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July 1, 2008

In 2008, Shades of October 1987

Notably, Fed policy was not the only variable at play when it came to our currency. Back in September of 1985, the top treasury officials of the G5 countries met at New York’s Plaza Hotel to realign the major currencies amidst worries, particularly at home, that weak foreign currencies were negatively impacting the ability of U.S. companies to export. The Plaza Accord communiqué specifically stated that “some further orderly appreciation of the main non-dollar currencies against the dollar is desirable.”

By October of 1987 the dollar was weakening, the Greenspan Fed was raising rates, and stocks began to sag. To make matters worse, investors had to contend with a Congress that threatened a combination of harsh protectionist legislation against Japan with new tax laws that would make efficiency-enhancing LBOs more difficult to complete.

All of the above came to a head on October 19, 1987. During a Meet the Press appearance the day before, Treasury Secretary James Baker suggested that the dollar’s fall would not be arrested. The Dow Jones Industrial Average fell 508 points (22.4%) the next day, and as Robert Bartley wrote in The Seven Fat Years, “I think that what the market was saying was that Secretary Baker was toying with the same dollar free-fall Secretary Blumenthal had outlined to President Carter nearly a decade before.” Indeed, with markets fearful of a 1970s inflationary redux, stocks sold off given the negative correlation between inflation and stock/economic performance. The latter in mind, today’s media consensus suggesting Wall Street welcomes cheap and easy money will remain one of those unproven and absurd assumptions.

In response to the crash, Alan Greenspan issued a press release affirming the Fed’s “readiness to serve as a source of liquidity to support the economic and financial system.” Importantly, the subsequent 50-basis point reduction in the Fed funds rate was not a “loosening” of the monetary strings as is so often assumed today. As former Fed Vice Chairman Manuel Johnson wrote with Robert Keleher in Monetary Policy, A Market Price Approach, due to the fall of longer-term Treasury yields on October 19th that shrank the spread between the 10-year and the Fed funds rate, failure on the Fed’s part to reduce its rate would have “constituted a de facto tightening of monetary policy.”

Sure enough, the dollar did not weaken in response to the Fed’s post-crash rate reductions. Far from the monetary “ease” that is frequently used to describe rate reductions today and which presumes devaluation, economist Nathan Lewis noted in Gold: The Once and Future Money that “the dollar wasn’t devalued on Tuesday, October 20, 1987. On the contrary, the dollar went up! After its sickening drop to $481.00/ounce on Monday, the dollar snapped back Tuesday to close London trading at $464.30/ounce.”

Fast forward to today, in some ways there are shades of 1987 in the economic backdrop. China has replaced Japan as the trade miscreant, with anti-China trade legislation ever a threat thanks to a political class eager to be seen doing something for the allegedly down-and-out American worker. And while LBO transactions aren’t threatened by tax changes, those who engage in this kind of activity face the threat of tax increases when it comes to “carried interest” that would reduce the incentives for those in this space to transact at all.

On the monetary front, the dollar has been weakening since 2001 amid varying rate stances from the Federal Reserve. Its fall versus gold began alongside rate cuts, accelerated during 425 basis points of rate increases, and it has continued during the latest round of cuts. Treasury has certainly aided this process in that Secretaries O’Neill and Snow mocked or questioned the importance of a strong dollar, while Secretary Paulson has made plain his desire to see the dollar weaken through his jawboning of China.

And even though the markets have priced in three rate hikes from the Fed beginning in the fall, the dollar has not strengthened as so many assumed it would. Indeed, at $925/ounce gold is once again testing highs experienced earlier in the year. This has occurred amidst a de facto tightening of the kind Johnson referenced judging by a not insubstantial fall in 10-year Treasury yields over the last two weeks.

So while nothing’s ever exact, just as in 1987 we presently have an unseasoned central banker seemingly lost at sea about the true nature of inflation. Much was made of Bernanke’s mention of the dollar a few weeks back, but the main thrust of his “dollar speech” was that rising commodity prices are not a result of monetary mismanagement, but instead a function of too much growth. Like Greenspan in ’87, Bernanke embraces the reprehensible view that growth is inflationary, and that slower growth will reduce commodity prices/inflation.

Bernanke’s lieutenant at the Fed, Donald Kohn seemed to channel his boss in a speech last week. As Bretton Woods Research’s chief economist Paul Hoffmeister wrote in a client report, Kohn’s view is that foreign central banks should seek to weaken their economies in order to fight inflation, or, in Kohn’s own words, in “those countries where strong commodity demands are associated with rapid growth in aggregate demand that outstrips potential supply, actions to contain inflation by restraining aggregate demand would contribute to global price stability."

Adding gasoline to the inflationary and market-enervating fire, Treasury Secretary Paulson continues to dance around the dollar subject. He talks up the importance of a strong unit of account, but refuses to engage in any actions that would signal to the markets he’s serious. With Paulson’s ambiguity in mind, investors should hope against a Sunday talk-show appearance where our Treasury Secretary is quizzed on the dollar’s direction.

Whatever the long-term result of all the above, the S&P 500 fell 3.5% last Thursday and Friday in concert with a 4.5 percent surge in the gold price. Feckless dollar policy from Treasury has joined with impressive economic illiteracy at the Fed in ways that have eroded the dollar’s credibility.

Amidst all this uncertainty there’s a rising consensus among strong-dollar types that the path to nirvana is paved with rate increases. History says this would be a bad idea. Rate increases in 1987 did nothing to shore up the dollar’s value, but did make the economic outlook cloudier alongside a falling unit of account that the Treasury countenanced. All we got out of this market and greenback jawboning was a massive stock-market correction.

Ultimately a strong currency is consistent with low, not high rates of interest. If a strong dollar is what we want, and we desperately need just that, the Treasury need only announce a dollar definition in terms of gold with the Fed’s backing. It could do this without any rate machinations from the Fed, though it should be said that actions taken to define the dollar price of gold lower would over time lead to lower rates across the board.

Just as we did in 1987, we need a stronger dollar in 2008. And as we learned in ’87, we don’t today need rate increases to achieve our dollar-price goals.

Has The WTO Reached a Tipping Point?

Policymakers worldwide are focused on the finishing the Doha trade talks and this is certainly important. The world trade system, however, faces a much larger threat – the erosion of WTO centricity.

One reads much about protectionist backlashes yet the truth is that trade liberalisation is as popular as ever among policymakers. The new century has seen massive liberalisation of trade in goods and services – much of it by nations that disparaged trade liberalisation for decades. But unlike last century, almost none of this has occurred under the WTO’s aegis.

Poor nations have cut their tariffs, opened their services sectors, and embraced foreign investment unilaterally or in bilateral trade agreements. Rich nations have relied on regional trade deals to achieve their market-opening goals. The deals signed this century are not commercially important, but this will change if the European Union’s Asian initiatives succeed, especially if the United States feels compelled to follow suit. The emerging trade powers – China, India, and Brazil – have had worryingly favourable experiences with unilateralism and regionalism in the new century while their commitment to multilateralism is relatively untested. The one part of the WTO system that works well – the dispute settlement mechanism – is increasingly used as a substitute for negotiated liberalisation with the result that de facto compliance by the United States, European Union and others is eroding.

To date, these changes seem more like challenges than threats. The key players believe the world trade system will continue to be anchored by the WTO’s shared values, such as reciprocity, transparency, non-discrimination, and the rule of law. WTO-anchorage allows each member to view its own policies as minor derogations. Yet, at some point derogations become the new norm. The steady erosion of the WTO’s centricity will sooner or later bring the world to a tipping point – a point beyond which expectations become unmoored and nations feel justified in ignoring WTO norms since everyone else does.

A polycentric trading system?

No one knows what happens beyond the tipping point. My guess is that trade would continue to grow and the system would continue to function – but not equally well for all nations. Before the GATT was set up in 1947, the Great Powers settled trade disputes by gunboats or diplomats depending upon the parties involved. Only the naïve thought market access should be reciprocal or fair. A return to this “Belle Époque” extreme is unlikely, but a new Great Powers trade system is likely to emerge. Its core will be the US and EU networks of bilateral trade deals.

Domestic special-interest groups, newly freed from WTO constraints, would push the EU and US templates in divergent directions. Regional arrangements of the new trade powers and Russia could diverge even more markedly, since WTO norms have never fully been internalised by their domestic special-interest groups. This would be a world of “spheres of influence” and bare-knuckle bargaining.

All would lose in this post-tipping point world but not equally. The United States, European Union, Japan, China, and India have enough market leverage to defend their interests. Small nation would suffer much more as they benefit the most from the WTO’s consensus-based rules and negotiations.

Worse yet, moving towards a might-makes-right trade system would be extremely corrosive to global cooperation on the new century’s greatest governance challenges – climate change, pandemics, water scarcity, and the Millennium Development Goals.

What is to be done?

Finishing the Doha Round this year would be a good start. Failing that, leaders must ensure it slips into a quiet coma rather than noisy death throes. But this would not be enough. We must figure out why nations find it so attractive to liberalise outside of the WTO and then change the WTO in ways that restore its central role in trade liberalisation and rule making. The GATT has faced several such historical moments in the past, and GATT members reacted by adopting the necessary reforms. The time has come again for such an effort. Once the old norms are gone, it will be exceedingly difficult to agree to new ones; much better to adapt the WTO’s current norms to address the new century’s realities.

Richard Baldwin is Professor of International Economics at the Graduate Institute in Geneva, CEPR Policy Director and VoxEU.org Editor-in-Chief.

July 2, 2008

The Zero at Ground Zero

Unfortunately, too many political and business leaders lent credibility to this parallel story line. “America’s Mayor,” Rudy Giuliani, whose own actions had been so heroic on 9-11, seemed so consumed by the grief that, quoting from Lincoln’s Gettysburg address, he called for the entire site to become “hallowed ground” free from commerce. His successor, the businessman mayor Michael Bloomberg, displaying a pessimism about the future of the city’s economy that was astonishing in an elected official, argued that Lower Manhattan’s days as a commercial venue were numbered and the site should be given over to residential building. John Whitehead, the respected former chairman of Goldman Sachs tapped by New York Gov. George Pataki to head the rebuilding effort, seemed seduced by the far-fetched schemes of planners and wound up advocating that the site become the center of a tourism district revolving around 9-11--a proposal that smacked of turning Ground Zero into a Disneyland of Death.

All of these voices, and others, have conspired to give us what we have now, which is a site where, approaching seven years after the attack, all one can see for the most part are a bunch of cranes and other machinery moving around dirt. On Monday, the latest report on “progress” at Ground Zero (and one can only use that word in parentheses when referring to the WTC site) noted that virtually all of the work there is behind schedule and billions of dollars over budget.

The mismanagement of the site has produced a design for a new transit station that is so expensive and impractical to build that even with a $2 billion budget, it can’t be constructed, and probably never will. Meanwhile, the so-called “iconic” Freedom Tower, conceived with no practical commercial purpose in mind so that it will be occupied mostly by government agencies, is a year behind schedule. The construction of the 9-11 memorial dubbed Reflecting Absence--an elaborate but vapid design that commemorates nothing except the absence of those who died that day (with barely even a special nod to the police and fire officers who gave their lives to save others)--is also behind schedule after cost estimates doubled beyond the original $500 million projections. It’s now nearly certain that the memorial, reengineered to be on budget, will not open by the 10th anniversary of the attacks, while memorials at the Pentagon and in Shanksville, Pa., are already completed. One component of the Ground Zero memorial, an accompanying museum dubbed the International Freedom Center, won’t ever open. The redevelopment team shelved it because its content was so controversial.

At this point, the only commerce taking place on the former site of the World Trade Center is in the rebuilt 7 World Trade, which sat to the north of the twin towers and also collapsed that day. Owned by the developer Larry Silverstein, 7 World Trade was never part of the original 16-acre Ground Zero site controlled by the Lower Manhattan Development Corp., and so Silverstein was free to move quickly to rebuild without government intrusion. Shovels hit the ground in May of 2002, and the new, 52-story tower opened in spring of 2006. It boasts more than 1 million square feet of leased space to blue-chip tenants like ABN AMRO, Ameriprise Financial, and Moody's Corp.

Silverstein should be something of a champion of Ground Zero. Through all of the talk about abandoning commerce at the site and all of the political infighting and pie-in-the-sky planning, he was crucial in fighting to ensure that the 16-acre site didn’t simply become parkland, or housing. A year ago he told me, "The financial center's locomotive was the World Trade Center, and for the sustenance of the city and the region, we need to get those jobs back.” In addition to 7 World Trade, Silverstein has the right to develop three other towers on Ground Zero, although he’s had to wait for the agency controlling redevelopment to design a site plan and do the foundation work for the towers.

For his efforts, Silverstein hasn’t been celebrated, but demonized. The Vice Chairman of the Port Authority of New York and New Jersey, which controls the site, called him “greedy” for his tough negotiations with potential tenants of 7 World Trade, which dragged out the announcement of some leases. Mayor Bloomberg accused him of asking too much to lease up 7 World Trade—as if our politicians should be setting office leasing rates. One of the city’s tabloids, the Daily News, responded to Silverstein’s defense of himself with the headline Butt Out, Larry.

Yet in the end, Silverstein has given us the only real progress at Ground Zero. And he’s constructing the real memorial down there, the return of the marketplace on the site where the terrorists eradicated it. To achieve that, it isn’t Silverstein or the free market that should be butting out.

July 7, 2008

Time To Put the Brakes on This Runaway Train

The spectacular and historic global economic boom of the past six years is
about to hit a wall. Unfortunately, no one, certainly not in Asia or the US, seems willing to bite the bullet and help engineer the necessary co-ordinated retreat to sustained sub-trend growth, which is necessary so that new commodity supplies and alternatives can catch up.

Instead, governments are clawing to stretch out unsustainable booms, further pushing up commodity prices, and raising the risk of a once-in-a-lifetime economic and financial mess. All this need not end horribly, but policy makers in most regions have to start pressing hard on the brakes, not the accelerator.

Don’t look to the US for leadership in a presidential election year. On the contrary, the US government has been handing out tax-rebate cheques so that Americans will shop until they drop .

Don’t look to emerging markets, either. Desperate to sustain their political and economic momentum, most have taken a wide variety of steps to prevent their economies from feeling the full brunt of the commodity price hikes. As a result, higher commodity prices are eating into fiscal cushions rather than curtailing demand.

I am puzzled that so many economic pundits seem to think that the solution is
for all governments, rich and poor, to pass out even more cheques and subsidies so as to keep the boom going. Keynesian stimulus policies might help ease the pain a bit for individual countries acting in isolation. But if every country tries to stimulate consumption at the same time, it won’t work. A general rise in global demand will simply spill over into higher commodity prices, with little helpful effect on consumption. Isn’t this obvious? Yes, there is still a financial crisis in the US, but stoking inflation is an incredibly unfair and inefficient way to deal with it.

Some central bankers tell us not to worry, because they will be much more disciplined than central banks were in the 1970 s, when the world faced a similar commodity price spike. But this time is different. The commodity price problem has sneaked up on us, despite notable institutional reforms in macroeconomic policy-making all over the world.

The historic influx of new entrants into the global workforce, each aspiring to western consumption standards, is simply pushing global growth past the safety marker on the speed dial. As a result, commodity resource constraints that we once expected to face in the middle of the 21st century are hitting us today.

Wait a second, you say. Why can’t our market economies roll with the punches? Won’t high prices cause people to conserve on consumption and seek out new sources of supply? Yes, and that eventually happened with energy supplies in the 1980s. But the process takes time, and, because of the rising weight of relatively inflexible emerging market economies in global consumption, adjustment will probably take longer than it did a few decades ago.

Rich country consumers are responding to higher energy prices, and it helps. New York City, for example, has seen a reduction of perhaps 5% in private vehicles entering the city over the past six months. Gridlock has abated, and you can almost get around the city by car these days.

But the response is slower elsewhere. It certainly is not getting any easier to drive around in places such as Sao Paulo, Dubai, and Shanghai. For a variety of reasons, mostly related to government intervention, few emerging market economies can be categorised as having flexible resource demand, so commodity price spikes are not having a particularly big effect on demand.

The central bankers who tell us not to worry about inflation point to relative wage stability. Expansions usually start collapsing when labour gets too scarce and too expensive. But the current expansion is unusual in that, due to unique (in the modern era) circumstances, labour constraints are not the problem. On the contrary, the effective global labour force keeps swelling.

No, this time, commodity resources are the primary constraint, rather than a secondary problem, as in the past. That is why commodity prices will just keep soaring until world growth slows down long enough for new supply and new conservation options to catch up with demand.

This runaway-train global economy has all the hallmarks of a giant crisis in the making — financial, political, and economic. Will policy makers find a way to achieve the necessary international co-ordination? Getting the diagnosis right is the place to start. The world as a whole needs tighter monetary and fiscal policy. It is time to put the brakes on this runaway train before it is too late.

Kenneth Rogoff is Professor of Economics and Public Policy at Harvard University and was formerly Chief Economist at the IMF.

July 8, 2008

Jimmy Carter's Oil-Price Prescience

Reagan, who succeeded Carter in the White House, wore only a smile. For him, there was no energy crisis. Whereas Carter had insisted that only the government could manage the energy crisis, Reagan, in his first inaugural, demanded that government get out of the way. Speaking of general economic conditions at the time, he said, "Government is not the solution to our problem." He went on to call for America to return to greatness, to "reawaken this industrial giant," and all sorts of swell things would happen. It was wonderful stuff.

To contrast the two speeches is like comparing the screeching of a cat to the miracles of Mozart. Yet today, Carter's speech reads as prescient. Most of his dire predictions -- "It is a problem we will not solve in the next few years, and it is likely to get progressively worse through the rest of this century" -- have generally come true, although not quite as soon or as calamitously as he had warned. The pity of it all is that in American politics, being right is beside the point.

It is not my intention to pummel the late Ronald Reagan for what he did or did not do back in the 1980s. It is my intention, though, to suggest that Reaganism -- to which Republicans now swear allegiance -- has outlived its very short usefulness and ought to be junked. This is not to say that government is the answer to all our ills. It is only to note that if you think the answer is private enterprise, then drive to the nearest gas station and admire the prices brought to you by private companies.

The worst part of Reaganism was its political success. It left behind a coterie of panting acolytes who learned from Reagan himself that optimism, cheerfulness, an embrace of magical thinking and the avoidance of the painful truth was the formula for victory at the polls. For a time, it worked -- the cost of gas went down -- and Carter, that scold in the silly sweater, was banished. As they say in New Orleans, "Laissez les bons temps rouler!" (Let the good times roll!) Upbeat? You bet. But not a business plan.

In "The Age of Reagan," Princeton historian Sean Wilentz posits that Reagan was the transformative president of our times. I don't know about that. But I do know that in the recent primary debates, Republican after Republican invoked Reagan the way Democrats once did Roosevelt, and they vowed, knock on wood, to be a similar kind of president. If they meant what they said, that would mean no energy plan worth its name and, worse, chirpy assurances to the American people that all would be well.

This is the doleful legacy of Reaganism. We have become a nation that believes that you can get something for nothing. We thought that the energy crisis would be solved . . . somehow, and that no one would have to suffer. We still believe in the magical qualities of America, that something about us makes us better. Yet we have a chaotic and mediocre education system that desperately needs more money and higher standards, but we think -- don't we? -- that somehow we will maintain our lifestyle anyway. Hey, is this America or what?

Somewhere in his peripatetic travels, the much-maligned Jimmy Carter -- an artless politician, to be sure -- must scratch his head at the reverence still accorded Reagan. The way things are going, the Gipper's visage will be added to Mount Rushmore. Not that anyone will notice. It'll be too expensive to drive there.

The End of Neo-Liberalism?

For a quarter-century, there has been a contest among developing countries, and the losers are clear: countries that pursued neo-liberal policies not only lost the growth sweepstakes; when they did grow, the benefits accrued disproportionately to those at the top.

Though neo-liberals do not want to admit it, their ideology also failed another test. No one can claim that financial markets did a stellar job in allocating resources in the late 1990’s, with 97% of investments in fiber optics taking years to see any light. But at least that mistake had an unintended benefit: as costs of communication were driven down, India and China became more integrated into the global economy.

But it is hard to see such benefits to the massive misallocation of resources to housing. The newly constructed homes built for families that could not afford them get trashed and gutted as millions of families are forced out of their homes, in some communities, government has finally stepped in – to remove the remains. In others, the blight spreads. So even those who have been model citizens, borrowing prudently and maintaining their homes, now find that markets have driven down the value of their homes beyond their worst nightmares.

To be sure, there were some short-term benefits from the excess investment in real estate: some Americans (perhaps only for a few months) enjoyed the pleasures of home ownership and living in a bigger home than they otherwise would have. But at what a cost to themselves and the world economy!

Millions will lose their life savings as they lose their homes. And the housing foreclosures have precipitated a global slowdown. There is an increasing consensus on the prognosis: this downturn will be prolonged and widespread.

Nor did markets prepare us well for soaring oil and food prices. Of course, neither sector is an example of free-market economics, but that is partly the point: free-market rhetoric has been used selectively – embraced when it serves special interests and discarded when it does not.

Perhaps one of the few virtues of George W. Bush’s administration is that the gap between rhetoric and reality is narrower than it was under Ronald Reagan. For all Reagan’s free-trade rhetoric, he freely imposed trade restrictions, including the notorious “voluntary” export restraints on automobiles.

Bush’s policies have been worse, but the extent to which he has openly served America’s military-industrial complex has been more naked. The only time that the Bush administration turned green was when it came to ethanol subsidies, whose environmental benefits are dubious. Distortions in the energy market (especially through the tax system) continue, and if Bush could have gotten away with it, matters would have been worse.

This mixture of free-market rhetoric and government intervention has worked particularly badly for developing countries. They were told to stop intervening in agriculture, thereby exposing their farmers to devastating competition from the United States and Europe. Their farmers might have been able to compete with American and European farmers, but they could not compete with US and European Union subsidies. Not surprisingly, investments in agriculture in developing countries faded, and a food gap widened.

Those who promulgated this mistaken advice do not have to worry about carrying malpractice insurance. The costs will be borne by those in developing countries, especially the poor. This year will see a large rise in poverty, especially if we measure it correctly.

Simply put, in a world of plenty, millions in the developing world still cannot afford the minimum nutritional requirements. In many countries, increases in food and energy prices will have a particularly devastating effect on the poor, because these items constitute a larger share of their expenditures.

The anger around the world is palpable. Speculators, not surprisingly, have borne more than a little of the wrath. The speculators argue: we are not the cause of the problem; we are simply engaged in “price discovery” – in other words, discovering – a little late to do much about the problem this year – that there is scarcity.

But that answer is disingenuous. Expectations of rising and volatile prices encourage hundreds of millions of farmers to take precautions. They might make more money if they hoard a little of their grain today and sell it later; and if they do not, they won’t be able to afford it if next year’s crop is smaller than hoped. A little grain taken off the market by hundreds of millions of farmers around the world adds up.

Defenders of market fundamentalism want to shift the blame from market failure to government failure. One senior Chinese official was quoted as saying that the problem was that the US government should have done more to help low-income Americans with their housing. I agree. But that does not change the facts: US banks mismanaged risk on a colossal scale, with global consequences, while those running these institutions have walked away with billions of dollars in compensation.

Today, there is a mismatch between social and private returns. Unless they are closely aligned, the market system cannot work well.

Neo-liberal market fundamentalism was always a political doctrine serving certain interests. It was never supported by economic theory. Nor, it should now be clear, is it supported by historical experience. Learning this lesson may be the silver lining in the cloud now hanging over the global economy.

Joseph E. Stiglitz, professor at Columbia University, received the 2001 Nobel Prize in Economics and co-author of 'The Three Trillion Dollar War: The True Costs of the Iraq Conflict'.

July 9, 2008

Memo to Washington: Let GM Fail

While GM’s vitality is increasingly irrelevant when it comes to the health and size of the U.S. economy, it is sadly a very relevant entity within the friendly confines of Washington, D.C. A collapsed GM would predictably lead to all manner of protectionist and currency-related punishment for those automakers who’ve apparently committed the grave offense of producing that which U.S. consumers want while being foreign.

GM’s descent into pointlessness has occurred despite it easily being one of the United States’ and the world’s most heavily subsidized companies. Those who doubt this need only reference the highway bills of the multi hundred-billion dollar variety that Congress routinely passes, and which make cars in what is the world’s largest car market a necessity. The highway subsidy isn’t so bad when we consider that Americans are at least free to use the roads which have created a market for all carmakers irrespective of origin, and which exist thanks to Congress’ generosity with the money of others.

What’s more offensive is that Americans have routinely been victimized by the automobile lobby in the form of voluntary export restraints imposed most notably on Japanese producers, not to mention with tariffs placed on the exports offered up by those same producers. Tariffs and various restraints on trade have been eagerly sought by U.S. carmakers over the years, and they’ve burned U.S. consumers twice; first for raising the prices of the goods they want, and second for decreasing the size of overseas markets that they themselves might like to export to. When we restrict the ability of exporters to send us what we want, we also restrict their ability to purchase from us.

But what’s been most problematic when it comes to U.S. automakers has been their impact on U.S. currency policy. The Big Three have routinely agitated for a weaker dollar against the yen, and as recently as 2005 in a Wall Street Journal op-ed, GM CEO Rick Wagoner cast some of the blame for the company’s poor performance on “unfair trading practices,” in particular “Japan’s long-term initiatives to artificially weaken the yen.”

Wagoner’s thoughts were remarkable in a number of ways, but were most notable because his comments about yen weakness were so impressively untrue. In reality, the dollar as recently as 1971 bought 360 yen, but today it buys 107; a gain for the yen versus the dollar of 236 percent! Over the last twenty-two years since the imposition of the Plaza Accord meant to strengthen non-dollar currencies against the greenback, the yen has risen 124 percent. Over the past year alone the yen has risen 9 percent against the dollar.

Despite the dollar’s collapse, GM’s U.S. market share has continued to wither; having fallen from 41 percent in 1985 to less than 25 percent today. Over that same timeframe GM shares have flatlined, while those of Honda and Toyota have risen over 600 and 800 percent respectively.

What’s fascinating is that GM’s management could be so obtuse about what aids its success. The obvious truth here is that with GM a successful producer of large, gas-guzzling autos, a weak dollar has and always will be a killer for a shrunken unit of account driving up the costs of commodity inputs for automobile production, and even more importantly the price of oil itself. Not surprisingly, GM’s shares rose 56 percent from June 1997 to May of 2000 when the dollar was strongest and oil was cheap.

Some say that GM’s problems are rooted in bad deals made with unions over pay and defined benefit/health plans, but judging by the mistaken policies that GM executives lobby for, it could realistically be said that GM suffers most from a lack of executive talent. It will never occur, but it says here GM’s saving grace would involve it moving its headquarters to a New York or San Francisco; two cities where there exists human capital that would never live in the economic mistake that is Detroit.

So while GM and the Big Three take out ads in the major Washington newspapers greatly exaggerating their economic importance to the overall U.S. economy, the unseen will continue to be the negative impact of unfortunate tariff and currency policies that they’ve lobbied for, and which have restricted U.S. consumer choice all the while greatly reducing the value of American paychecks. Indeed, the dollar’s sad enervation since the early ‘70s has materialized in the form of a massive tax increase on the incomes of American workers. All that, plus the aforementioned inflation has curbed investment that would have helped the wages of those same workers not “lucky” enough to work for heavily subsidized U.S. automakers.

In the end, GM’s continued existence will serve as an economic retardant not just for Michigan, but for the U.S. economy overall. Thanks to GM being able to punch well above its real economic weight in both Washington and Lansing, fear of tariffs and currency devaluations will persist in undermining the nation’s economic health, while Michigan’s economy will continue to suffer from the rising unemployment and lack of investment that are the tradeoffs for once important companies being propped up as thanks for past glories.

Politicians known to be sympathetic to GM would do best by ignoring the latter’s alleged interests, all the while dusting off their unread copies of Adam Smith’s Wealth of Nations to better understand what happens to stationary economies. Right now “stationary” describes GM, Michigan, and more generally, the U.S. auto sector.

The above in mind, if the intent is to “help,” true help would involve letting the antiquated symbols of an overrated economic past fail or be sold. Only then will the capital that’s been wasted on them be redeployed in ways that create real jobs and companies not reliant on the state to achieve what has become the antithesis of success.

McCain Moves to the Supply Side

McCain also slammed Obama on energy, essentially labeling him Doctor No. In the Denver speech McCain said, “My opponent’s answer is no to more drilling; no to more nuclear power; no to research prizes that help solve the problem of affordable electric cars. For a guy whose ‘official seal’ carried the motto, ‘Yes, We Can,’ Sen. Obama’s agenda sure has a whole lot of ‘No, We Can’t.’” This also is good.

Increasingly McCain is shifting his positions towards the supply-side: across-the-board tax cuts, keeping the Bush tax rates on investment, slashing the corporate tax rate, doubling the child deduction for family dependents, cutting pork-barrel spending, and producing more energy.

On the drill, drill, drill energy front, McCain argued in favor of producing more oil and gas, and he said this would send a message to the market that would result in lower prices. He argued for nuclear power, clean coal, and oil shale. And he noted for the first time that expanded energy production would be a strong job-creator. This is so important in terms of an economic fix.

And here are a couple things missing from McCain’s speech: There was no mention of “obscene profits”; no mention of cap-and-trade; and no mention of reckless traders. We will see if these ideas continue to be absent from the senator’s formal speeches. I hope so. Voters want more drilling and they do not want cap-and-trade, which is really tax-and-raise-gas-pump-prices and ultimately cap-and-kill-the-economy.

By the way, in his second economics speech today in Washington, D.C., Sen. McCain strongly defended free trade, saying it would create more and better jobs, increase wages, keep inflation under control, and make goods more affordable for low- and middle-income consumers.

He also supported more competition for schools and empowering parents with choice. I have not heard him argue for school choice before. He then argued for comprehensive immigration legislation that would include border security first, apprehending illegal felons who commit crimes, recognition of the important economic contributions of immigrants, and finally humanitarian treatment. I still believe the best way to stop illegal immigration is to promote more legal immigration — namely by raising the entry limits to meet U.S. job demands. But McCain is combining this with a tough border-security message, and I think that’s good.

In general, the senator is developing a good supply-side message for economic growth, with a big focus on tax cuts and new energy production. Obama is for tax hikes and opposed to energy production. These are important contrasts. Now it’s up to the Republican standard bearer to keep hammering these key points on the campaign trail. More energy. Lower taxes. A pro-growth economic recovery plan. Perhaps he will even add King Dollar to his repertoire. I might add that increasing the value of the dollar is part of McCain’s 15-page policy blueprint. Right now he is definitely on the right track.

July 11, 2008

Respectfully Disagreeing with Bill Gross

Regarding the economic mess, Gross failed to point out the main reason why that is so. It’s really simple, and is explained by the late John Maynard Keynes who noted that inflation is something “not one man in a million is able to diagnose.” The falling dollar this decade has wiped out paychecks, all the while reducing the investment necessary to increase wages shrunk by the dollar’s collapse. Inflation has always and everywhere made a mess of economies, and it’s greatly harmed the economy this decade in ways the leaders of both major political parties have failed to diagnose. Continued ignorance of the dollar’s debasement means that the economy will remain a problem regardless of November’s winner.

From there, the disagreements were many.

Commenting to Obama on President George W. Bush, Gross wrote that he failed in choosing “to emphasize tax cuts for the rich and excessive consumption for all Americans.” Gross added that in pursuing reduced penalties on the rich, Bush gave people like him “an eight-year lease extension on the ‘high life.’” Gross’s main policy conclusion was that Obama will have to “raise taxes on the rich.”

Sadly, Gross missed the point on taxes. Increased economic effort occurs on the margin, and while it’s likely true that Gross will continue to work even if tax rates move above 50 percent, other successful people will choose to work less or retire altogether. Those not on top will be burned twice. They’ll first lose out for there being less in the way of successful people to work under, and they’ll lose once again for the wealth of the rich being taxed for immediate government consumption over savings. Indeed, it is the rich who have capital, and when we penalize their wealth we put a bull’s eye on the wages of the non-rich who benefit from that money remaining in the private economy.

Gross went on to smack President Bush for promoting “deregulation and free markets when, in fact, the markets and their institutions needed tough love.” While Gross’s vision of Bush as a free-market advocate would certainly shock those who actually believe in free markets, his analysis there once again missed the point.

Indeed, it is through the imposition of free markets that “tough love” is doled out. Free markets penalize those who fail the consumer, all the while rewarding those who give people what they want.

Furthermore, it has to be remembered that economies don’t fail due to economic freedom, but instead recess when governments get in the way. Sure enough, the markets enforced their own rough justice on the U.S. economy thanks to the government’s failure to issue a stable dollar, and they’ll surely be similarly cruel to a President Obama should he tax and spend in the way that Gross suggests he should.

On the energy front, Gross contended that Bush failed to “put forth a coherent energy policy,” but there again he showed an impressive misunderstanding of what is needed from government for the private sector to give people what they want. The simple truth is that back when the dollar had a basic definition of 1/35th of an ounce of gold, oil was cheap, plentiful and always stable in terms of price. With oil everywhere irrespective of country origin for those in the market for same, the only policy a future president would need to implement is one where dollar-price stability is made paramount. The rest will take care of itself thanks to markets; “energy policy” be damned.

Given his constant worrying about housing over the past year, Gross unsurprisingly asked for “some immediate relief to homeowners.” This is laugh-inducing on its face when we consider how much taxpayers already subsidize homeowners (let’s see: Fannie/Freddie, mortgage-interest deductions, zero percent capital gains treatment on sales), but it becomes more troubling when we remember that government efforts to push money into housing keep that capital out of the hands of job-creating businesses and entrepreneurs.

If that’s not enough for Gross, he might dust off some unread history books about the ‘70s; a decade when housing was similarly the top asset class alongside an electorate that was very unhappy about the economy. Note to Gross: housing always goes boom/bust when the dollar is weak as it has been this decade. Furthermore, Gross no doubt knows well from his own career that failure begets success such that we learn from our failures what not to do in the future. Hoping as Gross does for better economic times ahead, the last thing he should want is for responsible taxpayers to subsidize failures in the housing space that will certainly beget similar mistakes down the line.

In proposing his various spending plans which would enable Obama to “produce this nation’s first trillion dollar deficit,” Gross suggested that the spending would “all be paid for by wealthy hedge fund managers, oil companies, or, pray tell, a robust economy that’s creating good jobs at home instead of exporting them abroad.” If we ignore his misunderstanding of the undeniable good that comes from comparative advantage, Gross should at least be reminded of the old Calvin Coolidge adage that high incomes “tend to disappear” when they’re taxed heavily. Indeed, going back to Pericles at least, high earners have successfully found ways to hide their earnings from overly greedy taxmen, so it would be folly for Gross to assume this would be any different under a President Obama.

Somewhat surprisingly, one of Gross’s policy fixes involves “an additional jolt of $500 billion or so of government spending real quick.” This is a surprise when we consider Gross’s low opinion of the Bush economy. One would think he might have picked up on how worthless were the two stimulus packages passed under our current president.

If not, a thought experiment is in order: Gross ought to imagine if instead of going to the government for $500 billion, Americans chose to reach into the pockets of the 500+ billionaires (including Gross) presently in the United States. If we acknowledge the simple truth that theft from savers describes stimulus perfectly, we can then return to basic economic principles and say that economic growth is about one thing and one thing only: work effort. That being the case, the robbery that is stimulus has and will continue to harm, rather than help the economy, and to the extent that it keeps the downtrodden from working to change their circumstances, any future wealth transfers will only serve to retard economic growth.

Gross used Japan’s economic recovery as his model for alleged Keynesian stimulus stateside, but with Japan, Gross misread what actually happened. Japan’s economy didn’t lack for spending, but thanks to protectionist impulses within the political class in the U.S., a punishing deflation was forced on Japan beginning with the Plaza Accord in 1985. Facing either protectionist penalties from Congress or a massive deflation, Japan chose the latter.

Oddly enough, it wasn’t spending that relieved Japan from some of its economic malaise, but instead the aforementioned dollar devaluation of this decade which allowed a deflated Japan to reverse some of the monetary error foisted on it by our government. Unfortunately, so great has been our devaluation that Japan now faces inflationary pressure. So much for governments being the source of economic renewal…

So while Gross has a point about the unfortunate economy of this decade, his solutions would only make things worse. In his letter to Obama, Gross correctly referred to the late President Reagan as a “Republican icon.” Importantly, Reagan intuitively knew that government is never the solution, but frequently the problem.

Reagan in mind, the simple reality is that it is human nature to work and produce until governments create barriers to economy-enhancing work effort. Heavy spending and taxes will only decrease work incentives, so rather than more government, all this economy needs is a strong, stable dollar, low rates of taxation, reduced regulation (no mention of Sarbanes-Oxley in his letter), and trade that can be engaged in freely. The markets will take care of the rest as they always do.

July 12, 2008

$1.6 Trillion in Losses and Counting

I get to travel a lot with my daughter and business partner Tiffani (actually she runs the business) and meet new people. Over the years, she has become as fascinated as I have with their individual stories. Everyone has a story to tell or a lesson to teach. We have decided to write a book about those stories, looking at the differences in perspective between old and young, retired and working, those who are wealthy and those who aspire to wealth. What are the differences in attitudes, in work habits, in how you manage money, in how you look at the future, and a score of other items? How do all of these things correlate?

We have created a totally anonymous online survey seeking answers to these questions and more. We hope to get at least 10,000 people to fill out the survey; and we are eager to see what we find as we pore over the resulting data and engage in a lot of in-depth analysis. Are the rich really different? Is there a difference in people from Europe, Asia, Latin America, Africa, and the US? I think we will find some very interesting information. Please note: this is not just a survey for millionaires. We want everyone, of all income levels and ages, to take the survey, so we can get a true representative sample.

You can get to the survey page by clicking here. It will take about ten minutes to complete, and I think that going through the questions will make you think about your own situation. Some have told us the survey is quite thought-provoking. If you have attempted to take the survey and had problems, we think we have worked out the bugs.

At the end of the survey, you will be sent to a page with the speech. If you cannot listen to it immediately, then simply save the page or the address. And of course, you can just take the survey to help us.

Also, Tiffani and I want to do live (mostly by phone) interviews with 200 millionaires, of all shapes and sizes and locales. We will interview you for about 30 minutes, and then you can have equal time asking me anything you want. Since I will have learned a lot about you, those questions can be as detailed or as general as you like. We want at least 20% of the interviews to come from outside the US. We will use those interviews in the book, but will attach no identifying items or real names. If we use something from your interview in the book, we will let you see it first. If you are interested in being one of the interviewees, just drop Tiffani a note at eu@2000wave.com and she will get back to you and work out the details.

I am really excited about this project and even more so about working with Tiffani. We will report back to you on what we find. Thanks for your help.

$1.6 Trillion in Losses and Counting

One of the great privileges I have is getting to read a wide variety of economic research. While I get a lot of material direct from the source, I also have a wide network of people who read other sources and send me what they think is important. When Ambrose Evans-Pritchard wrote this week about a report done by Bridgewater Associates, it got my attention, and fortunately this report was sent to me by a few friends. In my book, Bridgewater is one of the top analytical groups in the world. I pay attention and give strong credence to what they write. And this report is quite sobering.

First, let's look at what Evans-Pritchard wrote in the London Telegraph:

"Bridgewater Associates has issued an apocalyptic warning to clients that bank losses from the worldwide credit crisis may reach $1,600bn [$1.6 trillion], four times official estimates and enough to pose a grave risk to the financial system.

"The giant US hedge fund said that it doubted whether lenders would be able to shoulder the full losses, disguised until now by 'mark-to-model' methods of valuing structured credit.

" 'We are facing an avalanche of bad assets. We have big doubts as to whether financial institutions will be able to obtain enough new capital to cover their losses. The credit crisis is going to get worse,' said the group in a confidential report, leaked to the Swiss newspaper Sonntags Zeitung.

"Bank losses on this scale would have far-reaching effects. Lenders would have to curtail loans by roughly 10-to-one to preserve their capital ratios. This would imply a further contraction of credit by up to $12,000bn [$12 trillion] worldwide unless banks could raise fresh capital."

Let's look at some of the details in the report. First, these losses are not all subprime. In fact, more than half of it is from corporate liabilities, around $800 billion. About $550 billion of the corporate losses have yet to be written off. As an example, Bridgewater estimates losses on commercial loans to be as much as $149 billion, none of which has been written off.

Better than 90% of the losses from subprime assets that are on the books have already been written off. That is good. But Bridgewater estimates that there are losses lurking in the prime and Alt-A loan portfolios that could be much bigger than the subprime problems, as those loan books are more than six times the size of the subprime. Quoting:

"The US commercial banks are in a position to suffer the greatest losses, because the core of their portfolio is risky US debt assets. In order to get a sense of their expected losses we examine both their loan book and their securities portfolio and price each type of asset out based upon a reference market. If we use this current market pricing as a guide, there is a long way to go, as these institutions have only acknowledged about 1/6 of the expected losses that they will incur as a result of the credit crisis."

I could go on, but the details are not important. The bottom line is that they estimate there is at least another $1.1 trillion of losses that will have to be written off by institutions all over the developed world, including very large potential write-offs from insurance companies.

Banks and investment institutions worldwide may need another $400 billion in capital infusions. But where they are going to get it is the problem. They have burned through the usual suspects, and burned is the correct word. Any sovereign wealth fund or large investor who has put money into an investment or commercial bank has watched their investment take large losses in a very short time. How likely are they to be willing to belly back up to the bar with more money, on anything except very dilutive terms to current shareholders? The answer is obvious.

And let me be clear. There are some very large commercial and investment banks which are simply going to be absorbed, as regulators move to keep the entire system working. Bear Stearns is not a one-off deal. I think it is likely we will see at least one European bank nationalized. Losses the size that Bridgewater describes are beyond ugly. They are life-threatening for more than one major institution. More on this later.

Banks Start to Reduce Their Lending

Further, let's revisit a theme I have written about on several occasions over the past year. As banks incur losses, they either have to find new capital or reduce their lending in order to maintain their capital ratios, or some combination of both. And what we are seeing is that lending is starting to actually decrease.

Earlier this year lending rose as normal, even though anecdotal reports told of tightening lending standards and reduced loan lines. The tightening of standards did not seem to be affecting actual loans being made, which was odd. But this was partly illusion, as banks were taking back loans they had spun off in SIVs, taking capital away from their traditional loan business. This gave the appearance of expanding loan capacity. Evidently, this bringing back of off-book loans is now being worked through, as evidenced by this analysis by good friend and analyst par excellence Greg Weldon, who slices and dices the data to give us this view (www.weldononline.com):

"[looking at the chart below] ... FOR SURE, the recent decline strongly suggests that the risk of a US recession has intensified CONSIDERABLY, as defined by what amounts to one of the largest nominal credit contractions in DECADES, at (-) $154.3 billion, and a clear-cut violation of the uptrend in place since at least 2001."

Greg goes on to suggest that bank credit could contract a further $6-700 billion over the next nine months, which is a contraction of about 8%. Healthy economies have a rising rate of bank credit, which is one source of expansion. When banks have to reduce their lending, it reduces the growth of the economy or can put it into outright recession.

And if the Bridgewater report is anything close to right, Greg is being an optimist, which is not his normal milieu. Now, do I think worldwide credit will shrink $12 trillion, as Evans-Pritchard suggests? (Note, that was not a suggestion or conclusion by Bridgewater.) Not in my worst nightmares. Capital will be raised, and the various central banks of the world will do what is necessary to give banks the time to work through their problems.

But in the meantime, the trend toward lower lending is likely to continue. And lower lending is going to be a huge headwind for an economy that is already struggling.

This week Ben Bernanke suggested that the "temporary" Term Auction Facility might be extended into 2009. Let me suggest that it will be extended into at least 2010 before it is no longer needed. Banks are going to need to be able to take their illiquid paper and convert it into liquid Treasuries against which they can make loans and continue to function.

As I have written for a long time, it is all about buying time. In 1980, every major bank in the US was technically bankrupt, as they all had large amounts of Latin American bonds in their portfolios, at a size far larger than their capitalization. When the Latin American countries started to default, if the Fed had made the banks mark their portfolios to market, it would have been a disaster of biblical proportions. There would have been no American banks left standing. The US economy would have gone into a deep depression.

Instead, with a wink and nod, they let them keep the bad bonds on their books at face value, which they all did. Then in the latter part of the decade, starting with Citibank in 1986 (cue the irony), they began one by one to write off the bad loans, but only when they had enough capital to do so. It took six years (or more) of profits and capital raising to get to where they could deal with the problems without imploding themselves and the economy of the US at the same time.

Today is only different in the details. The Fed and central banks around the world are allowing banks to buy time to work through their problems. There really is no other option. That extra $1.1 trillion that the research by Bridgewater says will have to be written off? You can take it to the bank, pardon the pun, that it will not be written off this quarter. This is going to be an ongoing process that will take several years at a minimum. Just like in 1980, the regulators are going to allow banks to write down their losses as they can, except in the most egregious of circumstances, in which case those banks will be "absorbed," a la Bear Stearns.

Treasury Secretary Paulson said Thursday that no bank is too big to fail. That is for public consumption. The fact is that there are any number of banks that are too big to fail, depending upon (and borrowing from my favorite linguist, Bill Clinton) what your definition of fail is. If by fail you mean that shareholders are wiped out, then he is correct, there is no institution too big to fail. If by fail you mean that the operations and debt obligations will be allowed to collapse, then there are institutions whose collapse would pose major systemic risk to the world markets. They cannot be allowed to collapse.

Take Freddie Mac. Please.

(Cue Henny Youngman) Take Freddie Mac. Please. Its shares are down almost 90%. "Freddie Mac owed $5.2 billion more than its assets were worth in the first quarter, making it insolvent under fair-value accounting rules. The fair value of Fannie Mae [down 78%] assets fell 66 percent to $12.2 billion, data provided by the Washington-based company show, and may be negative next quarter, former St. Louis Federal Reserve President William Poole said." (Bloomberg) Poole asserted that these institutions are essentially on a short path to insolvency.

But in the same story, Senators Schumer and McCain both said Freddie and Fannie would not be allowed to fail. Even curmudgeonly former Fed Vice-Chairman Wayne Angell (someone whom I sincerely respect), said on CNBC yesterday that the government regulator of the GSEs (Government Sponsored Enterprises) ought to get some money from Congress to buy preferred stock and then get even larger amounts from the public through an offering of preferred stock. He said that Congress ought to learn about its responsibilities with regard to a GSE; and the public ought to realize that we are in for a long, tough fight. (He also expects the second half of 2008 to be no better than the first half, and he sees 1% growth in 2009.)

I wrote the above paragraph, and a few I deleted below, on Thursday, as I am on a plane to Las Vegas and need to finish the letter in order to attend a conference. I wrote with suggestions about how a collapse of the two Government Sponsored Enterprises might be handled. Last night, the New York Times broke a story that government officials are looking at how to go about taking over operations at Freddie and Fannie, should worse come to worst. Then this morning, the Wall Street Journal in its lead story elaborated on this theme.

The basic problem is that both Fannie and Freddie need more capital, and perhaps far more than their current market capitalization. Where to find it? What investor wants to try and catch this falling safe, without government guarantees? The Journal article quotes numerous people with various ideas about what to do. Most of their ideas will potentially cost US taxpayers.

And make no mistake. The problems with Fannie and Freddie have to be solved. They are now doing 80% of the mortgages in the US. Without them the housing market would grind to a halt quickly and housing prices would drop even beyond Gary Shilling's pessimistic views.

Not to mention that the world has assumed the implicit backing of the government in buying the paper of Freddie and Fannie. How easy would it be to finance US debt if this paper was allowed to default? The implications are serious. I understand the arguments for allowing them to fail, and I think shareholders should bear the risk they take on when buying equity.

A very reasonable idea was broached by Steve Forbes on a BizRadio program this afternoon, which Dan Frishberg graciously allowed me to co-host. He suggests breaking Fannie and Freddie into eight smaller companies, giving them whatever backing they need in the form of public financing to start business, and then cut them off to sink or swim on their own, with much tighter capitalization controls. Remember, this is one of the more free-market conservative thinkers.

The authorities are slowly losing control. All they can do is crisis manage. There are no good solutions, only expedient ones. And we must all hope they choose the best among a handful of not particularly pleasing options. Allowing the system to devolve into chaos is not an option. The Fed and whatever administration comes in will do the same as the current group, which is to buy time so that the wounds can heal, and hopefully put in place rules to prevent another such occurrence.

(Sidebar: I will go into greater detail in a later letter, but regulators need to move NOW to create a Credit Default Swaps Exchange. A problem/crisis in that unregulated market is actually a far bigger problem than the current subprime crisis. Why do you think Bear Stearns was not allowed to go into bankruptcy? There are banks that are too big to fail, despite what Paulson says for public consumption.)

There are a lot of conflicting opinions, which you can read at www.bloomberg.com if you care. Some say Fannie and Freddie will have to lose $70 billion before the regulators step in. Poole says they are insolvent now, using fair market accounting methods. I don't know, and neither do 99.9 % of the shareholders. At this point Fannie and Freddie are not an investment, they are a gamble. Sitting here at Caesar's in Vegas, and reading the opinions, makes me think I have better odds at the tables below me.

I hope that when (not if!) taxpayer money is used, it is at market rates and means that shareholders are last in line, if at all, to recoup any money. For those of us who for years have called for tighter regulation and increased capitalization of the GSEs, as well as a clear removal of any government backing, implicit or explicit, being able to say "I told you so" does not feel all that good. Freddie and Fannie cannot be allowed to go out of existence. They are too tightly wound into the core and fiber of the US economy.

What can and should happen is that shareholders bear their losses, taxpayers pick up the bill, and when they are healthy again, as they will be at some point, another public offering should be done to hopefully recoup the losses to taxpayers. Or perhaps an auction with some guarantees to a potential buyer, but a complete removal of implicit government guarantees on future loans, and higher capitalization requirements. There are any numbers of ways to lessen the ultimate cost to the taxpayer.

What I fear is that politicians will use the opportunity to prop up the mortgage markets with taxpayer guarantees and create much larger losses, which could quickly mount into the hundreds of billions if not properly dealt with. A new populist-oriented administration could find this problem on their desk as they take office.

I would not want to own any stock in the financial sector. There is going to be a continual stream of write-offs over the coming year, at a minimum. Yes, some banks are better managed and will avoid the real life-threatening problems. Some will be like JP Morgan and end up with solid assets backed by government guarantees.

But which ones? Do you want to trust the analysts that have been telling you there is value in the financials at each step, all the way down? The management who insists they are in good shape, then raises capital at dilutive prices? The very people who did not see the problems to begin with, telling you that they are now solved?

The "value" that analysts optimistically see in various financial stocks is evaporating with each quarter, as they slowly write down ever more losses. With another potential $1 trillion to be written off or absorbed through earnings from profitable parts of the business, there is more pain to come. Investing in financials today is like trying to catch a falling safe.

The Ugly Muddle Through

Goldman Sachs published a report Thursday in which they suggest the most probable scenario for the next 12 months is GDP growth between -0.25% and 0.25%, or basically zero. Wayne Angell, mentioned above, expects the second half of '08 to be no better than the first half and for GDP growth to be 1%.

In the Bridgewater report mentioned above, they estimate that the net worth of US-based assets is down about 13% since January 2007, a total loss of almost $8 trillion. This is hitting pension plans, corporations, and consumers, making them think twice about planned investments and expenditures.

Earnings estimates are being cut with each passing month. The P/E ratio for the S&P 500 is currently at a sporty 23. Historically, in times of rising inflation, the stock market goes through "multiple compression." That means P/E ratios fall more than earnings. If multiples fell just 20%, back to 18, which is still above long-term trends, the market would see another 20% drop from here. Even with earnings growth, the market is going to have a challenge rising in the current environment.

Sidebar: A number of you have written questioning my source for the P/E ratio, as you read or hear different numbers from what I write. You can indeed find estimates of forward P/E ratios as low as 12 a year from now. That is a lot different than the 23 I cited above.

There are two basic types of earnings that are reported. One is "operating earnings," or what I call EBBS, or Earnings Before Bad Stuff. Then there is "reported earnings," which is what the corporations report on their tax forms. Not all that long ago, in the mid-'90s, operating earnings and reported earnings were generally in line with each other. Companies would deduct genuine one-time, unusual losses from their reported earnings to give us operating earnings. And such a system has a valid basis for existence. If something is truly one-time, maybe an investor should overlook it when evaluating the company's potential.

But then the media and analysts started using the operating earnings as the primary number, and companies began to game the system. More and more items were considered one-time. One of the more egregious examples was when Waste Management Systems declared that painting the garbage trucks was a one-time extraordinary expenditure and should be accounted as such. Today the difference between as-reported and operating earnings can be 20-40% or more! It seems there are many losses that management assures us are just one-time items.

Standard and Poor's has a web page where you can see a spreadsheet of historical data and projections for both types of earnings. That is the source of my data. It is at http://www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS?GXHC_gx_session_id_=5350992f205e73e4& .

Analysts' estimates do tend to get brighter the further out one looks on the table. But if the growth scenarios mentioned above come about, and banks have to curtail all sorts of lending, the earnings projections are going to be way too high, as they have been for the last 12 months. That is going to mean more pain for the stock market.

I think it is quite likely we see the Dow slip below 11,000. (Ok, I wrote that Thursday!) As I said on Kudlow the other night, another 10% drop in the market would take us only to the average bear market. A "9 handle" on the Dow seems quite possible, if not likely. (Note: when someone says "a 9 handle," they mean that the first number in the index or stock price is a 9. The first number is the handle.) The risk is to the downside, given the tepid potential growth of the economy.

Once Again, the BLS Numbers Paint a False Picture

I almost get tired of writing this each month, but it is important, and I will do it quickly. The unemployment number from the BLS last week showed a loss of 62,000 jobs. Private sector jobs were off by 91,000, with the government showing growth of 29,000.

But once again, the birth/death ratio of estimated new jobs was 177,000. As The Liscio Report noted: "... without the b/d's contribution, private employment would have been down by something like 268,000. It added 29,000 [new jobs] to construction, 22,000 to professional and business services, and 86,000 to leisure and hospitality. Given the weakness of the economy and the crunchiness of credit, we doubt that there are enough startups around to match these imputations."

Revisions to the prior two months were a negative 52,000. When they do the final numbers a few years from now, we will find that the revisions will be in the hundreds of thousands for the first half of the year. We have now had five consecutive months of downward revisions, which is typical of recessions.

Unemployment held steady at 5.5%, but that masks an underlying and growing problem. There has been a huge increase in the number of people working "part-time for economic reasons" and a large number of people who are discouraged and not looking for a job but would like one. These two categories are not counted as unemployed. If you add them into the equation, the unemployment or underemployment number goes to 10.3%! (per Greg Weldon)

As I warned above, this has not made for pleasant reading. But it is reality, and we need to deal with it.

And let me say that even given the above, I am a long-term (and even mid-term) optimist. We have to work through some serious problems, but we will. Valuations are going to be low once again, and it will be time to become bullish. And researching and writing my book on how the world will change in 20 years makes me very optimistic. No one in 20 years will think of today as the "good old days." The changes that are in front of us will be amazing. So, simply take a deep breath, be conservative today, and get ready for a really wild and fun ride.

And speaking of investment banks, I need an introduction to someone who is deeply involved in the creation of Exchange-Traded Notes. Drop me a line.

July 14, 2008

Statement on Fannie Mae and Freddie Mac

In recent days, I have consulted with the Federal Reserve, OFHEO, the SEC, Congressional leaders of both parties and with the two companies to develop a three-part plan for immediate action. The President has asked me to work with Congress to act on this plan immediately.

First, as a liquidity backstop, the plan includes a temporary increase in the line of credit the GSEs have with Treasury. Treasury would determine the terms and conditions for accessing the line of credit and the amount to be drawn.

Second, to ensure the GSEs have access to sufficient capital to continue to serve their mission, the plan includes temporary authority for Treasury to purchase equity in either of the two GSEs if needed.

Use of either the line of credit or the equity investment would carry terms and conditions necessary to protect the taxpayer.

Third, to protect the financial system from systemic risk going forward, the plan strengthens the GSE regulatory reform legislation currently moving through Congress by giving the Federal Reserve a consultative role in the new GSE regulator's process for setting capital requirements and other prudential standards.

I look forward to working closely with the Congressional leaders to enact this legislation as soon as possible, as one complete package.

July 15, 2008

The CPI Understates Inflation

Indeed, increased sales taxes have nothing to do with changes in the value of the dollar, but when it comes to the CPI, they are booked as inflation. If hotel rooms in New York City become very expensive relative to the past, some would consider this an inflationary event despite simple logic showing otherwise. Put simply, if New York hotel rooms suddenly cost $200/night more than they once did, the broad impact on the price level would by definition be zero owing to the fact that consumers would have $200 less to spend on formerly attainable goods.

Conversely, if due to productivity enhancements a laptop computer today costs $1,000 when it previously would have set a consumer back $2,500, there would be no deflationary event to speak of there either. Falling consumer prices, be they the result of productivity innovations or due to low-priced imports from overseas, can in no way change the real price level. That is so because cheap goods merely expand the range of products we can buy. If a consumer has $1,500 extra after the computer purchase, either through savings or immediate consumption that money is used to demand other goods that were at one time out of reach.

As economist Nathan Lewis wrote in his essential book, Gold: The Once and Future Money, “Prices are supposed to change,” and the “information transmitted in changing prices organizes the market economy.” In other words, it is through freely set market prices that the consumer communicates to the producer what and what not to bring to market. When monetary authorities target consumer prices, they inhibit this important method of communication and the economy suffers as a result.

To the extent that there is a monetary devaluation, it shouldn’t be assumed that a weaker unit of account will immediately be reflected in all consumer prices. This so because prices are very sticky. Owing to the habitual nature of consumers, producers are often reluctant to break those habits with price changes.

Importantly, there’s a way to increase the cost of a good without increasing the nominal price of that same good. Indeed, as a recent USA Today story showed, ice cream makers, suffering under rising dairy costs, have in many cases reduced the size of standard ice-cream containers to 1.5 quarts from 1.75 quarts. Frito Lay and Dial have done much the same with bags of potato chips and bars of soap.

Forbes publisher Steve Forbes has pointed out that while the pastries he buys each morning at Starbucks cost the same, they’ve shrunk in size. Containers of Shedd’s Spread Country Crock used to consist of 48 ounces of margarine, but buyers now pay the same price to get 45 ounces. Frequent RealClearMarkets contributor Doug Johnson notes that the cost of a package of diapers for his children hasn’t gone up, but today there are four less diapers in each package.

So not only are consumer prices a bad measure of inflation given the numerous inputs that lead to one price, those same prices frequently hide real price increases that government measures of inflation can’t register. Ultimately, it has to be recognized that the only true measure of inflation does not involve prices, but instead involves the value of the dollar itself.

And when we consider the dollar, the most reliable benchmark is not the greenback’s value versus the euro, yen or pound, but the dollar’s value in terms of gold. Gold did not serve as a measure of money for thousands of years because it was unstable, but more realistically it has been used as “money” given its historical constancy in terms of price. Thanks to a massive stock of gold around the world relative to small annual new discoveries (flow), gold is the single best measure of money we have. When the price of gold moves, this is not a signal that gold’s price has changed, but instead tells us that the dollar’s value is rising or falling.

Notably, gold has risen 283 percent against the dollar since June of 2001. Whereas a dollar used to buy 1/253rd of an ounce of gold, as of this writing it buys 1/970th of an ounce. For those wondering why all manner of commodities, from gasoline to corn to meat have become so expensive over the last few years, look no further than the dollar’s debasement. Just as gold’s rise was a major inflationary event in the ‘70s, so is it today. CPI and other government measures of inflation that show light pricing pressures are charitably wrong.

And to the extent that some have great faith in CPI-like measures, they need only look at countries outside the United States to see that our version of CPI is greatly understating true inflation. Sure enough, if it’s agreed that inflation is purely a monetary concept, we then need only look to other countries whose currencies have greatly outperformed the dollar in this decade.

Despite the fact that the euro and pound have crushed the dollar in recent years, government inflation statistics in both show it at 16 and 18-year highs respectively. The Aussie dollar is near parity with the greenback (from the .50 cent range back in 2001), but inflation there is also at a 16-year high. Qatar and Vietnam have had direct-dollar links for quite some time; meaning our monetary policy is theirs, but CPI measures in both countries show it registering 15 and 25% respectively. And while China has allowed the yuan to rise 18 percent against the dollar since July of 2005, inflation there is at an 11-year high.

About the worldwide inflation story, the lesson there is not that non-dollar currencies are strong. Quite the opposite. In reality, non-dollar currencies are very weak (one need only measure them in gold this decade to figure that out); their weakness masked by the dollar’s much greater enervation since 2001. With the dollar still the world’s reserve currency, downward movements in its value almost always lead to broad currency debasement just as periods of dollar strength cause world currencies to strengthen.

So while inflation problems around the world confirm that our government measures of inflation are faulty, the bigger story is what a rising dollar price of gold means for the average American. In short, when gold rises paychecks are emasculated, investment in innovative, job-creating enterprises subsides, and money flows to the relative safety of the “real.”

Rather than clinging to the CPI as false evidence of light inflation, and worse, targeting consumer prices, monetary authorities should instead target a stable gold price with an eye on bringing it down substantially. If history is any kind of indicator, an upward correction of the dollar would quickly cheer an electorate that presently has much to whine about.

Statement on GSE Initiatives Before Senate Banking Committee

Fannie Mae and Freddie Mac, two of the government-sponsored enterprises (GSEs), are also working through this challenging period. Fannie and Freddie play a central role in our housing finance system and must continue to do so in their current form as shareholder-owned companies. Their role in the housing market is particularly important as we work through the current housing correction. The GSEs now touch 70 percent of new mortgages and represent the only functioning secondary mortgage market. The GSEs are central to the availability of housing finance, which will determine the pace at which we emerge from this housing correction.

In addition, debt and other securities issued by the GSEs are held by financial institutions around the world. Continued confidence in the GSEs is important to maintaining financial system and market stability.

Market stability and support for housing finance are among my highest priorities during this time of stress in our markets. Therefore, after consultations with the Federal Reserve, the Office of Federal Housing Enterprise Oversight (OFHEO), the Securities and Exchange Commission (SEC) and Congressional leaders we are asking Congress, as it completes its work on a stronger GSE regulatory structure, to also enact a three-part plan to address the current situation. Our plan is aimed at supporting the stability of financial markets, not just these two enterprises. This is consistent with Treasury's mission to promote the market stability, orderliness and liquidity necessary to support our economy.

Our proposal was not prompted by any sudden deterioration in conditions at Fannie Mae or Freddie Mac. OFHEO has reaffirmed that both GSEs remain adequately capitalized. At the same time, recent developments convinced policymakers and the GSEs that steps are needed to respond to market concerns and increase confidence by providing assurances of access to liquidity and capital on a temporary basis if necessary.

The plan we announced will strengthen our financial system as we weather this housing correction and establish a new world class regulator for the GSEs; it has three parts.

First, as a liquidity backstop, the plan includes an 18-month temporary increase in Treasury's existing authority to make credit available for the GSEs. Given the difficulty in determining the appropriate size of the credit line we are not proposing a particular dollar amount. Flexibility is the best means of increasing market confidence in the GSEs, and also the best means of minimizing taxpayer risk.

Second, to ensure the GSEs have access to sufficient capital to continue to fulfill their mission, the plan gives Treasury an 18-month temporary authority to purchase – only if necessary – equity in either of the two GSEs.

Let me stress that there are no immediate plans to access either the proposed liquidity or the proposed capital backstop. If either of these authorities is used, it would be done so only at Treasury's discretion, under terms and conditions that protect the U.S. taxpayer and are agreed to by both Treasury and the GSE. I have for some time urged a broad range of financial institutions to raise capital and at Treasury we have constantly encouraged the GSEs to do just that. In March, at my request, both the Chairman and Ranking Member of this Committee hosted a meeting with me and the CEOs of the two GSEs where they agreed to raise capital and you began the effort to move your GSE reform bill, which is now hopefully about to be enacted with the modifications we are recommending today.

Third, to help protect the financial system from future systemic risk, the plan strengthens the GSE regulatory reform legislation currently moving through Congress by providing the Federal Reserve authority to access information and perform a consultative role in the new GSE regulator's process for setting capital requirements and other prudential standards. Let me be clear, the Federal Reserve would not be the primary regulator. As I have said for some time, the Fed already plays the role of de-facto market stability regulator and we must give it the authorities to carry out that role. This role for the Federal Reserve with respect to the GSEs is consistent with the recommendation made in Treasury's Blueprint for a Modernized Financial Regulatory Structure. Clearly, given the scope of the GSEs' operations in world financial markets, a market stability regulator must have some line of sight into their operations.

We have long maintained that the GSEs have the potential to pose a systemic risk and worked with Congress on legislation to create a GSE regulator with authorities appropriate to the task and on par with other financial regulators. We must complete this work. The Senate passed GSE reform legislation last Friday, and we urge the House to act quickly to advance this process.

As I have said, we support the current shareholder-owned structure of these enterprises. Our plan addresses current market challenges by ensuring, on a temporary basis, access to both liquidity and capital, while also ensuring that the GSEs can fulfill their mission – a mission that remains critical to homeowners and homebuyers across the country, especially during this housing correction.

I look forward to working closely with you, your colleagues in the House, and Congressional leadership in both chambers to enact this plan as part of a complete legislative package, as soon as possible. Thank you.

Semiannual Monetary Policy Report to the Congress

Following a significant reduction in its policy rate over the second half of 2007, the Federal Open Market Committee (FOMC) eased policy considerably further through the spring to counter actual and expected weakness in economic growth and to mitigate downside risks to economic activity. In addition, the Federal Reserve expanded some of the special liquidity programs that were established last year and implemented additional facilities to support the functioning of financial markets and foster financial stability. Although these policy actions have had positive effects, the economy continues to face numerous difficulties, including ongoing strains in financial markets, declining house prices, a softening labor market, and rising prices of oil, food, and some other commodities. Let me now turn to a more detailed discussion of some of these key issues.

Developments in financial markets and their implications for the macroeconomic outlook have been a focus of monetary policy makers over the past year. In the second half of 2007, the deteriorating performance of subprime mortgages in the United States triggered turbulence in domestic and international financial markets as investors became markedly less willing to bear credit risks of any type. In the first quarter of 2008, reports of further losses and write-downs at financial institutions intensified investor concerns and resulted in further sharp reductions in market liquidity. By March, many dealers and other institutions, even those that had relied heavily on short-term secured financing, were facing much more stringent borrowing conditions.

In mid-March, a major investment bank, The Bear Stearns Companies, Inc., was pushed to the brink of failure after suddenly losing access to short-term financing markets. The Federal Reserve judged that a disorderly failure of Bear Stearns would pose a serious threat to overall financial stability and would most likely have significant adverse implications for the U.S. economy. After discussions with the Securities and Exchange Commission and in consultation with the Treasury, we invoked emergency authorities to provide special financing to facilitate the acquisition of Bear Stearns by JPMorgan Chase & Co. In addition, the Federal Reserve used emergency authorities to establish two new facilities to provide backstop liquidity to primary dealers, with the goals of stabilizing financial conditions and increasing the availability of credit to the broader economy.1 We have also taken additional steps to address liquidity pressures in the banking system, including a further easing of the terms for bank borrowing at the discount window and increases in the amount of credit made available to banks through the Term Auction Facility. The FOMC also authorized expansions of its currency swap arrangements with the European Central Bank and the Swiss National Bank to facilitate increased dollar lending by those institutions to banks in their jurisdictions.

These steps to address liquidity pressures coupled with monetary easing seem to have been helpful in mitigating some market strains. During the second quarter, credit spreads generally narrowed, liquidity pressures ebbed, and a number of financial institutions raised new capital. However, as events in recent weeks have demonstrated, many financial markets and institutions remain under considerable stress, in part because the outlook for the economy, and thus for credit quality, remains uncertain. In recent days, investors became particularly concerned about the financial condition of the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac. In view of this development, and given the importance of these firms to the mortgage market, the Treasury announced a legislative proposal to bolster their capital, access to liquidity, and regulatory oversight. As a supplement to the Treasury's existing authority to lend to the GSEs and as a bridge to the time when the Congress decides how to proceed on these matters, the Board of Governors authorized the Federal Reserve Bank of New York to lend to Fannie Mae and Freddie Mac, should that become necessary. Any lending would be collateralized by U.S. government and federal agency securities. In general, healthy economic growth depends on well-functioning financial markets. Consequently, helping the financial markets to return to more normal functioning will continue to be a top priority of the Federal Reserve.

I turn now to current economic developments and prospects. The economy has continued to expand, but at a subdued pace. In the labor market, private payroll employment has declined this year, falling at an average pace of 94,000 jobs per month through June. Employment in the construction and manufacturing sectors has been particularly hard hit, although employment declines in a number of other sectors are evident as well. The unemployment rate has risen and now stands at 5-1/2 percent.

In the housing sector, activity continues to weaken. Although sales of existing homes have been about unchanged this year, sales of new homes have continued to fall, and inventories of unsold new homes remain high. In response, homebuilders continue to scale back the pace of housing starts. Home prices are falling, particularly in regions that experienced the largest price increases earlier this decade. The declines in home prices have contributed to the rising tide of foreclosures; by adding to the stock of vacant homes for sale, these foreclosures have, in turn, intensified the downward pressure on home prices in some areas.

Personal consumption expenditures have advanced at a modest pace so far this year, generally holding up somewhat better than might have been expected given the array of forces weighing on household finances and attitudes. In particular, with the labor market softening and consumer price inflation elevated, real earnings have been stagnant so far this year; declining values of equities and houses have taken their toll on household balance sheets; credit conditions have tightened; and indicators of consumer sentiment have fallen sharply. More positively, the fiscal stimulus package is providing some timely support to household incomes. Overall, consumption spending seems likely to be restrained over coming quarters.

In the business sector, real outlays for equipment and software were about flat in the first quarter of the year, and construction of nonresidential structures slowed appreciably. In the second quarter, the available data suggest that business fixed investment appears to have expanded moderately. Nevertheless, surveys of capital spending plans indicate that firms remain concerned about the economic and financial environment, including sharply rising costs of inputs and indications of tightening credit, and they are likely to be cautious with spending in the second half of the year. However, strong export growth continues to be a significant boon to many U.S. companies.

In conjunction with the June FOMC meeting, Board members and Reserve Bank presidents prepared economic projections covering the years 2008 through 2010. On balance, most FOMC participants expected that, over the remainder of this year, output would expand at a pace appreciably below its trend rate, primarily because of continued weakness in housing markets, elevated energy prices, and tight credit conditions. Growth is projected to pick up gradually over the next two years as residential construction bottoms out and begins a slow recovery and as credit conditions gradually improve. However, FOMC participants indicated that considerable uncertainty surrounded their outlook for economic growth and viewed the risks to their forecasts as skewed to the downside.

Inflation has remained high, running at nearly a 3-1/2 percent annual rate over the first five months of this year as measured by the price index for personal consumption expenditures. And, with gasoline and other consumer energy prices rising in recent weeks, inflation seems likely to move temporarily higher in the near term.

The elevated level of overall consumer inflation largely reflects a continued sharp run-up in the prices of many commodities, especially oil but also certain crops and metals.2 The spot price of West Texas intermediate crude oil soared about 60 percent in 2007 and, thus far this year, has climbed an additional 50 percent or so. The price of oil currently stands at about five times its level toward the beginning of this decade. Our best judgment is that this surge in prices has been driven predominantly by strong growth in underlying demand and tight supply conditions in global oil markets. Over the past several years, the world economy has expanded at its fastest pace in decades, leading to substantial increases in the demand for oil. Moreover, growth has been concentrated in developing and emerging market economies, where energy consumption has been further stimulated by rapid industrialization and by government subsidies that hold down the price of energy faced by ultimate users.

On the supply side, despite sharp increases in prices, the production of oil has risen only slightly in the past few years. Much of the subdued supply response reflects inadequate investment and production shortfalls in politically volatile regions where large portions of the world's oil reserves are located. Additionally, many governments have been tightening their control over oil resources, impeding foreign investment and hindering efforts to boost capacity and production. Finally, sustainable rates of production in some of the more secure and accessible oil fields, such as those in the North Sea, have been declining. In view of these factors, estimates of long-term oil supplies have been marked down in recent months. Long-dated oil futures prices have risen along with spot prices, suggesting that market participants also see oil supply conditions remaining tight for years to come.

The decline in the foreign exchange value of the dollar has also contributed somewhat to the increase in oil prices. The precise size of this effect is difficult to ascertain, as the causal relationships between oil prices and the dollar are complex and run in both directions. However, the price of oil has risen significantly in terms of all major currencies, suggesting that factors other than the dollar, notably shifts in the underlying global demand for and supply of oil, have been the principal drivers of the increase in prices.

Another concern that has been raised is that financial speculation has added markedly to upward pressures on oil prices. Certainly, investor interest in oil and other commodities has increased substantially of late. However, if financial speculation were pushing oil prices above the levels consistent with the fundamentals of supply and demand, we would expect inventories of crude oil and petroleum products to increase as supply rose and demand fell. But in fact, available data on oil inventories show notable declines over the past year. This is not to say that useful steps could not be taken to improve the transparency and functioning of futures markets, only that such steps are unlikely to substantially affect the prices of oil or other commodities in the longer term.

Although the inflationary effect of rising oil and agricultural commodity prices is evident in the retail prices of energy and food, the extent to which the high prices of oil and other raw materials have been passed through to the prices of non-energy, non-food finished goods and services seems thus far to have been limited. But with businesses facing persistently higher input prices, they may attempt to pass through such costs into prices of final goods and services more aggressively than they have so far. Moreover, as the foreign exchange value of the dollar has declined, rises in import prices have put greater upward pressure on business costs and consumer prices. In their economic projections for the June FOMC meeting, monetary policy makers marked up their forecasts for inflation during 2008 as a whole. FOMC participants continue to expect inflation to moderate in 2009 and 2010, as slower global growth leads to a cooling of commodity markets, as pressures on resource utilization decline, and as longer-term inflation expectations remain reasonably well anchored. However, in light of the persistent escalation of commodity prices in recent quarters, FOMC participants viewed the inflation outlook as unusually uncertain and cited the possibility that commodity prices will continue to rise as an important risk to the inflation forecast. Moreover, the currently high level of inflation, if sustained, might lead the public to revise up its expectations for longer-term inflation. If that were to occur, and those revised expectations were to become embedded in the domestic wage- and price-setting process, we could see an unwelcome rise in actual inflation over the longer term. A critical responsibility of monetary policy makers is to prevent that process from taking hold.

At present, accurately assessing and appropriately balancing the risks to the outlook for growth and inflation is a significant challenge for monetary policy makers. The possibility of higher energy prices, tighter credit conditions, and a still-deeper contraction in housing markets all represent significant downside risks to the outlook for growth. At the same time, upside risks to the inflation outlook have intensified lately, as the rising prices of energy and some other commodities have led to a sharp pickup in inflation and some measures of inflation expectations have moved higher. Given the high degree of uncertainty, monetary policy makers will need to carefully assess incoming information bearing on the outlook for both inflation and growth. In light of the increase in upside inflation risk, we must be particularly alert to any indications, such as an erosion of longer-term inflation expectations, that the inflationary impulses from commodity prices are becoming embedded in the domestic wage- and price-setting process.

I would like to conclude my remarks by providing a brief update on some of the Federal Reserve's actions in the area of consumer protection. At the time of our report last February, I described the Board's proposal to adopt comprehensive new regulations to prohibit unfair or deceptive practices in the mortgage market, using our authority under the Home Ownership and Equity Protection Act of 1994. After reviewing the more-than 4,500 comment letters we received on the proposed rules, the Board approved the final rules yesterday.

The new rules apply to all types of mortgage lenders and will establish lending standards aimed at curbing abuses while preserving responsible subprime lending and sustainable homeownership. The final rules prohibit lenders from making higher-priced loans without due regard for consumers' ability to make the scheduled payments and require lenders to verify the income and assets on which they rely when making the credit decision. Also, for higher-priced loans, lenders now will be required to establish escrow accounts so that property taxes and insurance costs will be included in consumers' regular monthly payments. The final rules also prohibit prepayment penalties for higher-priced loans in cases in which the consumer's payment can increase during the first few years and restrict prepayment penalties on other higher-priced loans Other measures address the coercion of appraisers, servicer practices, and other issues. We believe the new rules will help to restore confidence in the mortgage market.

In May, working jointly with the Office of Thrift Supervision and the National Credit Union Administration, the Board issued proposed rules under the Federal Trade Commission Act to address unfair or deceptive practices for credit card accounts and overdraft protection plans. Credit cards provide a convenient source of credit for many consumers, but the terms of credit card loans have become more complex, which has reduced transparency. Our consumer testing has persuaded us that disclosures alone cannot solve this problem. Thus, the Board's proposed rules would require card issuers to alter their practices in ways that will allow consumers to better understand how their own decisions and actions will affect their costs. Card issuers would be prohibited from increasing interest rates retroactively to cover prior purchases except under very limited circumstances. For accounts having multiple interest rates, when consumers seek to pay down their balance by paying more than the minimum, card issuers would be prohibited from maximizing interest charges by applying excess payments to the lowest rate balance first. The proposed rules dealing with bank overdraft services seek to give consumers greater control by ensuring that they have ample opportunity to opt out of automatic payments of overdrafts. The Board has already received more than 20,000 comment letters in response to the proposed rules.

Thank you. I would be pleased to take your questions.

July 17, 2008

Oil, the Dollar and Comparative Advantage

The above number is important in many ways, but most notably it’s a reminder that even if future oil discoveries make the U.S. energy “independent,” U.S. consumers still won’t be free of monetary mistakes that make gasoline dear. Indeed, owing to discoveries in the North Sea in the mid-‘70s England was effectively energy independent, but this in no way shielded its citizenry from dollar and pound debasement that made fuel very expensive.

Furthermore, the law of comparative advantage states very clearly that as economic actors all, we should let others labor to make for us what doesn’t maximize our profitable talents so that we have time to pursue work that does.

Thanks to trade over the years that’s mostly been free, Americans have long done just that. While we could surely be “independent” when it comes to producing clothes, televisions and cars, we’ve often allowed foreigners to make those products so that we would have time to build the Googles and Microsofts of the world. A better, more enriching deal in terms of trade would be hard to fathom.

Where oil is considered, the simple wonders of comparative advantage have seemingly been ignored of late. Many politicians excitedly point to the economic nirvana that would surely result from a robust national energy policy. Thanks to increased exploration stateside, good jobs would be created in the oil space that would bless us twice for domestic petroleum purchases driving down our alleged trade deficit. On its face this sounds good, but basic economics suggests this would be an economic retardant.

Indeed, what’s been forgotten is that even in good times, the oil business is not a very good one. While oil companies presently enjoy returns of 8.3 cents in gross profit per dollar of sales, firms in the electronics and computer equipment sectors respectively make 14.5 cents and 13.7 cents per dollar. Former anti-trust miscreant Microsoft earns 27.5 cents per dollar of sales. In short, even if the rules regarding drilling were liberalized, it’s hard to imagine many Americans deserting the cushier margins earned in other industries for the relatively mundane returns offered from oil exploration.

Instead, it could credibly be said that we have an even better deal at present whereby we send weakened dollars overseas in return for oil. Some say this enervates our wealth position, but more realistically it enriches us. With all dollars eventually returning to these shores, the money we spend on a product offering low margins frequently comes back as investment in even higher-value ventures.

This isn’t to say that the unexciting returns earned in the oil sector should make the political class rethink whether enhanced exploration rights are wise. More drilling would be a positive. On the other hand, average returns in the energy sector are a certain reminder that liberalized drilling rights should include the right for foreign oil companies to bid for drilling access alongside our own oil companies. Let market forces prevail here, but be sure to let those not American into the tent.

Doing so would insure that just as we seek to apply comparative advantage to most other economic activity, so will we when it comes to oil exploration. If we ignore these economic realities, American human capital will be wasted on less profitable effort that will retard our economic advancement.

Some will naturally say that allowing foreigners to drill on our lands would be to this miss the point, that enhanced exploration should only benefit Americans. Forgotten there is the basic truth that it doesn’t matter where oil is discovered.

Whether oil is found in the Middle East, Canada or Alaska is immaterial. It’s only wealth if it’s sold, and once the oil reaches the marketplace there’s no accounting for its final destination. Americans will bid for oil alongside the rest of the world, and even if future discoveries make us “independent,” our demand will occur in concert with worldwide demand on the way to a world price.

To engage in talk about where oil originates is to make a distinction without a difference. And to implement a singularly American energy policy run by Americans would be to ignore simple economics on the way to sub-optimal use of what is limited human capital.

July 18, 2008

Paulson's View of the Storm

And he says he was troubled about Fannie Mae and Freddie Mac, the mortgage giants that had grown fat on an implicit (but never tested) government guarantee to back up their debt. "It didn't take a genius to know that there was a problem," he says. "The elephant was too big for the tent, frankly. They were too big, and they posed a systemic risk."

But it's one thing to sense that a crisis is looming and quite another to mobilize the federal government to do something about it. And these chronic financial problems were in Washington's "too hard" file.

The administration backed Paulson's decision in June 2007 to launch an elaborate program to create a new "Blueprint for Regulatory Reform." It proposed streamlining regulations, and a new role for the Federal Reserve as overall "market stability regulator," with an assignment Paulson likens to that of a roving free safety in football.

But by the time Paulson's blueprint was completed in March, the Bear Stearns crisis had erupted. The problems he had contemplated in theory were now exploding in fact. Three factors made this crisis different from ones in the past, he says: the complexity of the derivatives and other financial products in the system; the amount of leverage that was embedded on lenders' and borrowers' books; and the "unsustainable house-price appreciation that led to a housing correction that's still going on."

Paulson's job over the past several months has been crisis management. He says he has tried to follow the same rule he had at Goldman Sachs when he was chief executive: "If there's a problem, you don't run away from it, you run toward it." Certainly, he has been doing a lot of running.

Paulson and his fellow crisis manager, Fed Chairman Ben Bernanke, have been criticized for being too ad hoc in their policies, too quick to provide funds to rescue ailing financial giants, too little focused on the broader financial architecture. Conservatives, who regard Fannie and Freddie as bastions of liberal power and privilege, have argued that the two should be nationalized outright, rather than given new lines of credit and perhaps infusions of equity from the taxpayers.

Paulson counters that the critics aren't in the eye of the storm and don't understand the potential consequences of putting the $5 trillion of Fannie and Freddie mortgage debt on the federal books. Many in Washington and around the world have wondered whether Treasury bills would even keep their triple-A rating if Fannie's and Freddie's obligations doubled the national debt.

The other practical worry for Paulson is finding a mechanism for unwinding the skein of debt for financial institutions that aren't covered by banking regulations. If Bear Stearns had been allowed to collapse, for example, what would a bankruptcy judge have done with the billions of dollars in derivatives contracts -- and what would the other parties in these contracts have done in assessing their potential losses?

If Congress wants to avoid future bailouts similar to the one given Bear Stearns, "you need a resolution or wind-down facility," Paulson says, so that the liabilities of failing investment banks or hedge funds can be sorted out carefully, the way the Federal Deposit Insurance Corp. untangles the books of a failing bank.

The country needs to address the big systemic issues of regulation, Paulson says, but not in the middle of an emergency. "Right now, we need to emphasize stability. That's our top priority."


July 19, 2008

The World Will Not End

I thought, since so many think of me as a rather bearish person, I would show you my more optimistic side. Yes, I am bearish in the short term, for reasons I have documented at length in this letter. But long-term I am a wild-eyed optimist.

With all the negative news thrown at us today, why is the United States not in the midst of a deep recession? How, many of you ask, can I be so sanguine as to suggest a milder recession and a Muddle Through Economy?

First, things are somewhat different now than in the '70s and early '80s. Back then, a great deal of the US and developed world economies and their resulting employment were linked to manufacturing, which was largely geared to domestic sales. Exports were a much smaller part of the economy for most businesses. When the economy and consumption slowed down, manufacturers laid employees off rather rapidly. Unemployment would soar and a V-shaped recession would occur.

Now, the number of people employed in manufacturing is less in percentage terms than it was back then, and more of what is produced in the developed world is bought by a growing developing world. Exports from the US are booming. The number of TEUs (the large containers on ships: Twenty-foot Equivalent Units) moving through the ports of Los Angeles and Long Beach is up 23% in May year over year and up 26% since the beginning of the year. Because of the weak dollar, imports are down by 7% year to date. It is export growth that is keeping the US from sliding into the usual deep recession.

So, not only is manufacturing not down as in usual cycles, it is up quite handsomely for many products, except of course for automobiles, which are not just in a recession but facing a depression. But that growth in exports is keeping unemployment from going to 9%.

But let's take a longer-term outlook. My view has been, and is, that we are in for a period of very tepid growth that will last through at least 2009. We have to work our way through the after effects of the twin bubbles of housing and the credit crisis bursting. There is no magic Fed wand. That simply takes time. No (rational) government or Fed policy is going to change the facts on the ground (although they can make things worse). But, in the fullness of time, we will in fact get through this.

If you look back over the decades, things are getting better. Goldman Sachs estimates about 70 million people a year worldwide are entering the 'middle class' and that by 2030 two billion people will be in a far better condition than the poverty they experience today. That will also keep demand steady for all sorts of products and services produced in the developed world, even as our population (except for the US) declines.

The old joke is that a recession is when your neighbor loses his job and a depression is when you lose yours. And a rise in unemployment and lower corporate profits are no laughing matter. But the simple trend is that we will adjust and free markets in America and the world will grow, as they have always done.

My daughter and business partner Tiffani is getting married in three weeks on 08-08-08. Next year there will be 2.3 million weddings in the US, at an average cost of $30,000 (we have helped increase the average this year considerably). That is $72 billion on weddings. And many of those new families start with the need to find a place to live, furnish a home, and build their nest.

Tiffani and her fiancee are an example. They have bought a home at a pretty good price in an older neighborhood that is fast becoming trendy, as there are a lot of wonderful restorations and teardowns. They have lived rather simply and find they 'need' all sorts of items to make their house a home. Each day sees another delivery of gifts from their registry and a smile on her face.

(Sidebar: When I first got married I seem to remember getting three toasters and not a lot of other things we needed. Now, couples register online for what they need and want, and when an item is bought it is taken off the list. How cool is that?)

Last year a record 4.3 million babies were born in the US. Each of them will need all sorts of 'stuff' - food, education, and places to live - in (hopefully) 20-25 years.

Yes, consumers are cutting back, but they are still buying the basics. (See more below.) Manufacturing in the US is starting to make a comeback, with the lower dollar and management driven to compete globally. In free-market economies, every economic slowdown is followed by a period of solid growth driven by innovation. The point is that life goes on. Births, weddings, eating, living and enjoying friends and family. It is all part of the cycle.

The next 20 years are going to see the most powerful wave of technologically driven growth the world has ever seen. The accelerating pace of technological change did not slow down last century through multiple world wars, scores of 'minor' wars, a depression, all sorts of natural disasters, and an unbelievable amount of government folly. Why should that trend stop now?

As we add two billion people to the middle class, we are also going to bring the internet to even billions more. The explosion in information and creativity that we have seen in the last 20 years will double and double again. A small percentage of those people are going to invent amazing new technologies, new drugs, and create companies that will make life better for all of us.

That is one reason that technological growth will continue to accelerate. We will simply be throwing more people at an ever wider array of problems, and they will be able to share their discoveries at the speed of light.

We are on the verge of a revolution in biotechnology that is going to truly revolutionize medicine. No one in 20 years will look back on today as the good old days. And it will probably create yet another stock market bubble, but that is a story for another letter.

US diplomats are talking to Iran. Iraq may actually work out. In most places of the world, most people are better off today than they were 20 years ago. There is still a lot of progress to be made, but the point is that we are making it. There is a ton of opportunity for those prepared to look for it. It may not be in the usual places, it may not be where we would like it to be, but it is there. World GDP will have roughly doubled (or more) by the end of the next decade.

Yes, I know there are a lot of problems. Really big scary ones. I write about a lot of them all the time. But go back to any year ending in 8 for the last 100 years. When were there not problems? And in most times and places, the problems were bigger. And in the next ten years? There will be lots of problems. Some will be the same old problems and some will be new. I am not certain why mankind seems to have a need to find new ways to create mischief and lose money when the old ways work so well. But those too will pass.

So, when you read about current problems - and I will point some out in the next few pages - just remember that things will work out. Markets will adjust, and the world will be a better place. Things will work out better for you as an individual if you anticipate the problems and make the proper adjustments, as much as possible, in advance.

The next 20 years are going to be the most exciting time that the human race has experienced. Yes, there will be issues, but we will adjust. That is what we do. And now, let's look at some of the adjustments going on in the markets.

9% Growth in Housing or a 4% Loss?

When the news flashed on my screen that housing construction had jumped by 9%, I raised an eyebrow. That did not make sense given other data I was looking at. Immediately the media was full of talking heads and stories about the turnaround in housing and the end of the slowdown. I must admit to being a little confused.

Then we find the rest of the story. Asha Bangalore from Northern Trust actually took the time to read the details. It turns out that New York City had a change in its construction codes, and that affected what is considered a housing start in the Northeast, especially in multi-family construction, which 'jumped' 42% because of the code change. If it were not for the change, housing starts nationwide would have fallen by 4%. Because of the code change, housing starts jumped 102% in the Northeast. However, single-family starts nationwide declined 9.3% in June, to an annual rate of 647,000 units. That level of single-family starts is the lowest since January 1991. Look at the following chart from Northern Trust. Does this look like a 9% increase?

More Government Statistical Fun

Each week we see a release of initial unemployment claims. This week initial claims jumped to 366,000 on a seasonally adjusted basis. But what are the real underlying numbers? Every Thursday, I get a thorough review of the actual data from John Vogel, going back and looking at trends over the past 8 years in the non-seasonally adjusted data. That can be more interesting.

This week the actual number of initial claims of unemployment was 475,954, compared to 383,839 last year (2007). And the number of actual claims has been trending up. Taking the three first weeks of the current quarter, we are still below the recession years of 2001-3; but the trend is not what you would like to see, and given the decline in consumer spending (see below) it is likely to continue to trend up.

The actual data is very 'noisy' and jumps all over the place, hence the use of seasonally adjusted numbers for public consumption. Economy.com thinks the difficulty may be in accounting for auto-related plant shutdowns in the seasonally adjusted number. Vogel speculates that employers are no longer waiting until the end of the quarter to lay personnel off but are doing it at any time in the quarter.

Given the issues, it is likely we will see a rise in the number back toward the 400,000 range (SA) that we saw earlier last month. But just be aware that there can be something really different in the actual numbers.

Below is a graph from economy.com showing where the employment problems are. The majority of the states are seeing payroll employment drop.

Fannie and Freddie and Bears, Oh My!

Let me see if I have this straight. It is OK to short oil but not OK to short Fannie Mae? Or is it that it is OK to be long Freddie Mac but not long oil?

Oh, those evil speculators. As Barry Ritholtz points out, why is it that management blames speculators when their stock is being pummeled, when the usual reason is that management made some very bad decisions?

And let's not forget the importance of rumors. We all know rumors can bring down a stock. So, let's start one. Let's start a whisper campaign that Goldman Sachs is going to have to take down $100 billion in losses next quarter, and then we can all short the stock. What would happen is that we would all lose our money when we had to cover, because there was no basis in fact.

The best way for a company to deal with short selling is to increase earnings and blow the shorts out of the water. Good management trumps rumors.

This week the SEC has made it more difficult to short Fannie Mae, Freddie Mac, and other large financial firms. They are actually going to enforce the rule already on the books that says you must actually be able to deliver the shares you are shorting.

'Naked' short selling has been against the rules for some time. (That is, short selling a stock that you cannot actually borrow to sell.) Institutions make rather tidy sums offering the shares they own to short sellers for a price.

Making it more difficult to short Fannie or Freddie is not going to do one thing for their balance sheets, which is the real source of their problem. As former Fed governor William Poole said a few weeks ago, they are basically insolvent. Five-year bonds sold by Fannie Mae yield 90 basis points (0.9%) more than US Treasuries of similar maturity, almost double the average over the past 10 years, according to data compiled by Bloomberg. That spread, which translates to $90,000 in extra annual interest per $10 million of bonds, exists even after Treasury Secretary Paulson signaled the US would ensure the debt is repaid by offering larger amounts of backup financing and potential capital infusions.

Given Paulson's guarantee, why would you buy US bonds when you can get the same guarantee and almost 1% more?

Fannie and Freddie are private companies where the profits go to shareholders and losses go to taxpayers. There are a lot of people (including your humble analyst) who have complained about the current set-up. Basically, they were allowed to leverage their capital beyond what even your most leveraged hedge fund would think prudent. How could the value of homes go down? Leverage up and show huge profits, pay monster salaries and bonuses to management who did nothing but increase risk, and spend $170 million on lobbyists to make sure that no one changes the rules.

Paulson had no realistic choice but to do what he did. But the true point is, he should have never had to make that choice. A real regulator would not have let them leverage their capital to the extent they did. If taxpayers have to invest one penny before shareholders are wiped out, then there is no justice. Fannie and Freddie should be broken up into several much smaller firms which are not too big too fail, their shares floated to new owners, and taxpayers should get preferred shares until they are made whole. And the implicit, but now explicit, guarantee should be taken away.

And while we are on regulators, it is time for Bernanke and Paulson and SEC chairman Cox to force the credit default swap (CDS) market to move to a regulated exchange. If there is a major risk to my happy news scenario at the beginning of this e-letter, it is the credit default swap market collapsing. That is why Bear Stearns had to be rescued, and why other firms like them are too big to fail.

If the CDS markets were on an exchange like any futures contract, Bear could have been allowed to fail. It would have been a sad day, but the Fed would not have had to risk $30 billion. Greenspan was wrong when he said these derivatives did not need to be regulated. They are good for the markets, and I think they are necessary. But let's put them on an exchange where there is clear transparency and the entire economy of Western Civilization is not put at risk by some cowboys who decide to leverage up.

July 22, 2008

Corporate Welfare for XM/Sirius Competitors?

Yes, the merger would create a “monopoly” in satellite radio, but a merged Sirius-XM will still face fierce competition. AM and FM radio, podcasts, mp3 players, and cell phone programming all compete against satellite radio for listeners. In the future, mobile Internet radio with programmable stations could easily threaten satellite radio, which is not programmable.

“Regulation” by competition, not by the FCC and DoJ, is what is needed.

A big reason Sirius and XM want to merge is that they stand to save hundreds of million dollars in costs (Oprah and Howard Stern are expensive). Those savings will make satellite radio more competitive.

That competitive challenge is precisely why traditional over-the-air broadcasters launched a fierce lobbying and advertising campaign opposing the merger.

Why complain if a rival's merger will result in that competitor charging higher prices and degrading its services? A harmful merger would be cheered. Competitors’ opposition reliably signifies that a merger will benefit consumers.

The great irony of antitrust regulation is that, in the name of fostering competition, the laws themselves actually hobble competition, undermining consumer choice.

Antitrust authorities’ ritual holdup of ordinary business deals is bad enough. But whenever two companies of sufficient size merge, they must satisfy conditions so that the FCC and Justice Department can create pretended relevance for themselves.

One condition of appeasement for the Sirius-XM merger is that they hand over 8 percent of their channels to noncommercial and “public service” programming. Internet radio does not face this requirement.

Another condition is that they freeze their prices for three years. Meanwhile, their competitors are still free to set their own prices to reflect changing market conditions.

A third condition is that XM-Sirius must introduce á-la-carte subscription models. If this were economical, they would have done this already.

This is pure protectionism under another name. Restricting satellite radio unfairly benefits its competitors--yet another instance of antitrust regulations reducing competition.

Post-merger business strategies and decisions lie with people not even involved with either firm. Those calls should belong to managers and shareholders. They answer to consumers. If the merger does not give their customers a good product, they stand to lose everything. They have every incentive to make the deal work.

Regulators, by contrast, do not answer to consumers. If they make the wrong decision, they lose nothing. If they make the right decision, they gain nothing. The incentives to make the right call are simply not there.

FCC commissioners and DOJ appointees are political actors. Their decisions are thoroughly politicized. They have no real incentives to ensure an open, competitive market. Their goals are to keep bad press to a minimum, and to increase their budgets by appearing to be “doing something.” The FCC’s indecency rulings, for example, are notorious for shifting with the political winds.

This is hardly conducive to ensuring an open, competitive market.

Antitrust regulations did not work in the smokestack era, and they do not work now. Today, the temptation is great for competitors to go to Washington and cry foul instead of, well, competing.

The media market is more competitive than ever. Not too long ago, broadcast radio was the only game in town. That has changed with the advent of satellite radio and the Internet. Old radio does not like this, but broadcasters can still buckle down and compete. What a shame that instead of bettering their product they try to kneecap their competitors.

A Review of Thomas Donlan's A World of Wealth

Sure enough, while Thomas Edison did not invent the light bulb, Donlan reminds us that Edison did create the first manufacturable bulb thanks to capital provided by J.P. Morgan and other Wall Street financiers. Lives were forever changed for the better thanks to the marriage of innovation with capital, and the light bulb itself serves as a simple example of how capital-driven profit is a source of good for all.

The above is particularly true when poverty in the U.S. is considered. In addressing America’s poor, Donlan asks, “Poor as compared to what?” His point there is clear in that while indoor toilets, electric light and phones were somewhat of a rarity one hundred years ago even among the rich, they “now are commonplace items in virtually every American home, even the poorest.”

Donlan’s answer for why the formerly unattainable is now taken for granted even among the poorest has to do with how we treat what Canadian economist Reuven Brenner refers to as our “vital few.” To Donlan it’s a simple 80/20 concept; as in “if the 20 percent who create wealth are left unfettered and lightly taxed, they and their investments will create more wealth, so the benefits will trickle down to the rest of society in the form of wages and profits.”

In our present climate, the rich are often targeted as the problem, but Donlan eagerly debunks such unfortunate and impoverishing thoughts. Indeed, it is thanks to the profit motives of the vital 20 that goods and services formerly out of reach are increasingly accessible to all. The rich most often become rich because they make or finance the creation of goods for those not rich.

So while the rich almost by definition make our lives easier every day, Donlan also shows that they increasingly foot the bill for a federal government (some, including this writer, would say this is unfortunate) that takes their gains and returns them to those whose incomes are relatively small. Think the two “stimulus” packages of this decade, plus as Donlan notes, “Today’s poor also have a better social safety net.”

The doings of the federal government are largely paid for by the top 1 percent of earners, who, according to Donlan account for 36 percent of all federal revenues. Donlan also shows that while “tax freedom day” falls on July 23rd for our biggest earners, the bottom 50 percent of wage earners in the U.S. account for 3.3 percent of all federal revenues, and their own freedom from taxation begins on January 29th!

When we consider how much the government is reliant on the wealthy to cover its massive spending, the tax cuts the nation has enjoyed in the last 25 years will hopefully be reassessed in terms of fairness. With the rich accounting for the vast majority of government revenues, commentary suggesting reductions only aid the rich doesn’t fly with Donlan. As he makes plain, “tax cuts benefit only taxpayers.” Taxpayers ARE the rich.

Donlan’s solution is not one whereby the poor would be taxed more, but instead he would like a system that’s blind to individual income because in his words, “it is unjust to tax a dollar of income differently depending on who earned it.” Happily, Donlan supports some form of a flat tax or sales tax that would make us all relatively equal in the eyes of the federal government. Tax simplification is a must because as Donlan so articulately points out, Congress “has labored for almost 100 years to produce a fair tax code, with impressively awful results.”

On the corporate-tax front, Donlan lists it as an “unwise burden” designed “to appeal to voters who think corporations are like people, only bigger and meaner.” To Donlan, repeal of the corporate tax makes basic economic sense in that the tax itself “ignores the creative power of capital.” We’d be better off if corporations were able to keep their profits, for reinvested profits powering the economy.

With the glorious wonders of free trade increasingly under attack, Donlan simplifies that which vexes some by reminding readers that free trade “is the power to ignore borders and boundaries on the road to wealth and progress.” To bolster his point, he challenges readers to imagine what the U.S. economy would resemble if the U.S. were “50 countries with 50 currencies and 50 protectionist legislatures.” Rather than prosperous, “it would look like Old Europe or Latin America.”

No immigrant basher, Donlan happily notes that “immigration is trade by other means.” Importantly, he adds that every wave of immigration has been met with hostility, which presumably explains all the anti-immigrant sentiment we’re witnessing today.

Donlan shows the folly of increased border control funding that has actually led to an increased “flow of illegals” who “decided to stay because crossing the border in either direction had become much riskier.” Donlan’s economic solution to the alleged problem of immigration would be to open the borders to those who have jobs while requiring new entrants to agree “to take no social services.”

On the subject of climate change, Donlan offers the basic, but frequently ignored truth that “Over the eons, Earth has been much colder and warmer than it is now, without human help or hindrance.” And assuming that what is presently a theory is in fact a problem, Donlan suggests that we should treat it from an economic perspective and “try to figure out our most efficient response.”

While disagreements with Donlan are few, he addresses high-priced oil as more of a function of supply vs. demand, as opposed to it largely being the result of a weak dollar. Donlan also says “The United States should have an energy policy aimed at providing Americans with the greatest amount of energy at the least economic and social cost.” It says here the U.S. needs no energy policy, but instead should offer the world a stable dollar that when last implemented, gave us cheap oil at a stable price.

Better yet, throughout the book Donlan talks up the undeniable good that comes from comparative advantage, or in his words, “Everything in capitalism insists that we produce at the lowest possible costs.” This surely applies to oil, in that with oil everywhere irrespective of origin for the buyer of same, we should gladly import our fuel from locales around the world that have easier and cheaper access to it. A stable dollar and free trade will solve the alleged oil conundrum, all the while allowing Americans to pursue higher value work.

Surely no Keynesian, Donlan suggests that heavy World War II spending did in fact deliver us from recession. More realistically, the Laffer Curve of the average American rose substantially given the stakes involved during the war, and Americans quite simply worked harder. He also writes that the early ‘80s recession whipped inflation, but when we consider that inflation frequently coincides with recession, we should say that the Reagan tax cuts and the administration’s strong dollar policy beat inflation; Paul Volcker’s monetarism-induced recession a sad economic chapter that could have been avoided had the goal simply been a stable unit of account.

In what is an essential book, Donlan concludes that, “Economic booms and busts always have their causes in wrongheaded policies imposed by central bankers and governments trying to control economic forces that are actually too strong for them.” Truer words have rarely been written, so here’s hoping Donlan’s book reaches a wide audience that includes our allegedly wise leaders in Washington who see every problem as something for government to fix.

July 23, 2008

In the U.S., Selectively Applied Capitalism

Fannie Mae and Freddie Mac, for instance, didn’t become too big to fail by happenstance. Although the Roosevelt administration created Fannie Mae during the Depression to add liquidity to the mortgage market after lending had dried up, Fannie Mae continued to dominate the secondary market for mortgages long after the credit crisis of the Depression had passed. Rather than wind down Fannie Mae’s role in the mortgage market, in 1970 Congress created Freddie Mac, another government sponsored entity, to compete with Fannie Mae, which had been spun off two years earlier into a quasi-government lender.

Nothing illustrates how difficult it is to end a government initiative, even when its raison d’etre has long passed, than the persistence of Fannie and Freddie. Several studies have estimated that today what Fannie Mae and Freddie Mac give us through their giant borrowing power and implicit government backing (which has recently become explicit) is a reduction in the interest rate on mortgages of about 25 basis points. In other words, the federal government has remained our biggest player in the home mortgage market through these two quasi-public entities for the sake of knocking a quarter of a percentage point off your mortgage.

But this is nothing new and not confined to the mortgage market. Several years ago I attended a conference in Israel on reforming that country’s heavily regulated economy, where I heard a succession of speakers present models of how to reorganize everything from taxes to market regulation. Interestingly, none of the models were based on what we do here in the United States, and I could understand why. Our personal and corporate tax systems and our regulatory regimes are too intricate and burdensome to produce the kind of nimble economy that reformers were seeking.

Our corporate tax rate is now so high and uncompetitive that even re-destributive types like Charlie Rangel, chair of the House Ways and Means Committee, think it should be lowered. Our adjusted federal and average state corporate tax rate, at 39.27 percent, is higher than 28 out of 29 Organisation of Economic Co-operation and Development (OECD) members. In 24 states, including California, New Jersey, Massachusetts, Pennsylvania and New York, the combined federal-local tax rate is higher than in any other OECD country (in 22 OECD countries--including France, Italy, Spain, United Kingdom, Poland and Ireland--there are no state or provincial corporate taxes on top of the federal rate).

Meanwhile, our federal government and the states increasingly see our personal income tax system as a vehicle for achieving social goals instead of principally a method of raising revenue. That has given us a tax system that is not only more progressive but also much more complex than many countries. The country’s top 1 percent of households now earns 21 percent of U.S. income and pays 39 percent of income taxes, according to the Internal Revenue Service. When all income and all taxes are included in the equation, including payroll taxes and the share of corporate taxes paid by individuals, the top 1 percent earns 15.6 percent of income and pays 27.6 percent of taxes, according to the nonpartisan Congressional Budget Office. To achieve these numbers, our federal tax code alone now stretches to more than one million words designed to help politicians underwrite and subsidize everything from mortgages to energy efficiency to college education.

By contrast, 24 countries around the world have now gone in the opposite direction, employing simple flat-tax schemes with no loopholes for special interests and no double taxation in the form of capital gains or estate taxes. Significantly, many of these are former Soviet bloc countries which had a unique opportunity after the fall of the Iron Curtain to design tax systems from scratch. None chose anything remotely like our system, not surprisingly, though many were inspired by ideas they learned here in the U.S., where we talk a good game.

The fall of the Soviet Union has helped spark other free-market changes that have left the United States behind. As markets opened up in many former Soviet bloc countries, our officials, economists and business leaders urged the countries to free their state-controlled enterprises from public control, prompting a wave of privatizations around the world. Looking to rebuild their neglected infrastructures, countries also tapped private markets to finance and operate roads, bridges, airports, water systems and the like. Our Wall Street firms, with the financial expertise to manage these transactions, were happy to lend a hand. In the transportation field alone, some 1,100 privatization deals valued at some $360 billion have taken place over the last two decades--though most were overseas.

Here in the U.S., public sector unions have been effective at fighting privatization and competition for the delivery of public services. Another impediment to free-market reform has been our massive and increasingly corrupt and inefficient system of allowing states to raise money through the use of tax-free municipal bonds. The muni market has been a valuable enabler of corrupt pols, who have plunged states into billions of dollars of debt by using munis to finance pork-barrel projects, non-essential construction like publicly financed stadiums and sports arenas, and public authorities that are managed (and mostly mismanaged) by their patronage appointments. Why tap the private sector when you can ride on the taxpayers’ backs?

This has produced a sharp contrast between how public work is done here and in many other places. In the 1980s, for instance, the Thatcher administration in Britain began a program of contracting with private firms to build and operate toll roads, work continued by the Blair government. A 2002 study in Britain found that whereas 70 percent of publicly managed construction was completed late, and 73 percent came in over budget, only 24 percent of construction managed for government by private firms was late, and 20 percent was over budget. Compare that with the boondoggles produced in places like New York and New Jersey, where giant publicly financed construction authorities, fueled by muni bond offerings, have squandered billions of dollars through fraud, waste and mismanagement.

These days, in other words, we seem to lead only in the amount of energy we expend urging others to do what we don’t do ourselves.

Nothing Naked About Short Sales

Investors speculate whether they're long or short on company shares. When they expect a company to prosper, they go long on those shares and existing shareholders benefit through greater demand for that which they own. The economy benefits as well from market-driven speculation pushing capital to what markets deem its highest use.

On the flipside, short selling is a very risky form of speculation. Short sellers borrow shares to sell in the present under the supposition that when they cover their sale later with a share purchase, there will be a profit for the shares having falling in the interim. While a long purchaser only risks the funds invested, a short seller could see the shares sold go skyward — think of those who sold AOL short in the fall of 1996 before six splits of those same shares.

The economy is a great beneficiary of short selling in that this allows for negative sentiment about any company to be priced into the value of the company. If short sellers are vindicated by a falling stock price, capital is more quickly deployed to better uses and the broad economy benefits.

When this form of speculation is restricted, as in when regulators seek to muddle the process of price discovery, there exists an unseen negative for companies not achieving the best possible ownership. For one, takeovers that usher in new owners with new ideas about how to maximize the value of a company's assets might never occur due to the buyer being unwilling to pull the trigger on a firm whose value has not reached market-clearing levels.

Secondly, anyone with even the most rudimentary knowledge of money management knows that investors large and small have "wish lists" when it comes to stocks. There are many companies that investors are eager to own, but not at existing price levels. If short sellers achieve what some deem a short-term aim, a company can benefit over the long term for the shares falling into the hands of interested, long-term owners.

Naked shorting involves selling shares that the sell-side broker does not immediately have possession of. But for most shares, this is handled with ease. Once a client expresses interest in shorting the shares of a certain company, the broker checks with the trading desk to understand the "borrow" on those shares as a way of assessing if those shares can be sold short.

For shares that are "easy to borrow," the "naked" nature of a sale is irrelevant, and also legal, given the ease with which the executing short-sale broker will be able to deliver the shares to the buyer.

If shares are deemed "hard to borrow," brokers have to do additional legwork to be sure that the stock is available to be shorted. If the shorted shares are not delivered to the buyer within the three-day settlement period, this is called a "fail to deliver," as in the short-seller did not actually possess the shares sold. But this is somewhat corrective too in that if the shares are not located within 13 days, the broker who executed the trade must buy them back; thus nullifying the initial sale.

It should be said of "naked" shorting that long buyers are frequently naked themselves. Indeed, they often purchase shares through a broker without the correct amount of cash to cover the purchase. Importantly, this process is self-regulating in that those who fail to transfer the cash to complete the trade on the settlement date can have their accounts closed for trades being broken. Ultimately the shares sold short must be delivered, and the short seller faces major risk if the speculation proves incorrect. If brokers develop a reputation for failing to deliver the shares sold short, they find it difficult to locate those willing to transact.

It can't be stressed enough that contrary to visions of speculators flooding the markets with non-existent shares, there are two sides to every trade. Without a buyer who has a different opinion than that of the seller about the company in question, there is no short sale to speak of. In short, one cannot hedge anything without the existence of a contrarian speculator. It should also be said that those speculators who think the short-sellers are wrong are not buying shares they expect will not be delivered.

Without the SEC, the market for short sales would prove self-regulating very quickly. Furthermore, the liquid nature of the 19 financial stocks covered under the SEC's plan are not the kind of shares that are hard to borrow.

SEC Chairman Christopher Cox will doubtless pat himself on the back for aiding certain companies during a difficult period for the markets, but the losers will be many, including investors, the companies protected, and the economy itself.

Investors will lose for having to put capital to work in a market distorted by regulatory machinations, the protected companies will lose for their shares not reaching natural market levels that would put their shares in the right hands, and the economy will lose for capital not working efficiently in sorting out the market's winners and losers.

July 24, 2008

The Death of the Globalization Consensus

Recent events have heightened the urgency with which these issues are discussed. The presidential electoral campaign in the United States has highlighted the frailty of the support for open trade in the world’s most powerful nation. The sub-prime mortgage crisis has shown how lack of international coordination and regulation can exacerbate the inherent fragility of financial markets. The rise in food prices has exposed the downside of economic interdependence without global transfer and compensation schemes.

Meanwhile, rising oil prices have increased transport costs, leading analysts to wonder whether the outsourcing era is coming to an end. And there is always the looming disaster of climate change, which may well be the most serious threat the world has ever faced.

So if globalization is in danger, who are its real enemies? There was a time when global elites could comfort themselves with the thought that opposition to the world trading regime consisted of violent anarchists, self-serving protectionists, trade unionists, and ignorant, if idealistic youth. Meanwhile, they regarded themselves as the true progressives, because they understood that safeguarding and advancing globalization was the best remedy against poverty and insecurity.

But that self-assured attitude has all but disappeared, replaced by doubts, questions, and skepticism. Gone also are the violent street protests and mass movements against globalization. What makes news nowadays is the growing list of mainstream economists who are questioning globalization’s supposedly unmitigated virtues.

So we have Paul Samuelson, the author of the postwar era’s landmark economics textbook, reminding his fellow economists that China’s gains in globalization may well come at the expense of the US; Paul Krugman, today’s foremost international trade theorist, arguing that trade with low-income countries is no longer too small to have an effect on inequality; Alan Blinder, a former US Federal Reserve vice chairman, worrying that international outsourcing will cause unprecedented dislocations for the US labor force; Martin Wolf, the Financial Times columnist and one of the most articulate advocates of globalization, writing of his disappointment with how financial globalization has turned out; and Larry Summers, the US Treasury chief and the Clinton administration’s “Mr. Globalization,” musing about the dangers of a race to the bottom in national regulations and the need for international labor standards.

While these worries hardly amount to the full frontal attack mounted by the likes of Joseph Stiglitz, the Nobel-prize winning economist, they still constitute a remarkable turnaround in the intellectual climate. Moreover, even those who have not lost heart often disagree vehemently about the direction in which they would like to see globalization go.

For example, Jagdish Bhagwati, the distinguished free trader, and Fred Bergsten, the director of the pro-globalization Peterson Institute for International Economics, have both been on the frontlines arguing that critics vastly exaggerate globalization’s ills and under-appreciate its benefits. But their debates on the merits of regional trade agreements – Bergsten for, Bhagwati against – are as heated as each one’s disagreements with the authors mentioned above.

None of these intellectuals is against globalization, of course. What they want is not to turn back globalization, but to create new institutions and compensation mechanisms – at home or internationally – that will render globalization more effective, fairer, and more sustainable. Their policy proposals are often vague (when specified at all), and command little consensus. But confrontation over globalization has clearly moved well beyond the streets to the columns of the financial press and the rostrums of mainstream think tanks.

That is an important point for globalization’s cheerleaders to understand, as they often behave as if the “other side” still consists of protectionists and anarchists. Today, the question is no longer, “Are you for or against globalization?” The question is, “What should the rules of globalization be?” The cheerleaders’ true sparring partners today are not rock-throwing youths but their fellow intellectuals.

The first three decades after 1945 were governed by the Bretton Woods consensus – a shallow multilateralism that permitted policymakers to focus on domestic social and employment needs while enabling global trade to recover and flourish. This regime was superseded in the 1980’s and 1990’s by an agenda of deeper liberalization and economic integration.

That model, we have learned, is unsustainable. If globalization is to survive, it will need a new intellectual consensus to underpin it. The world economy desperately awaits its new Keynes.

Dani Rodrik is Professor of Political Economy at Harvard University’s John F. Kennedy School of Government. His latest book is "One Economics, Many Recipes: Globalization, Institutions, and Economic Growth".

July 29, 2008

The Real Shame About Fannie & Freddie

For the above alone, Fannie and Freddie’s problems are a major shame. Thanks to the guarantees that are part and parcel of institutions chartered by the federal government, they were able to overextend themselves in the mortgage market, and in the process they’ve helped discredit capitalism. Even though their activities had nothing to do with true capitalism, this hasn’t kept the E.J. Dionne’s of the world from proclaiming that today’s problems are rooted in too much economic freedom, as opposed to the reality that capitalism today is increasingly of the big-government variety.

But the bigger shame when it comes to Fannie and Freddie involves the longer-term economic harm that results from too much capital flowing into the ground. Founded to increase mortgage-market liquidity in the U.S., Fannie and then Freddie were supposed to foster greater “community” in the United States given the broadly held view that homeowners are better, more invested citizens. If we ignore the extra-Constitutional nature of such government activity, not to mention that equity holdings presumably “invest” us just as much in the U.S., we can then address the problems that result from government doing what it should not.

On the capital front, even though anyone with a pulse always knew that taxpayers would be on the hook if problems arose at Fannie and Freddie, their bonds were always a great investment for offering more yield than government-backed Treasuries of the same maturity. Thanks to their presumed government guarantee, Fannie and Freddie bonds have logically attracted far more investment than they would have in a free economy.

The above was and is problematic considering that we live in a world of limited capital. Fannie and Freddie themselves pull in a great deal of investment, plus private banks have greater incentives to make loans in the housing space with full knowledge that our government-sponsored institutions will be there to provide massive liquidity in the secondary mortgage market.

Taking nothing away from the necessity that is shelter, the extra subsidies have given us an unseen economic retardant. Indeed, when subsidies drive increased capital flows to certain sectors, others go wanting. What will never be known is how many Microsofts and Googles were strangled at infancy due to capital that was consumed in the housing market as opposed to making its way to job-creating businesses and entrepreneurs.

Simply put, subsidies distort investment flows, and with housing a heavily subsidized sector, capital that might have found its way to entrepreneurs in an economy not muddled by government intrusion found its way to the unproductive sector that is housing. When John Stuart Mill wrote about unproductive consumption, housing was at or near the top of his list.

Sadly, the story gets worse. With U.S. residential property worth just south of $21 trillion (easily exceeding the total stock-market worth of all public companies) as of last year thanks to land-use rules, its preferred status among our leaders in Washington, and the ever weakening dollar, it is increasingly the main source of wealth for most households. This is problematic from an asset diversification standpoint, particularly during times of housing uncertainty, but it’s most enervating for keeping many Americans stationary in an economy that is not.

Sure enough, with some Americans logically reluctant or unable to unload what might be their best investment, many feel the need to stay in one place despite the fact that capital moves at lightning speed, and with very little regard for the past residential choices of most Americans. No doubt many residents of Michigan and Ohio would like to move where economic opportunity is greater, but home ownership has become the proverbial ball-and-chain that makes following capital and opportunities difficult.

So not only is the housing subsidy that Fannie and Freddie represent unfortunate for distorting capital flows, it’s probably most harmful for discouraging the more robust migratory patterns that would enable our economy to grow in the most optimal way. Indeed, that Fannie and Freddie are effectively insolvent is almost beside the point. We should expect that from institutions whose successes are private, but whose losses are shared by the public.

Going forward, once the bailout of what’s been a government-created mistake is complete, Fannie and Freddie should be sold in order to shed any ties to the federal behemoth that created them. Additionally, the subsidies that are mortgage-interest deductions and tax-free sales should be normalized so as to make them no more enticing than that offered by equity investment.

As for our political class, here’s hoping the bi-partisan and politically correct notion suggesting everyone should own a home goes the way of Prohibition, “stimulus” and other bad ideas foisted on us by Washington throughout history. While housing is an essential good, government efforts to make ownership universal have redirected money away from the productive economy, all the while slowing the necessary movement of human capital in a world of fast-moving financial capital.

Why Does Gasoline Cost So Much?

At the end of 2007, both gasoline and crude oil prices (adjusted for inflation) were at levels last seen in 1981 and they continued to climb throughout much of 2008. While Europe has been cushioned in part from these developments, as the dollar depreciated against the euro, the fundamental forces that drove up US gasoline prices have done the same in Europe.
With retail gasoline prices in the US persistently above $4 per gallon, the determinants of gasoline prices is no longer an esoteric topic best left to industry insiders. The debate has moved into the mainstream. Congressional committees as well as media pundits have advanced explanations and proposed policy changes to stem or reverse the increase in gasoline prices.
Why did this surge occur? To answer this, it is important to distinguish between:
the price of gasoline and other motor fuels, and
the price of crude oil in global markets.
A distinction often ignored in discussions of higher energy prices. In a recent Vox column, Francesco Lippi discussed the price of crude. My column focuses on the US gasoline market, which is an interesting case for understanding the underlying market forces because of the availability of high quality data for extended periods.

Supply and demand shock in the US gasoline market

Recent research has stressed the importance of identifying the demand and supply shocks underlying unpredictable shifts in the price of imported crude oil.1 The same distinction between demand and supply shocks obviously applies to the retail gasoline market.
While crude oil is the main input in the production of motor gasoline, the US retail price of gasoline is also affected by gasoline-specific demand and supply factors, such as the ability of US refiners to process crude oil. Refinery fires, changes in the regulatory environment or refinery outages caused by hurricanes, for example, may cause increases in the retail price of gasoline that are not driven by events in the crude oil market.
But the US market does not operate in isolation. We can only hope to understand the evolution of US retail gasoline prices if we also account for the global demand and supply shocks that drive the price of crude oil.
In recent research, I propose such a model where global and US demand and supply shocks co-exist and there is feedback between the markets. Estimating it on US data, my analysis helps us understand the forces been behind the surge in US gasoline prices since 2002.2 The model allows for five distinct demand and supply shocks:
global crude oil supply shocks;
shocks to the demand for industrial commodities (including crude oil) that reflect fluctuations in global real activity;
demand shocks that are specific to the crude oil market;
domestic gasoline supply shocks (such as refinery outages); and
domestic gasoline demand shocks (reflecting changes in the degree of urbanisation, driving habits, tastes, etc.).
Given the importance of crude oil imports, it is natural to focus first on developments in global crude oil markets as the likely cause of the gasoline price increases in recent years.

Crude price hikes: it’s the demand shocks not the supply shocks

The model results show that unpredictable global oil supply disruptions (such as unanticipated production cutbacks by OPEC or disruptions of oil production in Venezuela or Nigeria, for example) played no role in the recent build-up of gasoline prices. Rather the bulk of the increase in US gasoline prices since 2002 has been associated with a series of unanticipated increases in global demand for crude oil (along with other industrial commodities).
Where did the extra crude demand come from? It can be shown that this sustained growth of demand was driven not so much by unusually high economic growth in OECD countries – although some of these economies experienced robust growth – but by additional demand from emerging Asia.
In addition to fluctuations in oil demand driven by global real activity, the model allows for demand shocks that are specific to the oil market. Economic theory suggests that growing uncertainty about future oil supply shortfalls boosts demand as oil companies attempt to build inventories to protect themselves from being caught short.3 As uncertainty shifts may be sudden, large and persistent, such “precautionary” demand shocks are a natural suspect in explaining the recent surge in oil (and gasoline) prices.

Precautionary inventory holding was not to blame

Such shocks played an important role in the oil price shocks of 1979 and 1990. My estimates, however, show that such shocks have not played a major role in recent years.
This evidence is important. There has been a lot of public discussion in recent years about the alleged role of speculators in crude oil markets and how speculators may be reigned in by legislative changes and regulatory supervision.4
A speculator in this context refers to someone who buys crude oil now, stores it, and hopes to sell it at a higher price later in anticipation of future shortages. If there were speculation in global crude oil markets, the resulting extra demand in the model would by construction be reflected in an increase in the component of the price of oil driven by precautionary demand.
My model estimates clearly tell us that there is no such increase, suggesting that speculation is not behind the recent gasoline price increases. The same conclusion is reached when looking at petroleum inventory data. If speculation were important, we would expect to see a noticeable increase in OECD oil inventories. The data show no such increase.
Finally, this conclusion is also consistent with the fact that most industrial commodity prices – not only the price of oil – have been growing at rapid rates in recent years. This pattern is consistent with a general increase in the global demand for industrial commodities but not with explanations that are specific to the crude oil market.
Having reviewed the role of shocks in the global crude oil market, I now turn to the role played by US domestic gasoline demand and supply shocks.

The US gas market: shocks to US refining capacity matter

A striking result is that US domestic gasoline demand shocks have had virtually no impact on the US retail price of gasoline in recent years. This is not surprising, as US consumption of gasoline has been moving very slowly and predictably. Indeed, that evidence is fully consistent with the notion that increased demand for crude oil and refined products comes from emerging Asia rather than the US.
In contrast, US domestic gasoline supply disruptions have played a role – in particular following Hurricanes Rita and Katrina in 2005. The primary effect of these exogenous events was not the reduction in US crude oil production (which was negligible on a world scale), but the reduction of crude oil refining capacity in the Gulf of Mexico.
Given that other US refineries were already operating close to capacity at the time, this event constituted a major unanticipated reduction of the supply of gasoline in the US, which would be expected to raise the price of gasoline sharply (while lowering slightly the price of crude oil, as demand for oil imports falls). The model indeed shows a sharp increase of US gasoline prices driven by adverse refinery shocks in late 2005. Only half a year later, the price seems to have stabilised again, although there is evidence of intermittent unanticipated refining shortages in 2006 and 2007 as well.
In short, the primary reason for the recent surge in gasoline prices has been growing global demand driven by developments abroad, given fairly inelastic global oil supplies. This evidence helps us understand why gasoline prices have risen to record levels, but what about the future?

Forecasting the future

Predicting gasoline prices is an all but impossible task even at horizons as short as one year. In recent co-authored work (Alquist and Kilian, 2008), I have shown that simple no-change forecasts are the most accurate forecasts of the price of crude oil in practice. In other words, the change in the price of oil is unpredictable.
Given the close relationship between global crude oil prices and domestic retail gasoline prices, the same result is likely to apply to US gasoline prices. The problem with forecasting the change in gasoline prices is not so much that we do not understand its economic determinants, but that it is difficult to predict the future evolution of these determinants. The fact that many media pundits disagree on the future course of gasoline prices reflects to a large extent the fact that they disagree on the future evolution of these determinants. It is this uncertainty that renders the no-change forecast of gasoline prices a good approximation.

Conjectures on the future price of US gasoline

It is instructive to speculate about the future evolution of the determinants of the price of gasoline. Abstracting from unpredictable refinery outages, the future evolution of US gasoline prices will depend primarily on developments in the global crude oil market.
Although past oil price increases have been followed by substantial increases in crude oil production with a delay of a few years, there is reason to be sceptical of the idea that substantial increases in oil production will be forthcoming in the foreseeable future. This is not a problem of the geological scarcity of oil. The problems are:
Oil exploration had been neglected, as the price of oil fell in the late 1990s.
The political environment in many oil-producing countries discourages oil companies from making the much-needed large-scale investments. In particular the threat of expropriation of successful investments in many countries prevents investments from taking place at the needed pace.
Additional crude oil likely to be available in the short run is heavy crude oil that US refineries are ill equipped to process. Building new refineries in the US takes many years.
Thus, a fair presumption is that the crude oil market will remain supply-constrained for the next few years.

With supply constrained, demand growth is the key

With crude oil production remaining flat or increasing only slowly, the price of crude oil and hence the price of gasoline will depend first and foremost on the extent to which countries in emerging Asia will continue to grow. Clearly, the current expansion in Asia will not continue unabated – all the more so as rising energy prices will leave their mark abroad while the US economy is already slowing. While a decline in demand seems inevitable, what is not clear is how soon that decline will occur and by how much global demand for industrial commodities will slow.
If past global expansions are a guide, global demand will recede only gradually. This is a direct implication of the model underlying this analysis. This suggests that US gasoline prices will remain high for the time being. Barring a major economic collapse in emerging Asia, prices will stabilise only as the world economy learns to economise on the use of oil and gasoline and as the supply of crude oil expands. Both corrective forces will take time to gain momentum.
In addition, there is reason to be concerned that oil-market specific developments, which for the most part have played no role since 2002, could become more important in the future.

Oil-market specific developments

Sharp shifts in the precautionary demand for oil reflecting uncertainty about political developments in the Middle East tend to occur only when demand for crude oil exceeds supply. When they do occur, they tend to cause sharp increases in the price of crude oil, as in 1990/91, for example. Under the current conditions, the world economy is particularly vulnerable to threats of military conflict in the Middle East. A good example is Iran’s threat to close the Straits of Hormuz if Iran were to be attacked by Israel. Such developments could potentially cause US gasoline price movements that dwarf the effect of sustained strong global demand for industrial commodities.
In short, based on this interpretation of the evidence, the price of crude oil and hence the price of gasoline is likely to stay high for the foreseeable future, but there is considerable uncertainty in either direction.

Lutz Kilian is Associate Professor at the Department of Economics at the University of Michigan and a Research Fellow at CEPR.


1 Also see Kilian, L. (2008b), “Not All Oil Price Shocks Are Alike: Disentangling Demand and Supply Shocks in the Crude Oil Market,” forthcoming: American Economic Review.
2 This article is based in large part on results in Kilian (2008a), “Why Does Gasoline Cost so Much? A Joint Model of the Global Crude Oil Market and the US Retail Gasoline Market,” CEPR Discussion Paper No. 6919.
3 See Alquist, R., and L. Kilian (2008), “What Do We Learn from the Price of Crude Oil Futures,” mimeo.
4 See the Vox column by Guillermo Calvo, and the reply by Paul Krugman.

July 30, 2008

When Will Henry Paulson Learn?

Paulson’s covered bonds would be backed by specific mortgages held by the banks. In essence, these would be large certificates of deposit. Though not necessarily insured, the bonds would be back by specific assets on the banks books, and the banks would take steps to ensure these mortgages were good—not the junk Merrill Lynch, Citigroup and others have been hoisting on investors.

Whether the bond market accepts these securities—essentially whether insurance companies, pension funds and other fixed income investors take the plunge—comes down to trust in the banks. Recent events at Merrill Lynch, Citigroup and others indicate that such trust will require a bold leap of faith.

The basic problem at the big banks is compensation schemes that encourage bank executives to make risky bets that allow them to profit when things go well, and to push the losses on bond and stockholders when things go sour. Upon taking over Merrill Lynch, John Thain increased executive bonuses, but established a weak risk management scheme. That hasn’t worked.

At Citigroup, CEO Vikram Pandit is selling off assets to cover losses, but he has not given back the $165 million he took from shareholders for his sale of the Old Lane hedge fund to his employer. The bank subsequently took more than $200 million in losses, yet the Citigroup bonus machine continues the payouts to its executives.

UBS is under investigation for fraud in the sale of auction rate securities.

It seems hard to find a major bank without some a record of sharp practices.

Mr. Paulson is trying to sell trust in the banks with his new covered bonds. It’s tough to sell trust in a Wall Street bank these days, because there is not much to trust.

An insurance company that buys Paulson’s covered bonds will likely be all right, but it is taking an imprudent risk. That should tell you something about the competence of its management, and it would be signal to dump its stock.

Paulson’s scheme to reopen the bond market to banks for mortgage lending will only work if the commercial banks clean up the management practices that caused the subprime crisis, and the subsequent massive losses imposed on shareholders and bond customers.

The federal government is imposing new a regulator on Fannie Mae and Freddie Mac, which will have authority to regulate executive compensation. The Federal Reserve has loaned hundreds of billions to Wall Street banks and securities companies without any real commitments for management reform. The asymmetry is puzzling.

Mr. Paulson will only get the mortgage market, housing crisis and economy turned around when he resolves the confidence gap on Wall Street. That requires systemic reform in the business practices and compensation structures. What’s good for Fannie and Freddie would be good for Citigroup, Merrill Lynch and the others.

Peter Morici is a professor at the University of Maryland School of Business and former chief economist at the U.S. International Trade Commission.

Let's Privatize Our Roadways

With America already underspending on infrastructure by about $130 billion a year, the country will require new financing sources in the era of high gas prices, especially when one-quarter of our bridges are deemed in poor shape, and one out of every seven miles of road pavement is considered “unacceptable.”

Here’s an area where the U.S. can learn from the many other countries around the world which for years now have been tapping huge pools of private capital to help build, maintain and operate roads, bridges, tunnels and mass transit systems. Some 3,400 miles of toll highways linking cities in France have been built with money from private investors. The United Kingdom has used so-called build-to-operate agreements with private companies and capital for 20 years to finance new roads, tunnels and bridges. Developing countries as different as Mexico, Thailand, Malaysia, and Indonesia have followed suit to one degree or another. China is using private capital for a massive road building effort which involves linking its major cities with super highways.

One reason such efforts have been successful is that there is plenty of capital out there looking for the kind of solid, predictable long-term returns that this investing brings. Huge global pension funds with very long investing horizons have targeted this area, which is considerably less volatile than investing in equities (or mortgage-backed securities, it seems). In a typical deal, a bank or investment house managing pension money partners with a company that is experienced in operating roads or bridges, and the pair either build or take over an existing road with tolls on it, then contract to operate it for many years in exchange for the toll revenues. In return, government typically gets an upfront payment, which in the case of existing roads that don’t have to be constructed, can be enormous. Government can use that money to provide further transportation building, especially of roads or bridges that can’t pay for themselves by being tolled.

The technique is so widespread and attractive that a few places in the U.S. have already tried it with surprising results. In Indiana, Gov. Mitch Daniels, facing a $3 billion transportation funding shortfall (even before the current spike in oil prices), put the operation of his state’s tollway up for bid. A state analysis estimated that road was worth some $1.8 billion, but the winning bid astounded officials: $3.8 billion from an international consortium to maintain and operate the road for 75 years.

The deal was no fluke. Chicago Mayor Richard Daley did the same with the city’s Skyway, which investment bankers estimated was worth $900 million. Instead, it fetched $1.8 billion from an international group that will run and maintain it for 99 years. Both deals include extensive operating agreements, stretching to hundreds of pages, which place limits on toll increases, and set out maintenance and operating standards that essentially require the companies over the life of the contracts to virtually rebuild the roads as they age. If the private operators fail to live up to the contracts, they risk losing their right to manage the roads and, in the process, their huge upfront payments.

How can the private bidders afford to pay so much? For one thing, the bidders are confident they can increase the efficiency of operating these roads, thereby generating more revenues and lower costs than when the roads operate under government supervision. In some cases that results from doing simple things that government managers aren’t incentivized to do, like adding electronic toll collection where it doesn't exist or buying automated coin counting machines to free toll collectors from laborious accounting jobs, and bidding out snow plowing and other contracts without the burdens of bureaucratic and rigid government bidding processes.

Some of the private operators who run these roads are also far more experienced than your typical local, state or city highway department, which can be a hotbed of patronage appointments. Proponents of a plan to privatize the Pennsylvania Turnpike note the steep costs and patronage legacy of the state’s Turnpike Commission, which employs 2,000 people, including more than 500 in administrative positions, to operate a 537-mile road. An analysis of the turnpike’s operation by the Reason Foundation determined that the authority spends 62.4 percent of its toll revenues on operations and maintenance, while the average among private operators is 27.6 percent.

The moves by Chicago and Indiana have certainly sparked more interest in this financing and operating technique, especially in places where population is growing rapidly and the need to build new roads outstrips government’s ability to pay for them. Texas, for instance, has looked at using build-to-operate agreements to construct some of the massive Trans-Texas highway. About half of states now have legislation which allows these sorts of transactions.

Still, opposition has arisen from a variety of places, including public sector unions who don’t want to see these assets in the hands of private operators, state pols who relish the rich patronage opportunities provided by government control of transportation agencies, and proponents of “economic nationalism” who don’t want to see our essential assets auctioned off to foreign bidders (although, of course, the investors can’t actually take these assets overseas).

In Pennsylvania, Gov. Ed Rendell’s plan to lease the Turnpike has met with tough opposition, even though a private group has offered an astounding $12.8 billion to operate the road for 75 years. Opponents have presented an alternate plan that would keep the road in the hands of the bloated Turnpike Commission and use bond offerings secured by future toll revenues to raise capital now, but that plan doesn’t provide enough money to meet the state’s needs, some argue, and would require new tolls along U.S. Route 80 in Pennsylvania, which is now free. In Texas, meanwhile, opponents of private deals in the state legislature are threatening to rescind the state department of transportation’s ability to contract with private operators for building the Trans-Texas highway.

Of course, this opposition arose before the sharp slump in driving that began in April and accelerated in May. Considering the shape of our roads and bridges, and the fact that even during flush tax-times we’ve consistently underinvested in infrastructure, it is going to get harder and harder to ignore the huge pools of private capital that would welcome a chance to invest in the transportation future of the world’s biggest economy.

The Homeownership Obsession

Does every house need a "home entertainment center"? Well, no. But when you subsidize something, you get more of it than you otherwise would. That's our housing policy. Let's count the conspicuous subsidies.

The biggest favor the upper middle class. Homeowners can deduct interest on mortgages of up to $1 million on their taxes; they can deduct local property taxes; profits (capital gains) from home sales are mostly shielded from taxes. In 2008, these tax breaks are worth about $145 billion. Next, government funnels cheap credit into housing through congressionally chartered Fannie Mae and Freddie Mac. Long perceived as being backed by the U.S. Treasury, Fannie and Freddie could borrow at preferential rates; they now hold or guarantee $5.2 trillion worth of mortgages, two-fifths of the national total. Finally, the Federal Housing Administration insures mortgages for low- and moderate-income families that require only a 3 percent down payment.

Congress's response to the present crisis is, not surprisingly, more of the same. The legislation enacted last week adds new subsidies to the old. It creates more tax breaks; most first-time home buyers could receive a $7,500 tax credit. It expands the lending authority of Fannie Mae and Freddie Mac. Previously, the permanent ceiling on their mortgages was $417,000; now it would be as much as $625,500. And the FHA would be authorized to support, at much lower monthly payments, the refinancing of mortgages of an estimated 400,000 homeowners who are in danger of default.

More subsidies may -- or may not -- stabilize the housing market in the short run. But there are long-term hazards. Make no mistake: I'm not anti-housing. I believe that homeownership strengthens neighborhoods and encourages people to maintain their property. It's also true, as economist Mark Zandi shows in his book "Financial Shock," that today's housing collapse had multiple causes: overconfidence about rising home prices, cheap credit, lax lending practices, inept government regulation, speculative fever, sheer fraud.

Still, the government's pro-housing policies contributed in two crucial ways.

First, they raised demand for now suspect "subprime" mortgages. The Department of Housing and Urban Development sets "affordable" housing goals for Fannie Mae and Freddie Mac to dedicate a given amount of credit to poorer homeowners. One way Fannie and Freddie fulfilled these goals was to buy subprime mortgage securities -- many of which have now gone bad. Second, government's housing bias created a permissive climate for lax lending. Both the Clinton and present Bush administrations bragged about boosting homeownership. Regulators who resisted the agenda risked being "roundly criticized," notes Zandi.

Good intentions led to bad outcomes: an old story. Fannie's and Freddie's losses impelled the Treasury Department to propose a rescue; given the companies' size and the government's implicit backing of their debt, doing otherwise would have risked a financial panic. Personal savings have been skewed toward housing. Many Americans approaching retirement "have accumulated little wealth outside their homes," concludes a study by economists Annamaria Lusardi of Dartmouth College and Olivia S. Mitchell of the University of Pennsylvania. Even some past gains from the pro-housing policies are eroding; the homeownership rate has now dropped to 68 percent.

We might curtail housing subsidies without exposing the economy to the disruption of outright elimination. The mortgage interest deduction could be converted to a less generous credit; Fannie and Freddie's expanded powers could be made temporary; the FHA's minimum down payment could be set at a more sensible 5 percent. But even these modest steps would require recognizing that the homeownership obsession has gone too far. It would require a willingness to confront the huge constituency of homeowners, builders, real estate agents and mortgage bankers. There is no sign of either. When tomorrow's housing crisis occurs, we will probably find its seeds in the "solution" to today's.

The WTO’s Failure in Light of the GATT’s History

The recent meeting of trade officials at the World Trade Organization in Geneva failed to reach preliminary agreements that would have made considerable progress toward concluding the Doha Round of trade negotiations. As a result, the outlook for the Round is grim, at least in terms of the immediate future. Inevitably, the failure of the meeting has raised questions about the future of the WTO as a forum for trade liberalisation. Although important progress has been made on some of the technical aspects of the negotiations, the political will to conclude the round appears to be missing at this stage, as Jeffery Schott noted in his recent Vox column.

It seems that we are a long way from the days when trade negotiations were a major priority.

What’s next? Look back to see forward

One way to ponder the future of the WTO is by examining its past. In a recent book (co-authored with Alan Sykes), we take a close look at the origins of the General Agreement on Tariffs and Trade (GATT), the WTO’s predecessor.1

The GATT was created in 1947 for a very specific purpose. That purpose was to reverse the commercial policies of the 1930s that involved greater restrictions on and more discrimination in world trade. These anti-trade policies arose in part because countries sought to insulate themselves from the Great Depression through what became known as “beggar-thy-neighbour” policies. Blocking imports proved to be a futile method of increasing domestic employment due to the economic slump, since one country’s imports were another country’s exports. The combined effect of every country trying to save its own industries and protect its own workers was a collapse in international trade, which merely exacerbated the problems of the world economy and contributed to political frictions between countries.

The GATT grew out of discussions between government officials from the United States and the United Kingdom during World War II. After seeing international trade suffocated under the weight of protectionist policies during the 1930s, officials from both countries had a compelling interest in pursuing policies that would reduce trade barriers and help expand world trade after the war. They sought to foster these conditions by creating a rules-based framework for liberal trade policies that would rein in the use of trade restrictions as well facilitate the process of reducing those barriers.

One of the first individuals to recognise the need for an international agreement was James Meade, then working for the British government and whose later work on trade policy earned him the 1977 Nobel Prize in Economics. In 1942, Meade drafted “A Proposal for an International Commercial Union” that influenced British policymakers and anticipated many features of the GATT.

While the US and UK governments agreed on the most important and basic principles to be included in a trade agreement, they differed on many substantive details that affected the shape of the GATT. The United States adamantly opposed trade discrimination and wanted Britain to dismantle its Imperial preferences, while Britain wanted major reductions in US tariffs, which were much higher than UK tariffs as a result of the Hawley-Smoot tariff of 1930. Britain also convinced the United States to seek a multilateral trade agreement rather than continue its old bilateral approach under the Reciprocal Trade Agreements Act of 1934.

Once these two countries agreed upon a document that could serve as a basis for negotiation, other countries were invited to participate in shaping the provisions of the GATT and the charter of the International Trade Organisation. At a conference in the Palais des Nations in Geneva, representatives of 23 countries met from April to October 1947 and established two key pillars of the post-war world trading system.

    They created a legal framework for commercial policy by finalising the text of the GATT.
    The Geneva participants negotiated numerous bilateral agreements to reduce import tariffs, the benefits of which were extended to other GATT parties through the unconditional most-favoured nation (MFN) clause.

As a result, the landmark 1947 meeting produced an enduring framework for post-war commercial relations in which government-imposed trade barriers were contained and then gradually scaled back over time. Under this system of multilateral cooperation, international trade has flourished for over half a century.

History and modern theories

What does the establishment of the GATT say about recent theories of trade agreements? These theories include the idea that the GATT is motivated by:

    terms of trade externalities across countries,
    governments seeking external commitments to reduce the power of domestic interest groups, and
    foreign policy considerations.2

We find some evidence for each of these theories, but the weakest appears to be commitment. Many signatories of the GATT insisted upon a variety of opt-out clauses and exceptions to ensure the flexibility of domestic policy in the face of future economic developments; that is, they did not want to tie their hands too much in an international trade agreement.

There is somewhat more evidence in favour of a terms of trade interpretation. The structure of the bargain suggests that terms-of-trade considerations were implicitly a part of its rationale. The negotiations took place following the principal-supplier rule, and reciprocity was the guiding negotiating principle. A focus on principal suppliers and reciprocal concessions hints that the arrangement was indeed focused on unravelling the damage done to the volume of trade by non-cooperative tariffs, akin to the core problem in the terms-of-trade models.

Even if terms-of-trade considerations were not at the forefront of the minds of the GATT founders or consciously articulated, the volume of trade (a notion intimately linked to terms of trade) certainly was. And their actions were consistent with the terms-of-trade view, that a multilateral tariff reduction would internalise an important international externality and be superior to countries setting their trade policies unilaterally.

Although some aspects of the GATT (such as the regulation of subsidies or antidumping) cast doubt on the terms-of-trade theory, the central motivation for the GATT was to unwind the retaliatory trade policies and other protectionist measures that had built up during the 1930s. In other words, the terms of trade perspective is useful in understanding the tariff bargain struck but does not help us understand each and every provision of the GATT.

The foreign policy view

There is considerable evidence from the record of the negotiations in favour of a foreign policy view of the GATT. Cordell Hull, US Secretary of State from 1933 to 1944 and America’s foremost champion of trade liberalisation, supported lower tariffs, non-discrimination, and trade cooperation even more for its political effects in promoting peace than for its beneficial economic effects.

Hull emphatically stated:

“I have never faltered, and I will never falter, in my belief that enduring peace and the welfare of nations are indissolubly connected with friendliness, fairness, equality and the maximum practicable degree of freedom in international trade.”
Regarding post-war trade cooperation, Hull argued that:
“a revival of world trade [is] an essential element in the maintenance of world peace. By this I do not mean, of course, that flourishing international commerce is of itself a guaranty of peaceful international relations. But I do mean that without prosperous trade among nations any foundation for enduring peace becomes precarious and is ultimately destroyed.”

Difficult negotiations are nothing new

In light of the difficulties that recent multilateral trade negotiating rounds have encountered, trade officials, sometimes with nostalgia, reflect back on the easier trade negotiations of the past. Yet what is clearly evident in our book is that, although the 1940s was a golden age of international institution building, the negotiations that led to the GATT were extremely difficult and had many pitfalls, delays, and obstacles. The ambitious plans for an International Trade Organisation were eventually abandoned. In its place remained a smaller and shorter agreement on commercial policy that had many weaknesses, yet the GATT survived as policymakers and export interests increasingly saw the benefits of the accord.


The US and the UK delegates can be credited with creating a document that fostered trade liberalisation for the subsequent 60 years and probably contributed to world peace. This was a time when leadership rose to the challenges that the world was facing. The institution they created helped to solve the specific problem they confronted: the danger that post-war trade policy would remain plagued by the high and discriminatory trade barriers that had stifled and compartmentalised world trade in the 1930s. Given the post-war record of expanding world trade and incomes, they succeeded perhaps beyond their wildest hopes.

The question today is whether the problems currently facing the world trading system are pressing enough to demand that today’s leaders also rise to the occasion and confront the challenges before us.


Douglas Irwin is the Robert E. Maxwell Professor of Arts and Sciences in the Department of Economics at Dartmouth College.

Petros C. Mavroidis is Professor of European Union and WTO Law at the University of Neuchâtel and at Columbia Law School.


Bagwell, Kyle, and Robert W. Staiger. 2002. The Economics of the World Trading System, Cambridge, MA: MIT Press.
Baldwin, Robert E. 1980. “The Economics of the GATT” in Issues in International Economics, edited by Peter Oppenheimer. Stocksfield, England and Boston: Oriel.
Irwin, Douglas A., Petros C. Mavroidis, and Alan O. Sykes. 2008. The Genesis of the GATT. New York: Cambridge University Press.
Maggi, Giovanni, and Andrés Rodríguez-Clare. 1998. “The Value of Trade Agreements in the Presence of Political Pressures.” Journal of Political Economy, 106: 574-601.

1 The Genesis of the GATT, by Douglas A. Irwin, Petros C. Mavroidis, and Alan O. Sykes, published by Cambridge University Press in June of 2008.
2 Bagwell and Staiger (2002) champion the terms of trade view, Maggi and Rodriguez-Clare (1998) support the commitment theory, and Baldwin (1986) take the foreign policy view. Baldwin (1986, 91) has noted that “economists tend to judge the rules of organizations such as the GATT on the basis of whether they promote economic efficiency, growth, and stability.” Yet, in his view, “maximizing the collective economic welfare of individuals making up either a country or the world is, however, not the main policy objective of the GATT.” Rather, “the broad objective is to help to maintain international political stability by establishing rules of ‘good behaviour’ as well as mechanisms for settling disputes.” Baldwin believes that “the objectives of those establishing the organization were mainly political” and that “even if the above reasoning by trade economists is valid in most cases, it seems to be more the result of a happy coincidence of economic and political objectives rather than of foresight and deliberate choice by the founders of the GATT.”

July 31, 2008

I'm Mad, and I Guess I'll Stay Mad

In this election year, the greatest concern for most Americans is the economy and there is good reason for that. Unemployment, foreclosures and prices are all rising. The stock market, home prices and the dollar are all falling. Economic growth is still positive but well below potential. The situation is not as bad as during the 70s, but we are moving in that direction. And Americans are rightly worried.

At whom should we direct our anger? That is the question that is not being asked by enough Americans, and not being answered to anyone’s satisfaction. Politicians and others are manipulating public opinion through the media by offering seemingly made-to-order villains such as Angelo Mozillo, Exxon-Mobil and the amorphous but always reviled “speculators.” Americans with little understanding of economics are easily misled by propaganda that indicts the market on charges of perfidy while sanctifying politicians who cast themselves as champions of the downtrodden. The true villains remain hidden away from public view.

Complicating the task of unmasking those villains is the resilience of the US economy. Keep in mind, the country’s economic growth has been weak but we have yet to register a negative quarter. Second-quarter growth will probably be reported at around 3% and you can bet there will be a line of politicians eager to take credit. Most economists expect the second half of the year to be weaker but if oil prices keep falling they may be as wrong about the second half as they were about the first.

The underlying problems, however, will not have been solved no matter what the performance of the economy is over the next few quarters or years.

In a recent market commentary, Bill Gross called access to credit “the mother’s milk of capitalism.” That sentiment, echoed by our politicians and policy makers, is the source of our problems. It is not credit, but capital that is the lifeblood of capitalism and the US doesn’t accumulate enough capital to support the growth that we’ve become accustomed to.

In their efforts to revive the credit markets, the Federal Reserve and their political enablers may have averted an economic crisis in the short-term, but the long-term implications have yet to be reckoned. Bear Stearns, Fannie Mae and Freddie Mac – deemed too big to fail – were given access to the public purse rather than face the consequences of excessive leverage. Now the acceptable cure for excessive private indebtedness is more public indebtedness. Private players will reap the benefits if these transactions turn out profitable, while the public will pay the price if they don’t.

Large financial institutions were encouraged to take on too much leverage and take too many risks by a Federal Reserve that held interest rates at artificially low levels for far too long. Rather than allow these companies to suffer the consequences of their actions our leaders are working overtime to ensure they continue to take imprudent risks in the future. The Fed has allowed overleveraged institutions to borrow funds at attractive rates with dubious collateral. Savers are punished with low interest rates while speculative players are encouraged to find new avenues for their speculation. Oil prices would seem to indicate they’ve found a new outlet for their speculative impulses.

The same is true of individuals who borrowed too much to buy homes they couldn’t afford. I feel for the people who face foreclosure but why should those of us who were prudent be forced to bail out those who weren’t? The recently passed housing bill will allow both lenders and borrowers to forgo the consequences of their actions. And again, if everything works out, the lenders and borrowers will benefit while failure is assigned to the taxpayer. It would be better for the foreclosures to proceed and former homeowners to become renters again. The real estate market would face a further increase in inventory but prices could finally fall to market clearing levels. That would make housing affordable for those who have saved and acted prudently.

Over the last 50 years (at least) but especially during the last 30 years, every economic problem has been buried under another layer of credit and government intervention. The Federal Reserve and Congress have worked together to promote an economic environment where failure is deemed a threat to the “system” and all economic ills are “solved” by reducing the cost of credit. The result is plain for all to see. The US has moved from creditor to debtor nation. Debtors are bailed out through the tax code while savers are consigned to a prison of low interest rates. It is no surprise that we must import capital to cover our debts when we encourage debt and discourage saving.

The long-term problems facing our economy will not be solved painlessly, nor will they be solved by providing more of the same policies that got us to this point in the first place. While the Federal Reserve sits at the center of our problems, the institution itself is not at fault. They have been given an impossible dual mission to maintain economic growth and to limit inflation. Having control only over the money supply, it is beyond the capabilities of the Fed to create growth. Inflation and credit expansion do not add anything to the amount of resources available or the capital stock. The Fed cannot create universal prosperity by creating more money. Inflation consumes precious capital by misdirecting resources into non-economic investments. If you have any doubts about that, think of all the empty houses sitting around the country which attracted so much investment over the last decade. The capital devoted to housing was diverted from more productive uses and is now being destroyed as banks are forced to write off bad loans.

The villains in this story are the inhabitants of our political institutions. They seek to buy our votes with our own money and when they find that is not enough, they turn to the Federal Reserve and the banking system to create more. Rather than raise taxes to pay for the goodies they promise or the wars they deem necessary, they depend on debt and inflation. They do not create jobs, but destroy them. They do not create equality but exacerbate the divide between the haves and have nots and manipulate the divide to accrue more power. They do not create capital but rather destroy it. They are not special but mere mortals susceptible to the same failings as all people. They are self interested actors acting on a stage of their own design in a play written for their own benefit.

It seems evident that the housing bubble that is the source of the current economic malaise was caused by Federal Reserve policy. Does it not seem perverse to turn to the same institution for a remedy? How can they be expected to prescribe a remedy when they obviously don’t understand the malady?

It would seem more logical to proscribe the manipulation of interest rates for any purpose other than to achieve price stability. While a gold standard or some other real asset backed currency would be preferable and less susceptible to political manipulation, setting a single goal for the Fed is preferable to the current situation. Higher interest rates are obviously needed to reduce the inflation evident to everyone except the government statisticians. Higher interest rates would also encourage saving and discourage further debt accumulation.

It also seems evident that the government budget deficit is a result of excessive spending rather than a lack of taxation. Tax revenue has been remarkably stable as a percentage of GDP for many years, ranging between 18% and 21% regardless of tax rates. Right now it stands at 19%. Furthermore, other countries, such as Hong Kong, are able to collect nearly the exact same percentage of revenue with much lower tax rates. Hong Kong has income tax rates, personal and corporate, of less than 20% and generates a budget surplus while spending over 15% of GDP on government services. Hong Kong also doesn’t tax capital gains or dividends. We do not need higher taxes to generate the revenue needed for essential government services. We do need to decide what is essential.

In particular, it is illogical to raise taxes on capital when the basic problem we face is a lack of capital. If anything, taxes on capital should be further reduced to encourage accumulation of the capital needed to fund our growth. As for income taxes, it is time for Americans to assess the wisdom of taxing the very thing we wish to generate. If it is logical to tax cigarettes to discourage smoking, what is the logic for taxing income? A consumption tax coupled with repeal of the income tax would realign incentives toward a more rational economy based on thrift and savings rather than conspicuous consumption.

It is time for the citizens of these United States to take back our Republic from the thieves and parasites that occupy the seats of power. Power in this country was intended to reside in the people and the states. A class of citizens numbering less than 600 now hold that power in Washington, D.C. and we have no one to blame but ourselves. It is time to get angry.

A Cloudy Crystal Ball for the Markets

To be sure, there is more than ample negative economic data to support virtually any bearish scenario. The price of oil is not only at an historic high, but also the full effects have yet to be felt in the broad variety of areas of the economy to be impacted over immediate term. Prices of other commodities, especially food, have spiked recently and don’t seem to be near a bottom. Home prices continue to moderate. This lousy list could go on and on.

My crystal ball is cloudy. I don’t have a strong view whether we are at the bottom, but I strongly doubt it. If forced to make a prediction, I would expect six to nine months of continued decline and distress.

History may provide an interesting context.

Basically, over the last 50 years the equity markets have experienced sharp pullbacks on nine occasions. On four of those nine occasions the market declined slightly in excess of 20%, and on five of those occasions the equity markets declined over 30%.

Now, the pundits have been reminding us that, as of last week, we are officially in a bear market, with the major indices down slightly over 20%.

So I think the proper question is whether this bear market will ultimately, with of course the benefit of hindsight, rank within the group of four pullbacks averaging roughly a 20% decline, or with the five pullbacks averaging over 30%?

Other disturbing circumstances: The Fed basically has its hands tied, the credit markets are bordering on the dysfunctional, and a dangerously high percentage of homeowners have only a slice of equity left in their homes. Many experts believe a 15 to 20% decline from here would not be unexpected.

Given the existing level of nervousness and overall economic weakness, if the correct answer is that this time around we are now not at the bottom, look for some good old-fashioned panic in the not too distant future.

So, for me, I am praying we are at a bottom but I am not willing to bet on it. I feel like I am whistling by the graveyard with fingers and toes crossed.

About July 2008

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