed in Communist days, leaving hundreds of millions who grew up with the security of the Iron Rice Bowl in the uncomfortable of role of fending for themselves in the mystifying harshness of the capitalist system.
Bo Xilai might have become a rallying point for China's discontented. Indeed, the press has reported that many in Chongqing continue to support him, if not for attribution. The Party's public destruction of Bo's political career would appear to be a message to the Chinese people that there ain't gonna be no change in the mandate of heaven, at least not if the power brokers in Beijing have anything to say about it (and they have a lot to say about it).
Why would they feel so threatened by Bo? Very possibly because they know that China's economy is headed for a downturn, one that could destabilize the fragile political compromise that holds China together today. Most Chinese don't care for Communism. But they also aren't ardent about fostering Western style democracy. They just want economic stability and an opportunity for a better life. As long as the government in Beijing delivers good harvests, most Chinese won't rock the boat. But if the economy starts to circle the drain, a charismatic leader like Bo Xilai, particularly if located far from the dour bureaucrats in the capital, could take advantage of the hard times in a gambit to seize power. Beijing's public exploitation of the scandal is, among other things, a pretty good indication that it expects China's economy to weaken. Hedge your bets if you're invested in the Central Kingdom.
Friday, April 13, 2012
The China GDP Head Fake?
Yesterday, April 12, 2012, rumors in the morning about China's first quarter GDP growth coming in around 9%, higher than the expected 8.4%, fueled a stock market rally. (See http://blogs.wsj.com/marketbeat/2012/04/12/stocks-jump-china-gdp-whisper-number-fuels-rally/). The Dow Jones Industrial Average bounded up 183 points.
Today, China's first quarter GDP growth was reported at 8.1%, lower than expectations by 0.3%. (See http://money.cnn.com/2012/04/12/news/economy/china-gdp/). The Dow closed down 136. The rumor was wrong, seriously wrong.
Maybe it was all an innocent mistake. After all, today's Friday the 13th. Maybe someone just misinterpreted something and spread the misinterpretation. But one thing's for sure. Some people made a bunch of money trading the market up yesterday, and then trading it down today. Volatility makes money for Wall Street pros, including market makers, specialists, high speed traders and so on. But some less cynical market participants, who bought and held overnight, probably lost money and quickly.
Volatility can come from exogenous sources. The idiocy underlying the EU's structural problems and its sovereign debt crisis weren't creations of Wall Street. But they sure as pumpernickel have caused a lot of volatility.
There's also home grown volatility, emanating from Wall Street sources that might have a good day at the office if the market is hopping. Spreading truthful and accurate news is generally okay, unless it happens within the context of insider trading. But spreading false information can make regulatory brows furrow.
It's difficult to investigate rumor mongering, especially if the rumor concerns aggregate economic data (as opposed to company-specific or security-specific information). But trading surges triggered by false information undermine investor confidence. Natural investors (i.e., those that buy with the hope of profiting from investing, as opposed to make a quick buck from trading) are the foundation of the financial markets. But, with the 2000 tech cash, the 2008 financial crisis, and the 2010 flash crash, they are leaning, if not running, toward the exits. It really doesn't help when they are jerked around by false rumors.
Today, China's first quarter GDP growth was reported at 8.1%, lower than expectations by 0.3%. (See http://money.cnn.com/2012/04/12/news/economy/china-gdp/). The Dow closed down 136. The rumor was wrong, seriously wrong.
Maybe it was all an innocent mistake. After all, today's Friday the 13th. Maybe someone just misinterpreted something and spread the misinterpretation. But one thing's for sure. Some people made a bunch of money trading the market up yesterday, and then trading it down today. Volatility makes money for Wall Street pros, including market makers, specialists, high speed traders and so on. But some less cynical market participants, who bought and held overnight, probably lost money and quickly.
Volatility can come from exogenous sources. The idiocy underlying the EU's structural problems and its sovereign debt crisis weren't creations of Wall Street. But they sure as pumpernickel have caused a lot of volatility.
There's also home grown volatility, emanating from Wall Street sources that might have a good day at the office if the market is hopping. Spreading truthful and accurate news is generally okay, unless it happens within the context of insider trading. But spreading false information can make regulatory brows furrow.
It's difficult to investigate rumor mongering, especially if the rumor concerns aggregate economic data (as opposed to company-specific or security-specific information). But trading surges triggered by false information undermine investor confidence. Natural investors (i.e., those that buy with the hope of profiting from investing, as opposed to make a quick buck from trading) are the foundation of the financial markets. But, with the 2000 tech cash, the 2008 financial crisis, and the 2010 flash crash, they are leaning, if not running, toward the exits. It really doesn't help when they are jerked around by false rumors.
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