‘DUBAI PANIC SPARKS ATTENTION TO EMERGING-MARKETS BONDS,’ in the Wall. Street Journal. Check out FNMIX at fidelity.com. I WOULDN’T BUY IT NOW. LOOK AT THE RISE SINCE MARCH 9TH.

Would you lend money right now to the government of Dubai?

To most ordinary investors the question may sound crazy. The Gulf emirate, after all, has just sparked a panic after Dubai World, a separate but government-controlled conglomerate, announced it needed to renegotiate terms on at least some of its $59 billion debt.

At times like this, members of the investing public understand why emerging market bonds—those issued by developing countries—are usually described as high-risk assets.

But the question to ask is not how much risk you’re willing to stomach, but how much you might be paid to take that risk. During the past 15 years we’ve had plenty of emerging-market crises, including the Asian Tigers collapse in 1997, the SARS panic in 2003, and of course last year’s financial crisis. And don’t forget, the Russian government actually defaulted on its bonds in 1998.

Nonetheless, emerging-market bonds overall have proved very good, though volatile, investments. Investors have endured some stomach-churning drops during the crises, but someone who held a broad basket of those bonds in a mutual fund, which reduces your exposure to individual issuers, has done well.

Consider the performance of the Morgan Stanley Emerging Markets Debt Fund , which invests in these types of bonds.

If you had invested $100 in this fund 15 years ago and just left it there, reinvesting your dividends, you’d have nearly $500 today. That’s about twice what you’d have if you had put the same amount in a typical basket of conservative U.S. corporate or Treasury bonds over the same time.

For most of that time, emerging-market bonds were cheap, because most investors were afraid to own them. So the investors who did reaped big rewards. Whether that is still the case is another matter. Emerging markets bonds are no longer anywhere near as cheap as they were.

One good measure of a bond’s value is the yield. As prices fall, the yields rise. At times—such as in 1998, and again in 2008—the annual yield on Barclays Capital’s emerging markets bond index has been well into the double-digits.

In the case of Dubai, there is little reason at the moment to believe the state would default on its own sovereign bonds. To allow such a default would be a monumental act of folly on behalf of the oil-rich United Arab Emirates, of which Dubai is a part. (Remember, Dubai World, the conglomerate that just defaulted on its debt, is owned by the government but is a separate entity.)

Thanks to this weekend’s panic, some Dubai government bonds, which come due in five years now yield about 9%.

They could be a bargain. But Dubai bonds are hard for individual investors to own, because they are traded over the counter and volumes are thin. So these are an investment for sophisticated investors only. Middle Eastern countries account for very little of the global inventory of emerging-market debt. (The bulk of the market is comprised of bonds issued by big countries like Brazil and Russia.)

The more relevant question for the individual investor is whether now’s a good time to buy shares in an emerging-market bond fund.

If the Dubai affair had caused a wider panic, the answer would probably be yes. But it hasn’t, at least not yet. Emerging-market bonds in general have boomed this year, sending the yield on the Barclays index down to about 6.6%. That’s nearly as low as it was two years ago, just before the big crash.

Abby McKenna, who runs the Morgan Stanley fund , sees a few opportunities right now. She’s been buying certain bonds issued by Brazil, Mexico and Indonesia, and says she’s found better values in bonds issued in local currencies rather than in U.S. dollars. Her fund, a closed-end one that trades on the stock market, has a distribution yield of 8.1%.

One reason: Right now the shares sell for about 10% less than the underlying value of the investments. For anyone with money to invest right now, that sort of discount has to help your odds.

But even better opportunities will doubtless come whenever the next big panic strikes and experts start hollering at investors to avoid emerging-market risk.

‘AN AFFORDABLE TRUTH,’ by Paul Krugman in the N. Y. Times.

Maybe I’m naïve, but I’m feeling optimistic about the climate talks starting in Copenhagen on Monday. President Obama now plans to address the conference on its last day, which suggests that the White House expects real progress. It’s also encouraging to see developing countries — including China, the world’s largest emitter of carbon dioxide — agreeing, at least in principle, that they need to be part of the solution.

Of course, if things go well in Copenhagen, the usual suspects will go wild. We’ll hear cries that the whole notion of global warming is a hoax perpetrated by a vast scientific conspiracy, as demonstrated by stolen e-mail messages that show — well, actually all they show is that scientists are human, but never mind. We’ll also, however, hear cries that climate-change policies will destroy jobs and growth.

The truth, however, is that cutting greenhouse gas emissions is affordable as well as essential. Serious studies say that we can achieve sharp reductions in emissions with only a small impact on the economy’s growth. And the depressed economy is no reason to wait — on the contrary, an agreement in Copenhagen would probably help the economy recover.

Why should you believe that cutting emissions is affordable? First, because financial incentives work.

Action on climate, if it happens, will take the form of “cap and trade”: businesses won’t be told what to produce or how, but they will have to buy permits to cover their emissions of carbon dioxide and other greenhouse gases. So they’ll be able to increase their profits if they can burn less carbon — and there’s every reason to believe that they’ll be clever and creative about finding ways to do just that.

As a recent study by McKinsey & Company showed, there are many ways to reduce emissions at relatively low cost: improved insulation; more efficient appliances; more fuel-efficient cars and trucks; greater use of solar, wind and nuclear power; and much, much more. And you can be sure that given the right incentives, people would find many tricks the study missed.

The truth is that conservatives who predict economic doom if we try to fight climate change are betraying their own principles. They claim to believe that capitalism is infinitely adaptable, that the magic of the marketplace can deal with any problem. But for some reason they insist that cap and trade — a system specifically designed to bring the power of market incentives to bear on environmental problems — can’t work.

Well, they’re wrong — again. For we’ve been here before.

The acid rain controversy of the 1980s was in many respects a dress rehearsal for today’s fight over climate change. Then as now, right-wing ideologues denied the science. Then as now, industry groups claimed that any attempt to limit emissions would inflict grievous economic harm.

But in 1990 the United States went ahead anyway with a cap-and-trade system for sulfur dioxide. And guess what. It worked, delivering a sharp reduction in pollution at lower-than-predicted cost.

Curbing greenhouse gases will be a much bigger and more complex task — but we’re likely to be surprised at how easy it is once we get started.

The Congressional Budget Office has estimated that by 2050 the emissions limits in recent proposed legislation would reduce real G.D.P. by between 1 percent and 3.5 percent from what it would otherwise have been. If we split the difference, that says that emissions limits would slow the economy’s annual growth over the next 40 years by around one-twentieth of a percentage point — from 2.37 percent to 2.32 percent.

That’s not much. Yet if the acid rain experience is any guide, the true cost is likely to be even lower.

Still, should we be starting a project like this when the economy is depressed? Yes, we should — in fact, this is an especially good time to act, because the prospect of climate-change legislation could spur more investment spending.

Consider, for example, the case of investment in office buildings. Right now, with vacancy rates soaring and rents plunging, there’s not much reason to start new buildings. But suppose that a corporation that already owns buildings learns that over the next few years there will be growing incentives to make those buildings more energy-efficient. Then it might well decide to start the retrofitting now, when construction workers are easy to find and material prices are low.

The same logic would apply to many parts of the economy, so that climate change legislation would probably mean more investment over all. And more investment spending is exactly what the economy needs.

So let’s hope my optimism about Copenhagen is justified. A deal there would save the planet at a price we can easily afford — and it would actually help us in our current economic predicament.

‘MEASURING THE FISCAL COSTS OF NOT FIXING THE FINANCIAL SYSTEM,’ by Simon Johnson at baselinescenario .com. BRILLIANT!

Measuring The Fiscal Costs Of Not Fixing The Financial System

Posted: 05 Dec 2009 06:30 AM PST

This post is a slightly edited version of remarks prepared for delivery at Unwinding Public Interventions in the Financial Sector: Preconditions and Practical Considerations, IMF High-Level Conference, Thursday, December 3, 2009, Washington D.C.  I participated in Session 2: Managing Fiscal Risks—Public Finance Aspects of Unwinding.

The Problem

1)      The underlying fiscal problems of the U.S. have significantly worsened as a direct result of how the financial crisis of 2008-09 was handled.

2)      The U.S. economic system has evolved relatively efficient ways of handling the insolvency of nonfinancial firms and small or medium-sized financial institutions.  A large number of these institutions have failed so far this year, without causing major disruption to the economy.

3)      The U.S. does not yet have a similarly effective way to deal with the insolvency of large financial institutions.  The dire implications of this gap in our system have become much clearer since fall 2008 and there is no immediate prospect that the underlying problems will be addressed by the regulatory reform proposals currently on the table.  In fact, our underlying banking system problems are likely to become much worse.

4)      The executives who run large banks are aware that the insolvency of any single big bank, in isolation, could potentially be handled by the government through the same type of FDIC-led receivership process used for regular banks.  However, these executives also know that if more than one such bank were to fail (i.e., default on its obligations), this could cause massive economic and social disruption across the U.S. and global economy.  The prospect of such disruption, they reason, would induce the government to provide various forms of bailout.  They also invest considerable time and energy into impressing this point onto government officials, in a wide range of interactions.

5)      Even more problematic is the underlying incentive to take excessive risk in the financial sector.  With downside limited by generous government guarantees of various kinds, the head of financial stability at the Bank of England bluntly characterizes our repeated boom-bailout-bust cycle as a “doom loop.”  The implication is repeated bailout and fiscal stimulus-led recovery programs.

6)      The implementation of the Troubled Asset Relief Program (TARP) exacerbated the perception (and the reality) that some financial institutions are “Too Big to Fail.”  This lowers their funding costs, enabling them to borrow more and to take more risk.  The consequences include a contingent fiscal liability – both for specific bank rescue measures and, on a larger scale, the fiscal stimulus needed to offset a potential future credit crisis.

7)      U.S. national debt will increase substantially as a result of direct bank bailouts and, more importantly, the discretionary fiscal stimulus needed to keep the economy from declining – as well as the standard deficit due to cyclical slowdown (a feature of the “automatic fiscal stabilizers”.)  Privately held net government debt will increase from around 40 percent of GDP to the 70-80 percent of GDP.

     If any country provides unlimited government support for its financial system, while not implementing orderly bankruptcy-type procedures for insolvent large institutions, and refusing to take on serious governance reform and downsizing for major troubled banks, it would be castigated by the United States and come under pressure from the IMF.  Yet this is the approach that the U.S. has implemented.

9)      At the heart of every crisis is a political problem – powerful people, and the firms they control, have gotten out of hand.  Unless this is dealt with as part of the stabilization program, all the government has done is provide an unconditional bailout.  That may be consistent with a short-term recovery, but it creates major problems for the sustainability of the recovery and for the medium-term.   Again, this is the problem in the U.S. looking forward.

10)  The Obama administration argues that its regulatory reforms will rein in the financial sector in this regard.  Very few outside observers – other than at the largest banks – find this convincing.

Towards a Solution

1)      As legislation on restructuring the banking industry moves forward, attention on Capitol Hill is increasingly drawn to the issue of bank size. Should our biggest banks be made smaller?

2)      There is a strong precedent for capping the size of an individual bank: The United States already has a long-standing rule that no bank can have more than 10 percent of total national retail deposits.  This limitation is not for antitrust reasons, as 10 percent is too low to have pricing power. Rather, its origins lie in early worries about what is now called “macroprudential regulation” or, more bluntly, “don’t put too many eggs in one basket.”

3)      This cap was set at an arbitrary level — as part of the deal that relaxed most of the rules on interstate banking — and it worked well (until Bank of America received a waiver).

4)      Probably the best way forward is to set a hard cap on bank liabilities as a percent of gross domestic product; this is the appropriate scale for thinking about potential bank failures and the cost they can impose on the economy.  Of course, there are technical details to work out — including how the new risk-adjustment rules will be enacted and the precise way that derivatives positions will be regarded in terms of affecting size. But such a hard cap would the benchmark around which all the specifics can be worked out.

5)      What is the right number: 1 percent, 2 percent, or 5 percent of G.D.P.? No one can say for sure, but it needs to be a number so small that we all agree any politician who cares about our future would have no qualm letting it fail, and when doing so have confidence that our entire financial system is not at risk as it fails.

6)      A hard cap at 4 percent of G.D.P. seems about right for a bank with the most conservative possible portfolio. This would mean no bank in our country would have no more than about $500 billion of liabilities, even with a relatively low risk portfolio.  On a risk-adjusted basis, most investment banks would face a cap around 2 percent of GDP.

7)      A large American corporation would still be able to do all its transactions using several banks. They would even be better off — competition would ensure that margins are low and the banks give the corporates a good deal. This would help end the situation where banks take an ever-increasing share of profits from our successful nonfinancial corporations (as seen in the rising share of bank value added in G.D.P. in recent decades).

     Indeed, the whole world would soon realize that our banks are more competitive and offer better pricing than others.

9)      If, as might occur, the Europeans subsidized their big banks with cheap finance and implicit subsidies, the U.S. should let our nonfinancial corporates benefit and understand that our banks may become ever smaller. We can let Europeans subsidize banking because we all get better deals through their taxpayer subsidies, and then our corporates will have more profits to bring back to America.

10)  Today our politicians and regulators lack credibility. They have bailed out too many banks and need to show they have truly regained the upper hand — by showing that they are installing such a hard size cap rule without exception.

11)  The litmus test is simple.  Does Goldman Sachs continue to grow, and continue to be regarded as almost as good a risk as the United States government (Goldman’s Credit Default Swap spread is currently around only 70 basis points above that of the United States), because it has demonstrated it is too big to fail? Or, will the government impose a cap on the size of such institutions and require Goldman Sachs to find sensible ways to break itself into pieces – becoming small enough so that it will not be bailed out again next time?

In the Absence of Real Reform

1)      Real progress towards reducing the risks inherent in the U.S. financial system is unlikely.  As long as there are financial institutions that are Too Big To Fail, we face a potential fiscal cost.  We should recognize this in our government budget and balance sheet accounting.

2)      The overriding principle behind IMF fiscal assessments is the need to capture true total fiscal costs.  Best practice for the U.S. needs to reflect this approach.

3)      All subsidies and taxation – including the entire cost of supporting the continued existence of large banks – should be reflected transparently in the budget and subjected to the prioritization of the budgetary process.

4)      Our current accounting for guarantees and governments’ assumption of other contingent liabilities create the impression that government actions to support the banking system are costless. This is a dangerous illusion – as seen in the recent increase in US federal government deficit and debt.

5)      If we don’t recognize these costs explicitly, we run the risk of taking on ever more contingent liability.  If the financial system reaches the point where its failure cannot be offset by fiscal (and monetary) stimulus, then a Second Great Depression threatens.

6)      Next time, we cannot be certain that the available size of fiscal stimulus – either in the US or worldwide – will match the negative shock to demand caused by the credit crisis.  Either we will already have too much debt or we will be constrained by the consequences of taking on even more debt.  Or – just as in 1930 – the financial decelerator will simply be too large to be offset by any feasible fiscal measures.

By Simon Johnson

‘A CONVERSATION WITH JOHN MAUDLIN,’ with Damien Hoffman.

John Mauldin coined the incredibly popular phrase, “Muddle Through Economy.” If the next few years continue to drag along as we rebuild from the greatest credit bubble in history, then John’s term may become the catch phrase used by every financial journalist and economist in the land.

John is a passionate traveler with business partners all over the world. He also puts out a free newsletter to over one million people worldwide. This reach of friends and travels give John an excellent macro view of the world economy. Further, his multidisciplinary interests offer some unique insights into economics and human behavior.

I had a chance to catch up with John and talk about his experiences as an economist, his perspective on which countries will grow the fastest in the coming decades, how he sees demographics affecting the world, and a bonus question from one of our 1400 Twitter followers …

Damien Hoffman: John, was economics part of your schooling or a passion of yours right from the start?

John: I had a triple major in college, one of them being economics and history. So I’ve always been fascinated by history, economics, and finance. The markets are a big puzzle to me and I’m a puzzle addict. So it feeds my addiction. I started reading the Austrian economists first, in the early ’80s as I entered the investment world. That was my real introduction to economics. Over time, if you stay around long enough and read enough, you can pick up all the other schools of thought, like I did.

Damien: Based on some of your newsletters, I can see you are also interested in anthropology via the studies of the generations. These are major themes for investors to trade, because they’re based on slow-moving macro phenomena. Can you share what interests you about this particular framework?

John: That’s a good question and a difficult one. This topic covers a book I’m trying to write. I don’t know if I’m ever going to get it done, but it’s called The Millennium Wave. It’s about what the world is going to look like in twenty years. My basic thesis is, we’re going to see a pace of change that far exceeds anything human beings have experienced since the dawn of man. Furthermore, in terms of technology, that change is going to accelerate. We’re going to have multiple waves of technological change. It would be as if electricity, the steam engine, and the automobile all showed up at the same time. Boom!

We’re going to see massive technological revolutions. However, as human beings, our psychology was developed on African savannas, dodging lions and chasing antelopes. So we have a much slower rhythm to us. We’re not paced for change. Therefore, we’re going to have a backdrop of slow-moving generational changes.

Demographic changes are predictable: we know how many people are going to be here in forty years because they’re already born. We know how many forty-year-olds we’ll have in forty years because they’re already born. So, we can see these changes coming at us.

If you’re Japan, you’re walking into a demographic nightmare. Russia is a demographic train wreck. And it’s not going to be but a few decades, in the grand scheme of things, until Iran will have more people than Russia. That’s got to be fit into your equations. You’ve got to look at these large, broad changes that are happening.

In the US, we’re going to be running into the freight train of Medicare and Social Security. There’s just not any way to get around it. We’re going to have to make tough generational decisions about how to handle that. And how we handle it is going to have enormous implications for our economy. If we handle it the way it’s likely to be handled – which is by raising taxes – then we have said we’re making a decision, conscious or not, that we’re going to become Europe. That means high residual unemployment and difficult, slower growth of individual opportunities.

There are other large changes when you talk about the demographic issues. Europe would have to take massive numbers of immigrants in order to support their system. They’re just not prepared for that. Neither is Japan. The US is blessed with a world population that wants to come here and are not very culturally different from us – especially the Hispanic populations. We’re going to need those immigrants. I think that one of the most economically suicidal things we’re doing today is trying to figure out how to close the borders. We need to be doing the opposite. We need to figure out how to open the borders. It needs to be a more rational policy than we have now. Again, you have to put those things into the financial equations.

We also have the fast-moving things such as the growth of biotech and the complete retooling of our telecommunications network over the next ten years. The way we communicate with each other and the way we receive information is also going to be significantly different in the next ten years. There will still be human beings talking, but how we sort through and assess information is going to be different. There are going to be winners and losers in that competition.

I do a lot of biotech research to determine where it’s going. For instance, you could construct an investment play where you are long life insurance companies and short annuity insurance companies, because we’re going to live much longer than any of the actuaries would tell us. That means life insurance companies aren’t going to have to pay, while annuity companies are going to have to pay longer. That trade is probably not ready to happen yet. But when the perception kicks in, that’s going to be a very good trade.

The new medical devices and therapies that are coming along are going to be transformational. I think about what kind of impact that will have on societies and generations – what John Howe and Richard Strauss call “the Fourth Turning,” which we’re in the middle of. All of these things have an impact on the way I think.

Damien: Keeping on a similar topic but shifting over into a different part of the logic tree, let’s talk about one of your passions: traveling. You kind of touched on which markets have a lot of trouble, but which markets will out-perform in the next decade?

John: If I’m picking regions, I would be an emerging market fan over the developed world, simply because the developed world, especially old Europe, is going to be running into such major underfunding problems in their pensions and healthcare. That’s going to put constraints on them and on their growth. Developing countries don’t have that problem. I’m not as much a China fan as an India fan. I like Brazil. I like Canada, Australia, and New Zealand. I know that Australia wouldn’t be an emerging market, but they sell the resources and the tools to the emerging markets.

Damien: Is there a specific reason why you prefer India over China? If you were going to have a conversation with Jim Rogers, who favors China, what would you say to him?

John: We’ve had a lot of conversations over time, but not that one. I think India is eventually going to get its act together. I think there’s more upside there. I think China is still trying to absorb 24 million new people into their markets annually. They’ve got major demographic issues. I’m talking about the next two decades. China may still be better than India in ten years, but I think India is the favorite over time, because they have natural resources, smart people, and better technology. But who knows. Governments can always alter the course by doing stupid things.

Damien: That’s inevitable.

John: Exactly. Government is the wild card. For example, Japan just elected a very left-of-center government. One that’s far more left of center than Obama. If interest rates were to rise by 1%, it would cut into their budgets by at least 25% or 30%. I think Japan is going to be a basket case ten years from now.

Damien: That’s interesting, because one of your letters sparked a conversation with my friend Andy Glatstein about the life cycle of empires. Thinking about the Roman Empire, the Iberian Peninsula, the British Empire, and the US after WWII, it seems our predecessors in the Western line of empires have a life-cycle. It started with entrepreneurism and ambition, exploring and conquering, then reached some sort of stability point that included a decent standard of living for the masses. However, ultimately the economy sort tripped over itself and all these former empires had major issues. If today you look at Italy, Spain, Portugal, and Britain, they’ve all moved in a similar direction. Is this the fate of the US?

John: We’re in the process of having that debate as we speak. It’s not clear how we’re going to answer that. We’re going to have to raise taxes when we hit the Medicare crisis in the next decade. No question about it. If we use that tax increase now, it will be hard to cut later. If we save the tax increases and hold our spending down, then we’ll be able to handle the Medicare crisis. It’s not clear which of two directions we’re going to take right now. We’re probably going to raise taxes and kick the ball down the road. It will have some very serious consequences in the middle of the next decade. We will probably be forced to implement a VAT tax, which is one more way to slow things down.

Damien: Switching topics, can you explain why Wall Street economists tend to be permabulls or permabears?

John: Mostly because their job descriptions create agendas. There are very few like David Rosenberg who feel they have the independence they need. Also, a lot of them are traditionally trained. So, they’re trained to create tools, and they think economics is a science. It’s not. It’s an art. And quite frankly, when you treat it as an art form you have a better chance of getting the numbers right.

Damien: Can you explain what you mean by that?

John: All of the economic models are created on past performance. For instance, right now the economic idea du jour is what the recovery will look like. So, economists go back and average the eight post-war recessions and say, “Look, this is what the average was and this is how it responded.” Well, making a prediction based on that only works as well as the underlying fundamentals of the recession.

This is a deleveraging, deflationary, asset-bubble-bursting recession. We’re going to lose 8-10 million jobs. We’re back to where we were in early 2000 in terms of jobs. Over the next five years, just to keep up with population growth, we must create another nine million jobs. Plus, we’ve got another almost five million people who are underemployed. And the Census Bureau took 450,000 people off this year because they said, “They’re no longer looking for jobs, and since they’re not looking for jobs they’re not unemployed.” That is a fascinating way of looking at it! Last month you were looking for a job and now you’re so discouraged you’re not looking for a job, so we’re not going to count you as unemployed. That’s a patently silly idea!

Damien: That’s absurd.

John: Right, it is absurd. Over the next five years we’re going to have to create something like 17-20 million jobs to get back to 4-5% unemployment. That’s a staggering number of jobs. That’s something like a 15% growth in the number of jobs over five years. You’d need real GDP growth of 15% to make that happen. What is the likelihood of total real GDP growth of 15% for the next five years?

Damien: Less than 0%. [Laughing]

John: I think we’re going to be lucky to have GDP growth of 8-10%. So there’s going to be a real shortfall with jobs. Unemployment is going to stay stubbornly high for the next five years unless something comes out of the clear blue – which is always possible. Somebody could invent a new energy source or we could start retooling our telecom systems – something like that.

Damien: Are those the technological catalysts that will bring us the next economic expansion?

John: Yes. Remember, in the late 1970s we were in an economic malaise. The Japanese were kicking our butts, inflation was high, and the market was in the doldrums. It was not a fun time. Yet the correct answer to the question “Where are the new jobs going to come from” was: I don’t know, but they will. Because that’s what happens in free-market societies. That’s why I’m an optimist. Even looking at all the data and all the problems, I’m saying that 130 million families will figure out what to do to make their lives better. Some of them will sit around and wait for the government to do it, but a lot of people will do it themselves. It’s like the two vultures sitting on the cactus, and one of them looks at the other and says, “Patience? Hell, let’s go kill something.”

Damien: As my regular readers know, that relates to one of my favorite quotes: “Desperation is the mother of ingenuity.”

John: Precisely. Most people will go out and try to figure out something to do. That’s just what we do as a country. It’s part of our particular genius. We’re going to be helped along by some major technological and scientific breakthroughs. I’m an optimist in that regard.

Damien: John, sometimes there are so many variables to think about and so much information it can lead to paralysis by analysis or even worse. Where do you draw the line while informing your investment decisions, when markets diverge from economic reality?

John: You’ve gotta look at why markets are diverging from economic reality. You have to ask yourself, “Do I need to reassess?” You must constantly question yourself and sift through the data.

Right now we’re at a place I call the Statistical Recovery. We’re going to see a recovery in the math, but it’s not going to feel like one in the real world. It’s probably going to be the middle of next year before we see job growth and reduced unemployment. If we’re not seeing job growth, if we’re not seeing income growth, if we’re not seeing a drop-off in foreclosures, if we’re not seeing a rise in consumer credit and consumer confidence, if we’re not seeing a lot of things of that nature, it won’t feel like a recovery.

Economists can say, “Look at these numbers! The numbers are good!” But in the real world you may say, “I’m still not getting the hours I want. I haven’t seen a revival of people coming into my store. Sales are still down 10%.” If that’s the case, then it doesn’t feel like a recovery.

That’s where I think we’re going to be. But that’s part of the process of going to the New Normal. We’re having to rationalize our entire economy, our world economy, which was built around ever-increasing amounts of leverage. And that leverage bubble has burst. The genie is not going back into the bottle. The psyche of the American consumer has been permanently scarred. And we’re going to get to a new level of economic activity that’s going to assume 7%, 8%, or 9% savings. We will see less credit. We’re watching unprecedented amounts of credit-card debt being paid off. That’s never happened in America. That’s positively un-American. Yet, we are. Because what happens? People are saying, “Maybe this leverage and debt thing is not so good. Let’s get more conservative.” It’s the new frugal.

All we did with this “Cash for Clunkers” thing was move cars forward that would have been bought later. You’re not increasing sales down the road. Yeah, you’re taking cars off the road and spare parts and stuff, but I think it’s kind of a silly investment in dollars. But, what’s $3 billion when we’re wasting a trillion here and a trillion there? Still, it’s disappointing.

Damien: Speaking of disappointment, I’m in my early thirties, and when I think about these trillions of dollars being thrown around I say, “I’ve been out of college a decade. We’ve had two bubbles and two collapses. It’s been a completely volatile employment and investment market. A completely volatile social environment. And, to top it all off, we’re kicked in the butt with all of this debt.” My peers look ahead and see our parents getting older and the cost to society. What do you say to our generation? Will we be the forgotten generation which toils our way through it and pays for the problems created before us, to repave the road for those behind us?

John: I tell you, I’m sorry. That’s what you’re going to have to do. You’re going to have to move the ball forward with an extra twenty pounds on your back. That’s just the way life is. I don’t think it’s only your generation in your thirties. I think it’s my kids in their twenties who are going to be dealing with it as well.

We’ve made some generationally bad choices, with unintended consequences. And now we’re going to have to deal with them. It just makes moving forward in the economic environment tougher. You play the hand that’s dealt to you.

You can’t wish, “I would have been better with 35% taxes.” I know that my tax bracket is going to go into the mid-40s at a minimum. Would I be happier and have more money to invest if I had a tax bracket in the mid-30s? Yeah. But that’s just not the hand that was dealt. So, I have to figure out how to move forward with my taxes. When they add the VAT tax in the middle of the next decade, my effective taxes will run into the 55%-60% range. That’s just the way it is. I can either crawl into some hole or go to another country, or just move on and make the best of the hand I’ve been dealt. I choose the latter.

Damien: John, we chose a question from one of our 1400 Twitter followers: Can you be very successful and still live a fulfilling family life without being obsessed with work?

John: I’m partly obsessed with work. But you have to take time for family. You can’t ignore it. It’s easier for me now; I’ve only got one left at home.

The most fulfilling part of my life is my seven kids. We adopted five, so it’s a colorful family. We all get along. It’s the one great pleasure of my life — the best pleasure of my life: my kids, and now grandkids.

Damien: What advice do you have for your grandkids if one day they read this and aspire to follow in your footsteps?

John: That’s a tough question, because I took the Yogi Berra path of career guidance: you come to the fork in the road and you take it. I am as surprised to be where I am today as anybody. I have partners around the world that take the leads we get and do sales and research on funds. Besides writing and trying to figure out the world of economics, my real job is to make sure I have the best partners, who are in the right spot to help readers find the appropriate investment ideas for them. That is not as easy as it sounds, because the majority of potential partners are either traditional money managers (which I am not) or have constraints because of their situation.

People ask me what I’d do if I retired. I’d read, write, travel, speak, and enjoy myself – that’s what I’m doing now! So, I don’t know if retirement is in my path. But for a young person starting now, looking at what I do, I’d say the first thing you have to do is start writing. It’s a craft. I didn’t start out writing top-quality work. When I look back on letters I wrote early on, I think, “My goodness that’s sloppy.” I’ve improved over time, over the decades.

One of the people who helped me learn how to write was my first publisher. I tried to copy his writing style. He had a particularly friendly, easy-to-understand writing style. I’ve long since developed my own style, but I am still grounded in that foundation. I tell people, “If you want to be a writer, find a writer you like and try to imitate him.” I have a certain style, a certain voice when I write. It’s not better than anybody else’s. Sometimes I go back and think, “I don’t particularly like that.” But it’s my voice and I’m comfortable with it.

Second, don’t be too hung up on knowing everything or thinking that you’ve got to have it all figured out. You won’t. You’ll never figure it all out. Economics is an art form. The goal is to kind of be in the middle of the lane and not end up in the ditch somewhere. Don’t think you’re going to be there by the time you’re 30 or 35. It takes time to reason, read, and mature.

Third, early in your career you should be reading more books and analyzing less data. Information is less important than theory and a grasp of the basics. You need to understand what the difference is between John Maynard Keynes and Irving Fisher and von Mises. If you don’t understand what they’re writing, if you can’t get your head around their concepts, data isn’t going to help you.

So, you’ve got to have a handle on how the big stuff works and what the theories are. But none of the theories have independently proven to be particularly adept at describing the problems we have. So, you’ve got to figure out how to blend them and weave them.

If you cling to one perspective, you are going to run into a wall. And you’re going to run into a wall at one of the most embarrassing times. It can be a career-ending event. I’ve been wrong. It’s easy to go back through my letters and say, “John, what were you thinking?” But on average, I’ve been more right than wrong. I often joke that I am often wrong, but seldom in doubt. But I never get married to a position. I constantly test my views. Constantly. It’s important to get the big things right and understand the big picture while not focusing too much on the little details.

Damien: John, thanks for that advice and thanks for indulging my curiosities this afternoon.

John: My pleasure. You asked some very interesting questions.

New York, London, Monaco, and Zurich

Today was a great (and going to be a long) day. I started off with a couple of interviews on Yahoo Tech Ticker with Henry Blodgett, had a few meetings, and then went to Henry Blodget’s office at Business Insider, where we did three more quick (and different) interviews. He is doing something quite intriguing. I walked in, and there were a dozen 20- and 30-something kids working intently at screens, crammed into a room not as big as my bedroom. In less than two years, he is getting two million unique visitors to come to his web site each month.

It made me feel like such an old lion. Tiffani and I have been giving a lot of thought as to how we should manage the business over the next two years. How do we adapt to a world that is changing so fast?

Zip to two million in two years? Interestingly, as we talked business at a long lunch, I wondered if I should write more, as there are so many blogs that hit us each day, and the number seems to be growing. He disagreed. He emphasized that I should not change my model. “You are the one guy I read each week who is above the fray. You see through the day-to-day noise. You come and tell me what was important and make me think. For you, less is more. Don’t change.” Maybe the old lion still has some teeth.

And speaking of old lions, I later visited with Art Cashin and the Friday evening gathering of the Friends of Fermentation, at Bobby Vann’s across from the exchange, at the close of the trading day. What a pleasure. Art is one of the world’s great market savants, full of wisdom and the greatest stories, and a true friend. There is never enough time to spend with him.

And when I hit the send button, I will go to Festivus with Todd Harrison and the crowd from Minyanville. That is always a great party and a worthy cause. Tomorrow night we see Gods of Carnage with Barry and Toni Habib, and then back on Sunday. And then home until the middle of January, when I go to London, Monaco, and Zurich.

But the most important news is that yesterday the doctor told Tiffani she may be getting ready to have my new granddaughter a little early. It is going to be a great Christmas.

Have a great week, and remember to make sure you have some fun on the way. And spend more times with friends. That is the best dividends you will ever get.

Your having fun in New York analyst,

John Mauldin

John@FrontLineThoughts.com

‘A LOST DECADE FOR PRIVATE SECTOR JOBS, ‘ in the Wall St. Journal.

By Jon Hilsenrath

To mark this week’s focus on the dismal state of the U.S. job market, check out the following chart, which shows the trajectory of private sector U.S. employment since 1998. It tells a story of a lost decade for U.S. workers.

The U.S. now produces fewer private sector jobs than it did a decade ago. This been the case since August, and it’s getting worse. In October, private sector companies employed 108.401 million U.S. workers, a million fewer than in October 1999, when they employed 109.487 million. Not since the Labor Department began tracking payroll employment in 1939 has there been such a stretch with no net job gains.

The problem resonates with President Barack Obama, who is holding a jobs summit on Thursday with executives, economists and union leaders, and with the Labor Department getting ready to tee up its November jobs report on Friday.

With the economy recovering from last year’s shock, private sector firms might start hiring again. But it likely will take months if not years to make up this gap.

How to explain the gap? One obvious answer is that the U.S. has suffered through two recessions during this stretch. The first, in 2001, was short and mild but included more than two years of job cuts. The second one starting in 2007 has been long and brutal. The other answer is that the U.S. has enjoyed a big burst of productivity growth during this stretch — which means firms are producing more with fewer workers. In the long-run this is supposed to be a good development because it leads to profit and income gains. But the short-term costs are looking increasingly more debilitating.

It’s worth nothing that overall employment is higher than it was a decade ago, but that’s only because the government has produced two million additional jobs during that stretch. You can expect both sides of Washington’s political spectrum to spin the lost decade for jobs in their own direction. Republicans will use it to blast Mr. Obama’s big government approach — though it’s worth remembering that most of these jobs were lost when a Republican controlled the White House. Democrats will use the data to demonstrate the benefits of a helping government hand in down economic times. The labor market would indeed be worse if it weren’t for those two million extra government jobs. But this hardly seems like the path to prosperity.

‘REFORM OR ELSE,’ by Paul Krugman in the N.Y. Times.

Health care reform hangs in the balance. Its fate rests with a handful of “centrist” senators — senators who claim to be mainly worried about whether the proposed legislation is fiscally responsible.

But if they’re really concerned with fiscal responsibility, they shouldn’t be worried about what would happen if health reform passes. They should, instead, be worried about what would happen if it doesn’t pass. For America can’t get control of its budget without controlling health care costs — and this is our last, best chance to deal with these costs in a rational way.

Some background: Long-term fiscal projections for the United States paint a grim picture. Unless there are major policy changes, expenditure will consistently grow faster than revenue, eventually leading to a debt crisis.

What’s behind these projections? An aging population, which will raise the cost of Social Security, is part of the story. But the main driver of future deficits is the ever-rising cost of Medicare and Medicaid. If health care costs rise in the future as they have in the past, fiscal catastrophe awaits.

You might think, given this picture, that extending coverage to those who would otherwise be uninsured would exacerbate the problem. But you’d be wrong, for two reasons.

First, the uninsured in America are, on average, relatively young and healthy; covering them wouldn’t raise overall health care costs very much.

Second, the proposed health care reform links the expansion of coverage to serious cost-control measures for Medicare. Think of it as a grand bargain: coverage for (almost) everyone, tied to an effort to ensure that health care dollars are well spent.

Are we talking about real savings, or just window dressing? Well, the health care economists I respect are seriously impressed by the cost-control measures in the Senate bill, which include efforts to improve incentives for cost-effective care, the use of medical research to guide doctors toward treatments that actually work, and more. This is “the best effort anyone has made,” says Jonathan Gruber of the Massachusetts Institute of Technology. A letter signed by 23 prominent health care experts — including Mark McClellan, who headed Medicare under the Bush administration — declares that the bill’s cost-control measures “will reduce long-term deficits.”

The fact that we’re seeing the first really serious attempt to control health care costs as part of a bill that tries to cover the uninsured seems to confirm what would-be reformers have been saying for years: The path to cost control runs through universality. We can only tackle out-of-control costs as part of a deal that also provides Americans with the security of guaranteed health care.

That observation in itself should make anyone concerned with fiscal responsibility support this reform. Over the next decade, the Congressional Budget Office has concluded, the proposed legislation would reduce, not increase, the budget deficit. And by giving us a chance, finally, to rein in the ever-growing spending of Medicare, it would greatly improve our long-run fiscal prospects.

But there’s another reason failure to pass reform would be devastating — namely, the nature of the opposition.

The Republican campaign against health care reform has rested in part on the traditional arguments, arguments that go back to the days when Ronald Reagan was trying to scare Americans into opposing Medicare — denunciations of “socialized medicine,” claims that universal health coverage is the road to tyranny, etc.

But in the closing rounds of the health care fight, the G.O.P. has focused more and more on an effort to demonize cost-control efforts. The Senate bill would impose “draconian cuts” on Medicare, says Senator John McCain, who proposed much deeper cuts just last year as part of his presidential campaign. “If you’re a senior and you’re on Medicare, you better be afraid of this bill,” says Senator Tom Coburn.

If these tactics work, and health reform fails, think of the message this would convey: It would signal that any effort to deal with the biggest budget problem we face will be successfully played by political opponents as an attack on older Americans. It would be a long time before anyone was willing to take on the challenge again; remember that after the failure of the Clinton effort, it was 16 years before the next try at health reform.

That’s why anyone who is truly concerned about fiscal policy should be anxious to see health reform succeed. If it fails, the demagogues will have won, and we probably won’t deal with our biggest fiscal problem until we’re forced into action by a nasty debt crisis.

So to the centrists still sitting on the fence over health reform: If you care about fiscal responsibility, you better be afraid of what will happen if reform fails.

‘SOME QUESTIONS FOR MR. BERNANKE,’ by Simon Johnson at baselinescenario .com.

Some Questions For Mr. Bernanke

Posted: 03 Dec 2009 04:55 AM PST

On Thursday, Ben Bernanke will appear before the Senate Banking Committee, to begin his reconfirmation process as chairman of the Federal Reserve Board.

Based on committee members’ public statements, Bernanke already appears to have enough votes on his side.  But Thursday’s hearing and the subsequent floor debate are an important opportunity for senators to raise important issues about how the Fed will operate moving forward.

This is more than a ritual.  Questioning (the monetary) authority and politely insisting on a coherent answer is an important part of our political governance structure – and something that was sorely lacking during the Greenspan era.

There are three possible lines of enquiry that could draw Mr. Bernanke out.  These questions could be separate or part of a sequence:

1. Andrew Haldane, head of financial stability at the Bank of England, argues that the relationship between the banking system and the government (in the UK and the US) creates a “doom loop” in which there are repeated boom-bust-bailout cycles that tend to get cost the taxpayer more and pose greater threat to the macroeconomy over time.  What can be done to break this loop?

2. Senator Aldrich and the National Monetary Commission explicitly sought to establish a bailout mechanism that would replace the role played by JP Morgan in saving the financial system during the panic of 1907, and Aldrich saw the creation of the Federal Reserve in 1913 as the lynchpin of that system.  But this approach has a fatal flaw.  As we saw in the 1920s, a lightly regulated financial sector can produce a boom, based on a high degree of debt, that causes major disruption when it crashes and leads to a Great Depression — even if the major banks are (initially) saved.  How should we modify the Aldrich system to remove such risks?

3. Mervyn King, governor of the Bank of England, argued in his recent Edinburgh speech that re-regulating the financial system will not effectively reduce its risks.  And history suggests that Big Finance always gets ahead of even the most able regulators.  Governor King insists instead that the largest banks should be broken up, so they are no longer “too big to fail.”  Paul Volcker and Alan Greenspan, in recent statements, have supported the same broad approach.  Can you explain why you differ from Mervyn King, Paul Volcker, and Alan Greenspan on this policy prescription?

In the history books, the Bernanke era at the Fed will be divided into three parts.  Through September 2008, Bernanke operated in the shadow of the Greenspan legacy: laissez-faire with regard to bank regulation, taken to the point of absurdity.

In the second phase, once the global financial crisis broke in earnest, Bernanke moved with alacrity to rescue the financial system.  History will likely judge him as too generous to the bankers at the center of the mess, but the real point person on bank-by-bank bailouts was NY Fed President/Treasury Secretary Tim Geithner.  Bernanke will be reappointed because our Worst Crash did not turn (yet) into a Great Depression.

The third phase is for Mr. Bernanke to decide.  Will he become a great reformer, like Marriner S. Eccles in the 1930s, leading the charge to rein in the damage that investment banking, writ large, could cause? Or will his legacy be closer to that of George L. Harrison, head of the New York Fed as the stock market crashed in 1929.  Harrison led vigorous efforts – sometimes stretching his legal authority to its limits – to save big banks and by the fall of 1930 was congratulating himself that no major financial institutions had failed.  At that point, Harrison thought his work was substantially done; sadly, he was very wrong.

By Simon Johnson

‘IS IT TOO QUIET OUT THERE?, ‘ by Mark Hulbert at MarketWatch.

ANNANDALE, Va. (MarketWatch) — The many advisers who are worried about the market’s low trading volume remind me of cowboys patrolling their camps at night: They worry that, when it gets too quiet, trouble must be brewing.

And it indeed has been growing increasingly quiet of late: NYSE average daily volume during November, for example, was lower than it was in October. And October’s average daily volume was, in turn, lower than it was in September.

In fact, NYSE average daily volume in November was 20% below its average for the entire rally from the March 9 low through the end of October.

Period NYSE daily average volume

November 1.11 billion

November through 11/20 1.16 billion

October 1.31 billion

September 1.36 billion

Mar. 9 through Oct. 31 1.39 billion

Note carefully, furthermore, that November’s low volume wasn’t caused by traders taking the Thanksgiving week off. Average daily volume was low even for the period through Nov. 20, the Friday before Thanksgiving.

Is this trend of lower and lower volume a source of concern? Is it becoming dangerously quiet out there?

“Yes” is the answer from many of the advisers I monitor, on the oft-quoted technical theory that “price follows volume.”

Not everyone agrees, however. In a communication sent to clients earlier this week, Ned Davis, president of Ned Davis Research, argued that, while the trend towards lower volume is something that deserves close attention, it is not yet a reason to give up on the rally.

For example, Davis pointed out, it is entirely normal for volume to back off during the earliest stages of a new bull market, since during the panic selling that typically takes place at a bear market bottom, there usually is extraordinarily high volume.

This was certainly the case for the stock market at the March 9 lows, by the way. Average daily trading volume over the week leading up to the low, for example, was 1.77 billion — 30% more than the average daily volume since then.

To be sure, lower volume becomes increasingly a source of concern as the length of time since the bottom grows. Even so, Davis argues, it doesn’t have to be bearish — provided that most of the volume that does remain is concentrated in stocks that are rising. And that has been the case throughout this rally.

Are there are flies in the ointment? Of course; there always are.

One, according to Davis: Demand for stocks, as evidenced by advancing volume, peaked two months ago — suggesting a “tiring uptrend.”

The bottom line? The technical picture would improve if the trend of trading volume were to reverse and start rising again — and especially so if it is concentrated in advancing stocks.

But recent volumes trends, in and of themselves, do not appear to have immediately doomed the rally.

‘CAN STOCKS KEEP 2009 GAINS THROUGH DECEMBER?, ‘ from Business Week at fidelity.com.

Stocks are in a final sprint toward the end of 2009.

After nine months of favorable market conditions, equity investors face a further month before they can declare victory in 2009. The flip of the calendar may be arbitrary, but the full year is the standard by which mutual funds, hedge funds, and other stock investors are judged on their performance.

Investors could be forgiven for wishing that 2009 would end placidly and profitably. But there’s one thing that the past couple of years have taught us about the market: Expect the unexpected. Dubai’s debt troubles, which came to a head on Nov. 25, when the emirate’s investing arm said it was seeking to delay payments on $59 billion in debt, disrupted a growing confidence among investors. Until the news broke over the Thanksgiving holiday, it looked as if markets might glide easily toward the new year.

It has been a quiet couple of months on Wall Street. “We are seeing some signs of normalcy,” says Erik Davidson, managing director of investments for Wells Fargo Private Bank.

Since the end of September, the broad Standard & Poor’s index of 500 stocks  is up 3.3%. Volatility is down. Although the market has risen and fallen day by day, the ride has not been bumpy. From its October starting point, the S&P 500 has never varied by more than 5% to the upside or 3% to the downside.

The S&P 500 has jumped 60% since its low in March. The turbulence in Dubai spread quickly because it raised questions about two important pillars of that rally — improving strength in the financial sector and credit markets and the resilience of the global economy, particularly in emerging markets.

Dubai’s woes: Just a local issue?

The true depths of Dubai’s financial difficulties remain unclear. Investors appeared concerned but not overly alarmed. At one point on Nov. 27, the S&P 500 had dipped 2.4%, but the stocks battled back and the index closed down 1.7%.

Market participants’ worries may have been eased by assertions that Dubai’s problems were a local issue. “The current troubles being seen in Dubai are a direct result of its efforts to tie its fortunes to global real estate, tourism, and services,” Brown Brothers Harriman currency strategist Win Thin wrote on Nov. 27. They “are particularly unique to Dubai and should not have wider implications for [risk to other emerging market sovereign debt].”

But many questions remain unanswered. UBS  analyst Saud Masud suggested one explanation of Dubai’s surprise move to postpone debt: Its debt may be higher than the $80 to $90 billion that many assume. But, Masud says, the restructuring of “Dubai Inc.” could have positive benefits. “While this process will be painful and will take time, it should put Dubai on a sounder footing medium term,” Masud wrote on Nov. 26.

Experienced investors know that news such as that from Dubai can easily jeopardize the market’s recovery. There is always the danger of an “exogenous shock” — whether it’s a geopolitical event or a market surprise — that could send investors fleeing risk toward safer investments. “There is always the danger of a correction,” says Quincy Krosby, Prudential Financial market strategist. “That can happen any time at any place.”

The dreaded “double-dip” recession

At the moment, the most disruptive scenario could be a rapid strengthening of the U.S. dollar, Krosby says. That could unwind the so-called “carry trade,” in which investors have been taking advantage of low U.S. interest rates to borrow and then buy risky assets both in the U.S. and abroad.

Despite the threats, investors still have reason to hope that the year will end quietly. Economic data have steadily improved, a trend that should continue for a while. “All the economic data [point] to continued growth,” says Peter Cardillo, chief market economist at Avalon Partners. He is increasingly confident that the U.S. can avoid a “double-dip” recession.

One test could be how willing U.S. consumers are to spend this holiday season, which officially began on Nov. 27’s so-called “Black Friday.” Stifel Nicholas  analysts visited retailers on Nov. 27 and offered initially positive reviews. “We believe sales are meeting or exceeding [the] plan for Black Friday,” they said.

For holiday spending, “expectations are set so low,” says Davidson of Wells Fargo. “If anything, the surprise of the holiday season could be to the upside.”

So far in 2009, the Dow Jones industrial average  has advanced 17.5%, while the S&P 500 has risen 21% and the tech-heavy Nasdaq composite  is up 35.6%. As Davidson notes, the S&P 500 is now almost perfectly halfway between its October 2007 peak of 1,565 and its March 2009 low of 676.53.

As investors waver between optimism and pessimism, the question they must answer in the months to come is whether that means the market is half-full or half-empty.

‘THIS I BELIEVE,’ by Thomas L. Friedman in the N.Y.Times. Excellent read!

OP-ED COLUMNIST

This I Believe

By THOMAS L. FRIEDMAN

Published: December 1, 2009

Let me start with the bottom line and then tell you how I got there: I can’t agree with President Obama’s decision to escalate in Afghanistan. I’d prefer a minimalist approach, working with tribal leaders the way we did to overthrow the Taliban regime in the first place. Given our need for nation-building at home right now, I am ready to live with a little less security and a little-less-perfect Afghanistan.

I recognize that there are legitimate arguments on the other side. At a lunch on Tuesday for opinion writers, the president lucidly argued that opting for a surge now to help Afghans rebuild their army and state into something decent — to win the allegiance of the Afghan people — offered the only hope of creating an “inflection point,” a game changer, to bring long-term stability to that region. May it be so. What makes me wary about this plan is how many moving parts there are — Afghans, Pakistanis and NATO allies all have to behave forever differently for this to work.

But here is the broader context in which I assess all this: My own foreign policy thinking since 9/11 has been based on four pillars:

1. The Warren Buffett principle: Everything I’ve ever gotten in life is largely due to the fact that I was born in this country, America, at this time with these opportunities for its citizens. It is the primary obligation of our generation to turn over a similar America to our kids.

2. Many big bad things happen in the world without America, but not a lot of big good things. If we become weak and enfeebled by economic decline and debt, as we slowly are, America may not be able to play its historic stabilizing role in the world. If you didn’t like a world of too-strong-America, you will really not like a world of too-weak-America — where China, Russia and Iran set more of the rules.

3. The context within which people live their lives shapes everything — from their political outlook to their religious one. The reason there are so many frustrated and angry people in the Arab-Muslim world, lashing out first at their own governments and secondarily at us — and volunteering for “martyrdom” — is because of the context within which they live their lives. That was best summarized by the U.N.’s Arab Human Development reports as a context dominated by three deficits: a deficit of freedom, a deficit of education and a deficit of women’s empowerment. The reason India, with the world’s second-largest population of Muslims, has a thriving Muslim minority (albeit with grievances but with no prisoners in Guantánamo Bay) is because of the context of pluralism and democracy it has built at home.

4. One of the main reasons the Arab-Muslim world has been so resistant to internally driven political reform is because vast oil reserves allow its regimes to become permanently ensconced in power, by just capturing the oil tap, and then using the money to fund vast security and intelligence networks that quash any popular movement. Look at Iran.

Hence, post-9/11 I advocated that our politicians find sufficient courage to hike gasoline taxes and seriously commit ourselves to developing alternatives to oil. Economists agree that this would ultimately bring down the global price, and slowly deprive these regimes of the sole funding source that allows them to maintain their authoritarian societies. People do not change when we tell them they should; they change when their context tells them they must.

To me, the most important reason for the Iraq war was never W.M.D. It was to see if we could partner with Iraqis to help them build something that does not exist in the modern Arab world: a state, a context, where the constituent communities — Shiites, Sunnis and Kurds — write their own social contract for how to live together without an iron fist from above. Iraq has proved staggeringly expensive and hugely painful. The mistakes we made should humble anyone about nation-building in Afghanistan. It does me.

Still, the Iraq war may give birth to something important — if Iraqis can find that self-sustaining formula to live together. Alas, that is still in doubt. If they can, the model would have a huge impact on the Arab world. Baghdad is a great Arab capital. If Iraqis fail, it’s religious strife, economic decline and authoritarianism as far as the eye can see — the witch’s brew that spawns terrorists.

Iraq was about “the war on terrorism.” The Afghanistan invasion, for me, was about the “war on terrorists.” To me, it was about getting bin Laden and depriving Al Qaeda of a sanctuary — period. I never thought we could make Afghanistan into Norway — and even if we did, it would not resonate beyond its borders the way Iraq might.

To now make Afghanistan part of the “war on terrorism” — i.e., another nation-building project — is not crazy. It is just too expensive, when balanced against our needs for nation-building in America, so that we will have the strength to play our broader global role. Hence, my desire to keep our presence in Afghanistan limited. That is what I believe. That is why I believe it.

‘SOME POSITIVES DESPITE WEAK EMPLOYMENT?,’ from Fidelity Viewpoints at fidelity.com.

We’ve seen some surprises—both good and bad—in the past month’s economic data.

The economy continues to show signs of recovery, but there are indications of a bumpy ride. For instance:

Even though unemployment numbers were surprisingly high, leading indicators for the job market are improving.

Consumers are still uncertain about their current economic situation, but there are signs that consumer spending is slowly recovering.

While housing has been the worst hit sector during this contraction, pending home sales have rebounded strongly.

The manufacturing sector has been through the worst production declines in decades, but orders are beginning to rise. This should remove the U.S. oversupply of inventories and trigger another uptick in production.

Global demand has also recovered and this, coupled with a weak U.S. dollar, can improve U.S. exports.

The combination of a rebound in growth and a still weak labor market produced a massive upswing in corporate earnings and helped propel the capital markets higher.

Let’s take a closer look.

Unemployment disappointingly high

The October unemployment rate unexpectedly surged well above consensus to 10.2%. The job market weakness was broad-based with only one third of industries adding to payrolls. This large step up in unemployment took many analysts by surprise since many leading indicators for unemployment had been signaling some improvement in job trends. For instance, layoff announcements and initial unemployment claims were down, temporary employment hiring was up, manufacturing hours worked increased, and overtime hours continued to rise.

The hardest hit were younger workers and those with high school or lower education. Workers younger than age 24 lost nearly half a million jobs, while adults (those over age 24) with less education (high school or lower) lost 508,000 jobs. On the other hand, adults with more than a high school education gained 463,000 jobs. The job market weakness was broad based with only one third of industries adding to payrolls in October.

But in any economy, jobs are constantly being created and destroyed. When the economy is in an expansion mode, more jobs are created than lost. As an economy enters recession, this dynamic changes and job creation fails to keep pace with job destruction. The JOLT (Job Openings and Labor Turnover) survey from the U.S. Bureau of Labor Statistics helps capture this natural churn in the economy. In September, the survey reported that 4.01 million new hires or jobs were created, but 4.31 million jobs were lost.

Going forward, therefore, it becomes important to understand where jobs are being created and where they’re being destroyed. On the job creation side, there was some good news from the Institute for Supply Management’s manufacturing survey. While the overall survey is an excellent leading indicator of U.S. industrial production, it also provides details on what supply managers see in terms of orders, production, and hiring. In November, the employment subindex fell back to 50.8, but this remains consistent with improving manufacturing employment. This has typically signaled future job increases in the manufacturing sector. On the job loss side, the story is also improving. Initial unemployment claims and layoff announcements have both fallen significantly from the extreme levels earlier this year. Overall, while the unemployment rate highlights the very rough environment we’ve been through, the leading indicators are showing that the worst of the storm may be over.

Consumers optimistic about the future

Two closely followed consumer sentiment surveys, the Conference Board Survey and the University of Michigan Consumer Sentiment Survey, ask consumers how they felt about current and future business conditions, employment, income, spending, inflation, and finances. In November, the surveys recently showed that consumers are not feeling good about their current financial positions and have low expectations for income, employment, and spending—not surprising given salary and benefit growth rates are at their lowest on record. When the same individuals were asked about how they felt about future financial conditions over the next 6-12 months, however, they were much more positive. They are expecting the overall economy to improve, as well as business and employment conditions—another sign that the worst may be behind us.

Consumer spending still weak

During this recession, consumers increased their savings and paid down debt at the fastest rate in recorded history. Nevertheless, consumer spending has begun to recover. Retail sales and real consumer spending both appear to have bottomed as long ago as December of last year. Improvements from the lows, however, have been slow and halting. There’s still a strong unwillingness to “spend on things you don’t necessarily need.” But there’s a natural replacement cycle within consumer spending that should continue to boost spending. One excellent example comes from the vehicle sector. While vehicle sales were temporarily boosted by the “Cash for Clunkers” program, it appears that spending has held up better than expected after the program’s expiration. One reason may be that the average age of a vehicle on the road is now 9.4 years. As the maintenance cost for these cars begins to soar, it becomes very compelling for more households to replace their older cars. We may just be seeing the start of this cycle.

Inventory cycle could boost GDP

The manufacturing inventory cycle is a powerful driver of gross domestic product (GDP) both going into and out of recessions. While excess inventories were a key driver of the collapse in industrial production in late 2008 and early 2009, it may be the same indicator that signals a dramatic rebound. In the fourth quarter of 2008 and the first quarter of 2009, manufacturers experienced a dramatic decline in demand as the worst of the recession hit. As a result of the demand decline inventories were well in excess of normal levels and producers shut production and sold their inventories. This is a decision producers make during every recession, but it results in a decline in production and jobs well in excess of the decline in demand.

Production declines, however, create inventory declines. As we’ve moved through 2009, consumer demand has stabilized and begun to recover. As a result, inventories have begun to come in line with demand and the need for new production has begun to recover. This is the point at which inventories could become a powerful upward force on GDP. The ISM manufacturing survey was the first to signal this change in production. Indeed, industrial production has increased for the past four months. Going forward this can signal that the need for workers is likely improving. So is the recovery sustainable? The inventory cycle is now a wind at our back, which has typically been a key variable for sustainability.

Global demand can increase U.S. exports

In terms of the global economic picture, the U.S., which historically has led other countries out of a global recession, is currently in the middle of the recovery pack. U.S. leading economic indicators are rising at a 3-month annualized rate of 6.8%, consistent with economic recovery. The OECD (Organization for Economic Cooperation and Development) countries, which are a collection of the largest developed economies in the world, are seeing their leading indicator rising at a 3-month annualized rate of 16%, the highest rate since the end of the 1975 recession. This shows that the global economy is growing at a faster rate than the U.S. economy. Much of the higher growth has been spurred by demand from countries like China, India, and Brazil where consumer spending is rising. This growth, coupled with a weak U.S. dollar, creates an excellent export environment for U.S. companies. The increased exports from the U.S. should be a powerful positive increment to U.S. GDP growth.

How to invest

How might investors take advantage of these economic developments? An extremely high productivity rate, an increase in output per hour, and falling employment costs are signaling stable and increasing corporate profitability. Corporate profits rose in the second and third quarters of 2009 and stocks could continue to be strong if profits continue rebounding.

The early cyclicals (sectors and companies that tend to do well in the early stages of an economic recovery) such as home builders, autos, and retailers have already rallied. Next, investors could expand their portfolios to other sectors to include a wide variety of asset classes as corporate profits rise and the expansion broadens. The next wave of growth could be in technology and industrial stocks. This stage of the cycle, however, may be choppy. While the overall market will likely follow earnings trends, the market has already rebounded strongly and it appears to be a stock picker’s environment. For example, in the area of consumer staples stocks, some companies may grow at a faster rate due to their increased share in the market, despite somewhat slow growth in overall consumer spending. Identifying those market share leaders both in the U.S. and global markets may be a recipe for investing success.

‘DUBAI NOT A CANARY IN THE MINE BUT ANOTHER BIRD NEEDING OXYGEN,

HUNTSVILLE, Alabama, December 1 (Reuters) – Taken all in all, Dubai’s debt crisis is the most significant financial development of 2007. Here in late 2009 it amounts to far less.

Back in the day it would have been a newsflash that apartments ultimately require occupants, that investment needs to be ratified by cash flows, and that debt, Sharia-compliant or garden variety, someday must be repaid.

Dubai’s difficulties are being sold as the commercial real estate debacle somehow morphing into a sovereign debt crisis and it is true that the effective borrowing rates of the more raddled national borrowers such as Ireland have been driven up in recent days.

Dubai’s government said on Monday that it is not responsible for the borrowings of Dubai World, a state-controlled development conglomerate saddled with huge debts amid a property market where the going rate has halved.

Dubai last week applied for, or imposed depending on your point of view, a six-month repayment freeze for Dubai World and its property developer Nakheel.

“Creditors need to take part of the responsibility for their decision to lend to the companies. They think Dubai World is part of the government, which is not correct,” said Abdulrahman Saleh, director general of Dubai’s department of finance.

Quite, and hopes that credit extended to Dubai World would be made good by the state of Dubai or by the richer emirate of Abu Dhabi seem to be foundering. This is bad news for those creditors, with the worst potential losses traceable to banks in Britain and Europe, but its probably just not that big of a deal.

For one thing, the amount potentially at issue, even if you allow for an extra 50 percent off balance sheet taking it to circa $125 billion, is simply not big enough in the scale of things to tip significant players over the edge.

And it tells us very little about the state of the world or the likely outlook for real estate. It is very hard to call something a canary in the coal mine when you are already cleaning up after a mining disaster.

For a time the magical thinking behind Dubai, “build it and they will come”, worked and despite it being remote, having an inhospitable climate and little inherent commercial reason for existing, the city boomed. It’s a bit like having a feast so the harvest will be good rather than when it actually is, but it was effective for a time as prices rose and investment was attracted.

Dubai world meets moral hazard world

The nub of the meme in financial markets is that this is about sovereign exposure and that creditors will be shocked if the state support they thought they had coming never arises.

But is it terribly bad news for the rest of us? Probably not. Investors should have seen it coming – there have been quite a few headlines recently about the real estate crash- and should not have conflated “implicit” with “explicit”.

Dubai has made clear in its own bond prospectuses that it might lend support but that it was under no obligation to do so. Teaching investors the difference between “quasi-state” and “state” is a good thing.

So why then did the cost of borrowing for Greece and Ireland, as expressed in insurance contracts against default, go up?

Nothing about Dubai’s predicament will have much of an impact on Irish or Greek tax revenues clearly, and the banks and the pool of lendable capital has not been diminished by much.

Nor is it easy to draw a new connection between Dubai and the emerging European countries which represent a much more substantial and potentially grave threat to banks in Europe.

Perhaps this is ultimately about moral hazard – risk taking under the belief that you are “insured” – as are all stories involving the words “quasi,” “government,” and “debt.”

Fannie Mae  and Freddie Mac’s  quasi-government status fed moral-hazard driven risk taking, as did Dubai World’s, as is most certainly the case where government insurance allows for cheap borrowing.

Markets went down on Dubai because they have become addicted to moral hazard and anything that doesn’t conform with the idea that all shall be bailed out is scary.

It is apparently terrifying that a government should say “hard luck” to anyone anywhere, no matter how difficult the government’s situation is or how ill-founded the investors claim to relief.

None of this is to say that the commercial real estate crash isn’t terrifying, or that countries like Ireland and Greece don’t face difficult times and huge risks, but only that Dubai tells us little new about those things.

There is definitely a moral hazard trade out there, but Dubai is not the event which will cause it to unwind

‘FEUDAL LORDS OF FINANCE, ‘ by Simon Johnson at baselinescenario .com. “Powerful financiers, by and large, did just fine during the Great Depression.”

Feudal Lords Of Finance

Posted: 01 Dec 2009 09:40 AM PST

In some influential circles, these questions are now asked: What’s wrong with high levels of inequality in general, and with having very rich bankers in particular.  After all, human societies have survived the presence of extremely wealthy individuals in the past – in fact, some now argue, the presence of such a “new aristocracy” can finance growth and spur innovation.

This argument is deeply flawed along three dimensions.

Such super-elites care very little for anyone other than themselves.  Certainly, there will be some charity – but remember that John D. Rockefeller’s greatest donations came after he had been dragged through the mud by some very persuasive rakers (Ida Tarbell).

It is a mistake to assume that any country’s institutions (the laws, rules and norms that govern behavior) are fixed for all time.  In reality, institutions change all the time – partly in reaction to who has wealth and power, and what they are trying to do.  What are the odds that our financial super-rich will want to build democracy and strengthen the middle class?

Can the rich and powerful really be counted on to save the system, or just themselves?  Go back carefully through the early history of the Great Depression (see Lords of Finance).  Certainly the big  New York players saved banks and securities firms that were seen to be part of their club (e.g., Kidder Peabody), but they – and the New York Fed – were not so inclined to save financial institutions they regarded as less than central (e.g., Bank of the United States), even if this meant thousands of people lost their life savings.

When the Bank of England’s Andrew Haldane speaks of a “doom loop,” he is describing the declining future for our middle class.  Powerful financiers, by and large, did just fine during the Great Depression.

By Simon Johnson

‘FOREIGN BONDS PROVIDE BUFFER IF DOLLAR DECLINES ,’ in the N.Y. Times via fidelity.com.

Foreign Bonds Provide Buffer if Dollar Declines

By J. ALEX TARQUINIO

Published: October 28, 2009

AMERICAN investors can buy bonds issued by foreign governments that are designed to provide protection against inflation, but strategists say those bonds are really more of a bet against the dollar

“If you are a U.S. dollar-based investor, the currency fluctuations will overwhelm anything you get from inflation indexing” on the foreign bonds, said Aaron Gurwitz, the head of global investment strategy at Barclays Wealth.

For more than a decade, the United States Treasury has been selling bonds protected from inflation, known as Treasury Inflation-Protected Securities, or TIPS, whose coupon payments are based on changes in the Consumer Price Index. Investors primarily concerned about protecting their purchasing power during retirement should own TIPS, Mr. Gurwitz said.

Some strategists say that owning the foreign bonds — individually in a well-rounded bond portfolio, or through an exchange-traded fund — can be a good way to diversify and add exposure to other currencies.

Brett Hammond, the chief investment strategist at TIAA-CREF, pointed out that global inflation-protected securities, as these bonds are called, typically perform very differently from other asset classes like stocks and commodities — and even other types of bonds.

Owning any type of foreign bonds hedges an individual investor’s portfolio against a decline in the dollar and is especially useful if the portfolio has little exposure to other currencies through investments like foreign stocks. This is true, he said, for investors of any age.

David Darst, the chief investment strategist for the global wealth management group of Morgan Stanley Smith Barney, recommends global inflation-protected securities precisely because they are both a hedge against a decline in the dollar and protection against global inflation.

“It is more of a currency play than an inflation play,” he said. “But to the degree that inflation picks up with a global economic recovery, then you will be getting two hedges.” Morgan Stanley projects the dollar will fall to $1.60 against the euro by the end of 2010, down from about $1.50 now.

Mr. Darst recommends that individual investors hold 3 percent to 4 percent of their total portfolio in inflation-protected bonds. This allocation could be entirely in TIPS or in a combination of TIPS and global inflation-protected securities, he said, depending on what the investor thought of the dollar.

American investors can buy bonds from specific foreign countries through a broker, or investors can own a diverse basket of the bonds by purchasing the SPDR Deutsche Bank International Government Inflation-Protected Bond exchange-traded fund. This fund owns inflation-adjusted bonds from 17 countries, including France, Brazil and South Korea, but not the United States. The bonds are denominated in 14 currencies. At the moment, no comparable traditional mutual fund is available, according to Morningstar.

Scott Burns, the director of exchange-traded fund analysis for Morningstar, recommends owning both the Deutsche Bank fund and the iShares Barclays TIPS Bond Fund, which only owns American TIPS.

He pointed out that a decline in the dollar often coincides with rising inflation. “If the dollar goes down, the Consumer Price Index generally goes up,” he said, because the cost of imported goods increases for American consumers.

For investors who want exposure to foreign currencies but are not interested in inflation-protected bonds, Mr. Burns recommended two funds that own traditional foreign government bonds: the SPDR Barclays Capital International Treasury Bonds fund, which primarily owns bonds issued by developed countries, and the iShares JPMorgan USD Emerging Markets Bond fund. Because inflation has been very low during the recession, many investors have not been focused on inflation-adjusted bonds, which makes it easy to gauge the broad market consensus for inflation: the difference between the interest rates offered for TIPS and for plain Treasury bonds indicates what investors think future inflation will be. At the moment, TIPS prices suggest an average annual inflation rate of 1.6 percent over the next five years and 2.11 percent over the next 10 years.

If inflation is higher than that over 5 to 10 years, the current TIPS bondholders would get a higher return. If inflation fears return, though, those expectations will probably be priced into the TIPS market.

Some investment strategists say that makes this a good time to buy inflation-protected bonds — either TIPS or their foreign counterparts — precisely because the outlook for inflation is relatively benign. “You don’t want to buy flood insurance when the river is already in your living room,” Mr. Burns said.

‘THE JOBS IMPERATIVE, ‘by Paul Krugman in the Times.

If you’re looking for a job right now, your prospects are terrible. There are six times as many Americans seeking work as there are job openings, and the average duration of unemployment — the time the average job-seeker has spent looking for work — is more than six months, the highest level since the 1930s.

You might think, then, that doing something about the employment situation would be a top policy priority. But now that total financial collapse has been averted, all the urgency seems to have vanished from policy discussion, replaced by a strange passivity. There’s a pervasive sense in Washington that nothing more can or should be done, that we should just wait for the economic recovery to trickle down to workers.

 

This is wrong and unacceptable.

 

Yes, the recession is probably over in a technical sense, but that doesn’t mean that full employment is just around the corner. Historically, financial crises have typically been followed not just by severe recessions but by anemic recoveries; it’s usually years before unemployment declines to anything like normal levels. And all indications are that the aftermath of the latest financial crisis is following the usual script. The Federal Reserve, for example, expects unemployment, currently 10.2 percent, to stay above 8 percent — a number that would have been considered disastrous not long ago — until sometime in 2012.

 

And the damage from sustained high unemployment will last much longer. The long-term unemployed can lose their skills, and even when the economy recovers they tend to have difficulty finding a job, because they’re regarded as poor risks by potential employers. Meanwhile, students who graduate into a poor labor market start their careers at a huge disadvantage — and pay a price in lower earnings for their whole working lives. Failure to act on unemployment isn’t just cruel, it’s short-sighted.

 

So it’s time for an emergency jobs program.

 

How is a jobs program different from a second stimulus? It’s a matter of priorities. The 2009 Obama stimulus bill was focused on restoring economic growth. It was, in effect, based on the belief that if you build G.D.P., the jobs will come. That strategy might have worked if the stimulus had been big enough — but it wasn’t. And as a matter of political reality, it’s hard to see how the administration could pass a second stimulus big enough to make up for the original shortfall.

 

So our best hope now is for a somewhat cheaper program that generates more jobs for the buck. Such a program should shy away from measures, like general tax cuts, that at best lead only indirectly to job creation, with many possible disconnects along the way. Instead, it should consist of measures that more or less directly save or add jobs.

 

One such measure would be another round of aid to beleaguered state and local governments, which have seen their tax receipts plunge and which, unlike the federal government, can’t borrow to cover a temporary shortfall. More aid would help avoid both a drastic worsening of public services (especially education) and the elimination of hundreds of thousands of jobs.

 

Meanwhile, the federal government could provide jobs by … providing jobs. It’s time for at least a small-scale version of the New Deal’s Works Progress Administration, one that would offer relatively low-paying (but much better than nothing) public-service employment. There would be accusations that the government was creating make-work jobs, but the W.P.A. left many solid achievements in its wake. And the key point is that direct public employment can create a lot of jobs at relatively low cost. In a proposal to be released today, the Economic Policy Institute, a progressive think tank, argues that spending $40 billion a year for three years on public-service employment would create a million jobs, which sounds about right.

 

Finally, we can offer businesses direct incentives for employment. It’s probably too late for a job-conserving program, like the highly successful subsidy Germany offered to employers who maintained their work forces. But employers could be encouraged to add workers as the economy expands. The Economic Policy Institute proposes a tax credit for employers who increase their payrolls, which is certainly worth trying.

 

All of this would cost money, probably several hundred billion dollars, and raise the budget deficit in the short run. But this has to be weighed against the high cost of inaction in the face of a social and economic emergency.

 

Later this week, President Obama will hold a “jobs summit.” Most of the people I talk to are cynical about the event, and expect the administration to offer no more than symbolic gestures. But it doesn’t have to be that way. Yes, we can create more jobs — and yes, we should.

‘GET READY FOR HALF A RECOVERY,’ by Gretchen Morgenson in the Sunday Times.

Get Ready for Half a Recovery …..By GRETCHEN MORGENSON

Published: November 28, 2009

A ROBUST economic recovery in 2010 is certainly on most investors’ wish lists as this year draws to a close. A return to prosperity would not only mean an end to our long financial nightmare, but it would also buttress a rebounding stock market, one of 2009’s few bright spots.

The news out of Dubai late last week, however — that its investment company is struggling to meet repayments on some of its $59 billion in debt — reminds us that we are far from finished with a ferocious deleveraging process that began last year. And the weight of debt that still must be worked out is one reason that Ian Shepherdson, chief United States economist at High Frequency Economics, estimates that growth in the United States’ output for 2010 will be no better than 2 percent.

Mr. Shepherdson — whose economic forecasts have been more right than wrong throughout the credit crisis — says that while cost-cutting has produced enviable productivity figures and rising earnings at large companies, continued growth in corporate output will be much harder to come by.

“Looking further ahead, you can’t survive on cost-cutting forever,” he says. “We will have to see decent volume growth but we won’t see that immediately.”

Mr. Shepherdson’s 2 percent estimate for gross domestic product growth next year is roughly half what he would normally expect for a solid economic recovery. And a crucial reason is the fact that bad assets on personal and institutional balance sheets are the equivalent of a ball and chain strapped to the economy, he says.

“You can pick up that ball and walk with it,” he says, “but you have to walk slowly.”

All that debt overhanging consumers and organizations is the pivotal reason we are still seeing a free fall in bank lending. And small businesses, which account for half of all jobs in this country, are taking the brunt of this credit contraction. Smaller banks are especially worried about their own balance sheets and aren’t making loans. This puts small businesses — important engines of growth — squarely on the brink.

INVESTORS may be celebrating data that points to improvements in economic activity — this month, for example, the Institute for Supply Management said manufacturing had expanded for three months in a row. But Mr. Shepherdson worries about what he sees in monthly figures put out by the National Federation of Independent Business, a trade group representing small businesses.

The N.F.I.B. data was far more prescient than that of the I.S.M. in predicting the current recession, which began in December 2007, Mr. Shepherdson says. The N.F.I.B. survey signaled a downturn in the spring of 2007, while I.S.M. studies didn’t point to a recession until after Lehman Brothers failed in September 2008.

In its survey, the N.F.I.B. asks small businesses how easy it is for them to get loans. The most recent data shows that credit tightness peaked earlier this fall — the worst levels in 23 years, Mr. Shepherdson says. Although credit continues to remain troublingly hard for small business to come by, that phenomenon is a largely untold story.

“Wall Street focuses on big companies because they are in the Standard & Poor’s 500, but small businesses are still in a very grim state,” he says. “Small-company activity according to the N.F.I.B. is still at deep recession levels.”

And while small businesses do not make up the big stock indexes, they do contribute significantly to the overall economy. The tens of millions of people who work at small concerns are, after all, customers of those big, high-profile corporations like McDonald’s, Wal-Mart and Whirlpool.

What we all are enduring — and what small businesses, workers and consumers continue to be pummeled by, even as Wall Street wizards jump back into the bonus pool — is the dismantling of the great credit boom of the early 2000s. This necessary but grueling deleveraging began last year and is now in full swing. But it is nowhere near over.

Bank credit outstanding peaked in October 2008 at $7.3 trillion and is now down to $6.72 trillion. Still, Mr. Shepherdson says he thinks that banking-sector loan and lease assets have to fall by an additional $2 trillion. That could take another two years.

“We are in unknown territory here,” he said. “Since the peak in October ’08, bank credit has dropped by 8 percent. That is enormous and it is accelerating. The peak-to-trough drop in the early ’90s was just 1.3 percent and that was enough to scare the pants off the Fed.”

This credit cave-in is the driving force behind the Federal Reserve’s mortgage purchase program, Mr. Shepherdson says. The last thing the central bank wants to see is a decline in the broad-based money supply, because when that happens it usually means a depression is afoot. Money supply didn’t fall in the early 1990s, but it fell by one-quarter during the 1930s.

The Fed’s asset purchase program is therefore not about driving down mortgage rates, Mr. Shepherdson says, but about trying to prevent a collapse in the money supply. When the Fed buys assets it creates deposits, which, in turn, helps offset the credit pullback. If the Fed wasn’t buying mortgages with both hands, Mr. Shepherdson estimates, the money supply would be falling 1 percent a month.

The message amid this gloom, he says, is that the Fed isn’t likely to raise interest rates anytime soon. In fact, he doesn’t anticipate an increase in rates until the spring of 2011.

“I WOULD be astonished if they raised rates in the heart of the credit contraction storm,” Mr. Shepherdson says. “The credit contraction will last for a couple of years and if the Fed is interested in offsetting it, they will have to buy assets through next year.”

Deflating an asset bubble is never fun, and this particular specimen is one for the record books. The binge may have been a blast, but the purge, alas, sure is painful.

‘DOES DUBAI MATTER? ASK IRELAND,’ by Simon Johnson at baselinescenario .com.

Does Dubai Matter? Ask Ireland

Posted: 28 Nov 2009 05:53 AM PST

Presumably the rulers of Dubai and Abu Dhabi are currently locked in negotiations regarding the exact terms that will be attached to a “bailout” for Dubai World.  We’ll never know the details but if, as seems likely, the final deal involves creditors taking some sort of hit (perhaps getting 75 cents in the dollar, at the end of the day), does that matter?

Dubai probably has around $100bn in total liabilities, if we include off-balance sheet transactions, so total credit losses of $30-50bn need to be assigned.  The direct effects so far seem small.  HSBC leads the pack, in terms of exposure,  but our baseline estimate is a 3 percent loss relative to its equity – not good, but manageable (and the stock already fell 5 percent on the news).  The impact among other financial institutions that lent to Dubai seems fairly spread out and mostly within continental Europe.

Korean construction companies and Ukrainian/Russian steelmakers are also affected by the likely fall off in construction activity, but the broader boom in emerging markets is unlikely to be disrupted.  The repricing of risk so far does not apply significantly to East Asia or Latin America.

However, there is a worrying impact on Ireland.

The credit default swap spreads for Irish banks have widened signficantly — even relative to HSBC, with its direct Dubai involvement.  In part, this is hedge funds betting that others will want to insure against the rising risk of an Irish default, but what’s the connection?

The thinking is that a partial bailout – with creditor losses – for Dubai from Abu Dhabi implies something about how Ireland will be treated within the European Union (and the same reasoning is also more vaguely in the air for Greece).  This may make sense for three reasons.

If Dubai can effectively default or reschedule its debts without disrupting the global economy, then others can do the same.

If Abu Dhabi takes a tough line and doesn’t destabilize markets, others (e.g., the EU) will be tempted to do the same (i.e., for Ireland and Greece).  “No more unconditional bailouts” is an appealing refrain in many capitals.

If the US supports some creditor losses for Dubai (e.g., because of its connections with Iran), this makes it easier to impose losses on creditors elsewhere (even perhaps where IMF programs are in place, such as Eastern Europe).

The main effect will be to strengthen the hand of Ben Bernanke in Fed policymaking discussions – so US interest rates will stay low for a long while.  If financial intermediaries draw the appropriate lessons from Dubai, Ireland, and Greece (and Iceland, the Baltics, Hungary, etc), they will be more careful about extending credit to places that are becoming overexuberant – even when it is cheap to increase debt levels.

But an outbreak of caution and care on the part of our biggest banks (and other investment managers) does not seem likely.

By Simon Johnson

‘WHY I’M AN OPTIMIST,’ by John Mauldin at FrontLineThoughts .com. Great but long read.

I admit that of late my writings have had a rather dark tone. There are certainly a number of severe long-term problems that we must deal with, and they’re going to serve up a lot of economic pain. But the Thanksgiving weekend with the kids has me in a reflective mood, and one that has only served to underscore my long-term optimism. This week we look at why 2007 will not be the good old days we will yearn for in 20 years, after we briefly visit Dubai and the latest unemployment numbers.

 

Subprime Dubai

 

While we in the US spent our Thursday eating turkey and watching football, the rest of the world’s markets went into a downward spiral as Dubai announced it wanted its lenders to give the country a six-month moratorium on some $80-90 billion in debt. This has the potential to be the largest sovereign debt default since Argentina. Somehow this was a shocking development. (How can too much debt and real estate be a problem?) And by markets I mean gold, commodities, oil, stocks, and risk assets everywhere. They all went down. Today the US markets experienced their own sell-off, though not as deeply as the rest of the world.

 

As I wrote last Friday, the world is now negatively correlated with the dollar, and as money went into the dollar and US treasuries, everything else went down. Vietnam devalues, Greece is looking increasingly risky, Russia wants to devalue some more, the world is still deleveraging, etc. Is this another repeat of 1998, when Russia and the Asian debt crisis tanked the markets?

 

To get an answer, let’s look at some facts about Dubai. It is one of the Arab Emirates; but unlike its neighbor Abu Dhabi, oil is only about 6% of the economy. While the foundations of the country were built with oil, the country has diversified into finance, real estate, tourism, trading, and manufacturing. It is a small country, with a little under 1.5 million residents, but with less than 20% being natural citizens – the rest are expatriates. The gross domestic product is around US $50 billion.

 

(Note: http://www.ameinfo.com/67802.html and then converting the currency. I found the numbers on various websites and services strangely at wide discrepancies. This seems close to a median number. I think the discrepancy is mostly people confusing the GDP for the United Arab Emirates as a whole, which includes Abu Dhabi, rather than just Dubai.)

 

Dubai has become a byword for thinking large. The world’s tallest building, underwater hotels, the largest manmade islands (plural), indoor snow skiing in the desert… For links to more information try this from Wikipedia: “The large-scale real estate development projects have led to the construction of some of the tallest skyscrapers and largest projects in the world, such as the Emirates Towers, the Burj Dubai, the Palm Islands and the world’s second tallest, and most expensive hotel, the Burj Al Arab.” The list goes on and on.

 

UBS suggests that the $80-90 billion in debt may not include rather large off-balance-sheet debt (where have we seen that one?). So, a country with a GDP of $50 billion borrows $100 billion. They build massive projects, which are now among the most expensive real estate in the world. The latest manmade island plans for one million people to buy property there. Seriously. Talk about Field of Dreams.

 

Then came the credit crunch. Property values dropped by as much as 50%. Sales, say the developers in understatements, have slowed. Seems there was a lot of debt used to speculate on real estate, not to mention buying Barney’s, Las Vegas casinos, banks, etc. And while US banks have little exposure, it seems England has about 50% or so of the debt, with the rest of Europe having the lion’s share of the remainder. Admittedly, the estimates seem to confuse the debt of Dubai with that of Abu Dhabi, so it is hard to know a reliable number, other than that European banks are the most exposed.

 

Now, here’s the deal. Abu Dhabi has the world’s largest sovereign wealth fund, at over $650 billion. Dubai has a “mere” $15 billion. If they cared to, Abu Dhabi could write a small check and make all the problems disappear. It just seems that they are not ready to do that, at least not yet. Abu Dhabi already got the world’s tallest building on past debt problems.

 

Construction and real estate were as much as 25% of the economy. Let’s see. Large leverage with maybe $5 billion in interest in a $50 billion economy that is 25% construction? A construction and real estate-driven economy. A real estate bubble. Sound like California, Florida, Spain? How can this be a surprise, except that everyone expected big brother Abu Dhabi to pick up the check?

 

While Abu Dhabi did advance $5 billion earlier, Dubai is not letting that money out of the country. There are projects to be finished, you understand. From where I sit, this is just rather hard-headed negotiations, a restructuring of who owns what and who will get what assets. It will all settle out. Given the massive losses that world banks have already taken, this is rather small potatoes.

 

So why the reaction by the markets? Because I think many participants know that the potential for there to be a serious correction is quite real. When anything as relatively small as Dubai spooks the market, it should serve as a warning sign. The world has priced in 5% GDP growth for the US and much of the developed world in the equity and commodity markets. Either we have to get that or the markets are going to have to come back to the reality of what I think is going to be a much lower growth figure.

 

But in any event, one of the lessons to be learned is that investors should pay attention to where the leverage is. Unsustainable debt trends end in tears. They always do. Spain, Greece, Italy, the UK, and Japan will all have to face major restructuring in the next decade due to leverage. And we in the US will also find that we cannot grow debt at our current levels. Will we pare our debt willingly or be forced to by the market? Either way, it will make for a less than optimal economy over the coming years. Muddle Through, indeed.

 

More Government Data Fun:

Unemployment Claims Were Not Down

 

The headlines said that initial claims dropped to 466,000 here in the US, finally falling below 500,000. This was greeted with proclamations of recovery. First, let me say that 466,000 people filing for unemployment is still way too high. That is a lot of people losing their jobs, and when we first crossed over 450,000 a few years ago that level was seen as a sign of recession.

 

Second, the headline number was a seasonally adjusted number. The actual number was 543,926. What is happening is that we are coming off of wickedly high numbers in 2008 and a seasonal number that was much lower in the preceding years. It is another part of the Statistical Recovery. And this trend is likely to keep on for the rest of the quarter. My friend John Vogel, who analyzes the unemployment numbers for me each week, shows pretty convincingly that the average for this current quarter will be over 500,000 per week on a non-seasonally adjusted basis. This is less than a 10% drop from last year for the same quarter. Job losses are continuing to mount, and we are on our way to an 11%-plus unemployment number by next summer. Statistical Recovery, indeed.

 

Why I Am Optimistic About the Future

 

I am optimistic by nature. An entrepreneur friend of mine gave me a term that I have grown to love. She calls it “psychic income.” It’s that bit of hoped-for future income that is in our minds, that drives some of us, inflicted with the entrepreneurial gene, to do the next deal, make the next big plan, scheme yet another scheme to finally hit whatever counts as the big one for each of us. How much better would our life be, how our problems would go away, if only this one thing would come about! It has not yet become real income, yet we live and act as if it is almost real. We can feel it getting ready to happen. It is still in our heads, this psychic income. Yet it is in some ways real for us.

 

I get my propensity for psychic income naturally. My Less-Than-Sainted Dad lived on psychic income. He was always trying to invent something or launch a new business. He had large ups and downs, and at times we would be now classified as below the poverty line. Not that I knew that as a kid. Mostly, Dad lived in his dreams, though often alcoholic ones, of a better future, but he never gave up. In his mid-70s he was re-inventing the small printing press in his garage, with plans for national production. It was only after we had to take his car from him in his mid-80s that he quit. It was a very sad day. I now know we had not just taken his car, but far more than that: his dreams, his psychic income.

 

For some, I should note, psychic income is not just about money. It may be about the next promotion or the next big discovery. For some of us, it is just having our ideas accepted and validated in the court of human opinion. It is simply what drives us.

 

I graduated from seminary in the winter of 1974, entering the workforce in the hard year of 1975. We were coming off a recession, about which I technically knew little. I did know jobs were tight. I was unknowingly faceing another eight years of high unemployment, a tumultuous stock market, rising commodity prices, high inflation, and rising interest rates. Japan was just beginning to be a real force in the world. People were still buying bomb shelters, as Russia was a feared and powerful enemy. As the price of gold rose, there were those who told us the dollar would soon be worthless (the Fed was a problem and the deficit was out of control), and so we needed to buy yet more gold and also a year’s worth of dried food.

 

Not the best time to start a business; yet within a year or so, I ended up starting my own print brokering business, as jobs were scarce and that is what I knew. I often get letters from readers giving me grief about my rich hedge-fund friends and our fabulous wealth, and how little we relate to the real world. And for some of my rich hedge-fund friends, that may be true (although for most of my friends that is not true). And I am sadly far from rich, although I have dreams.

 

I remember waking up in the late 70s at 2 AM with a knot in my stomach, because a small bank was in trouble and had called my loan (an amount which now seems so small, but at the time it was all the money in the world). How would I make payroll? Gas and food? I know what it is like to work long hours and live on a very tight budget, with some months being behind on everything, while all the while your family is growing.

 

But I got lucky, and through a series of events got into the investment publishing field in the early ’80s, then partnered in an investment firm, and then went on my own in 1999. I stuck this letter on the internet in August of 2000, and things just took off.

 

But how many setbacks, bumpy rides, and false starts have I gone through over the decades? Frankly, I try to forget. But the point is that each of those episodes was another learning opportunity. And I woke up the next morning and started trying to figure it all out.

 

But it’s not just me, it’ is tens of millions of entrepreneurs and businessmen and women in the US, and hundreds of millions worldwide, that have the same ambitions and drive. Every night we go to sleep on our psychic income, and every day we get up and try to figure out how to turn it into real income. And some of us are talented or lucky (that would be me) enough to make it happen.

 

Long-time readers know that I think we are in the midst of a secular bear cycle, much like 1966-82. The next decade is likely to produce less than average growth, due to structural problems and the bad choices we have made with personal and government debt. I am perfectly cognizant that unemployment will be over 10% for a protracted time. That is tragic for those unemployed and underemployed. I realize the entire developed world has huge and seemingly insurmountable pension and medical obligations over the next few decades, which we cannot possibly hope to meet. The level of angst that we will live through as we adjust will not be fun.

 

But the point is, that is just what we do – we live through it. In spite of the problems, we get up every day and figure out how to make it. Would it be better if we could get our act together in (pick a country) and not be forced to adjust because we have come to the end of the line? Yes, I know we will likely have some very tumultuous times ahead of us, making business and investment decisions more than a little difficult.

 

So what? The future is never easy for all but a few of us, at least not for long. But we figure it out. And that is why in 20 years we will be better off than we are today. Each of us, all over the world, by working out our own visions of psychic income, will make the real world a better place.

 

The Millennium Wave

 

Let’s look at some changes we are likely to see over the next few decades. My view is that we have a number of waves of change getting ready to erupt on the world stage. The combination of them is what I call the Millennium Wave, the most significant period of change in human history. And one for which most of us are not yet ready.

 

Some time next year, we are going to see the three-billionth person get access to the telecosm (phones and internet, etc.). By 2015 it will be five billion people. Within ten years, most of the world will be able to access cheap (I mean really cheap) high-speed wireless broadband at connection rates that dwarf what we now have.

 

That is going to unleash a wave of creativity and new business that will be staggering. That heretofore hidden genius in Mumbai or Vladivostok or Kisangani will now have the ability to bring his ideas, talent, and energy to change the world in ways we can hardly imagine. When Isaac Watts was inventing the steam engine, there were a handful of engineers who could work with him. Now we throw a staggering number of scientists and engineers at trivial problems, let alone the really big ones.

 

And because of the internet, the advances of one person soon become known and built upon in a giant dance of collaboration. It is because of this giant dance, this unplanned group effort, that we will all figure out how to make advances in so many ways. (Of course, that is hugely disruptive to businesses that don’t adapt.)

 

Ever-faster change is what is happening in medicine. None of us in 2030 will want to go back to 2010, which will then seem as barbaric and antiquated as, say, 1975. Within a few years, it will be hard to keep up with the number of human trials of gene therapy and stem cell research. Sadly for the US, most of the tests will be done outside of our borders, but we will still benefit from the results.

 

I spend some spare study time on stem cell research. It fascinates me. We are now very close to being able to start with your skin cells and grow you a new liver (or whatever). Muscular dystrophy? There are reasons to be very encouraged.

 

Alzheimer’s disease requires somewhere between 5-7% of total US health-care costs. Defeat that and a large part of our health-care budget is fixed. And it will be first stopped and then cured. Same thing with cancers and all sorts of inflammatory diseases. There is reason to think a company may have found a generic cure for the common flu virus.

 

A whole new industry is getting ready to be born. And with it new jobs and investment opportunities.

 

Energy problems? Are we running out of oil? My bet is that in less than 20 years we won’t care. We will be driving electric cars that are far superior to what we have today in every way, from power sources that are not oil-based.

 

For whatever reason, I seem to run into people who are working on new forms of energy. They are literally working in their garages on novel new ways to produce electric power; and my venture-capital MIT PhD friend says they are for real when I introduce them. And if I know of a handful, there are undoubtably thousands of such people. Not to mention well-funded corporations and startups looking to be the next new thing. Will one or more make it? My bet is that more than one will. We will find ourselves with whole new industries as we rebuild our power grids, not to mention what this will mean for the emerging markets.

 

What about nanotech? Robotics? Artificial intelligence? Virtual reality? There are whole new industries that are waiting to be born. In 1980 there were few who saw the rise of personal computers, and even fewer who envisioned the internet. Mapping the human genome? Which we can now do for an individual for a few thousand dollars? There are hundreds of new businesses that couldn’t even exist just 20 years ago.

 

I am not sure where the new jobs will come from, but they will. Just as they did in 1975.

 

There is, however, one more reason I am optimistic. Sitting around the dinner table, I looked at my kids. I have seven kids, five of whom are adopted. I have two Korean twins, two black kids, a blond, a (sometimes) brunette, and a redhead. They range in age from 15 to 32. It is a rather unique family. My oldest black son is married to a white girl and my middle white son is with a black girl. They both have given me grandsons this year (shades of Obama!). One of my Korean daughters is married to a white young man, and the other is dating an Hispanic. And the oldest (Tiffani) is due with my first granddaughter in less than a month.

 

And the interesting thing? None of them think any of that is unusual. They accept it as normal. And when I am with their friends, they also see the world in a far different manner than my generation. (That is not to say the trash talk cannot get rather rough at the Mauldin household at times.)

 

I find great cause for optimism in that. I am not saying we are in a post-racial world. We are not. Every white man in America should have a black son. It would open your eyes to a world we do not normally see. But it is better, far better, than the world I grew up in. And it is getting still better.

 

My boys play online video games with kids from all over the world. And the kids from around the world get on the internet and see a much wider world than just their local neighborhoods.

 

Twenty years ago China was seen as a huge military threat. Now we are worried about them not buying our bonds and becoming an economic power. Niall Ferguson writes about “Chimerica” as two countries joined together in an increasingly tight bond. In 20 years, will Iran be our new best friend? I think it might be, and in much less time than that, as an increasingly young and frustrated population demands change, just as they did 30 years ago. Will it be a smooth transition? Highly unlikely. But it will happen, I think.

 

I look at my kids and their friends. Are they struggling? Sure. They can’t get enough hours, enough salaries, the jobs they want. They now have kids and mortgages. And dreams. Lots of dreams. That is cause for great optimism. It is when the dreams die that it is time to turn pessimistic.

 

I believe the world of my kids is going to be a far better world in 20 years. Will China and the emerging world be relatively better off? Probably, but who cares? Do I really begrudge the fact that someone is making their part of the world better? In absolute terms, none of my kids will want to come back to 2009, and neither will I. Most of the doom and gloom types (and they seem to be legion) project a straight-line linear future. They see no progress beyond that in their own small worlds. If you go back to 1975 and assume a linear future, the projections were not all that good. Today you can easily come up with a less-than-rosy future if you make the assumption that things in 20 years will roughly look the same as now. But that also assumes there will not be even more billions of people who now have the opportunity to dream up their own psychic income and work to make it happen.

 

We live in a world of accelerating change. Things are changing at an ever-increasing pace. The world is not linear, it is curved. And we may be at the beginning of the elbow of that curve. If you assume a linear world, you are going to make less-than-optimal choices about your future, whether it is in your job or investments or life in general.

 

In the end, life is what you make of it. With all our struggles, as we sat around the table, our family was content, just like 100 million families around the country. Are there those who are in dire distress? Homeless? Sick? Of course, and that is tragic for each of them. And those of us who are fortunate need to help those who are not.

 

We live in the most exciting times in human history. We are on the verge of remarkable changes in so many areas of our world. Yes, some of them are not going to be fun. I see the problems probably more clearly than most.

 

But am I going to just stop and say, “What’s the use? The Fed is going to make a mess of things. The government is going to run us into debts to big too deal with? We are all getting older, and the stock market is going to crash?”

 

Even the most diehard bear among us is thinking of ways to improve his personal lot, even if it is only to buy more gold and guns. We all think we can figure it out or at least try to do so. Some of us will get it right and others sadly will not. But it is the collective individual struggles for our own versions of psychic income, the dance of massive collaboration on a scale the world has never witnessed, that will make our world a better place in the next 20 years.

 

All that being said, while I am an optimist, I am a cautious and hopefully realistic optimist. I do not think the stock market compounds at 10% a year from today’s valuations. I rather doubt the Fed will figure the exact and perfect path in removing its quantitative easing. I doubt we will pursue a path of rational fiscal discipline in 2010 or sadly even by 2012, although I pray we do. I expect my taxes to be much higher in a few years.

 

But thankfully, I am not limited to only investing in the broad stock market. I have choices. I can be patient and wait for valuations to come my way. I can look for new opportunities. I can plan to make the tax burden as efficient as possible, and try and insulate myself from the volatility that is almost surely in our future – and maybe even figure out a way to prosper from it.

 

A pessimist never gets in the game. A wild-eyed optimist will suffer the slings and arrows of boom and inevitable bust. Cautious optimism is the correct and most rewarding path. And that, I hope, is what you see when you read my weekly thoughts.

 

New York and My Own Psychic Income

 

This week I go to New York to be with Todd Harrison and so many friends at the annual Festivus, put on by the folks from Minyanville. Then the theater on Saturday with Barry and Toni Habib to see Gods of Carnage. Then back home for the rest of the month, turning to book writing and waiting for my granddaughter to appear.

 

And speaking of psychic income, I remarked to some of the kids the other day that for the first time in my life I have no psychic income. There is no scheme I am working on that will change the world, no dramatic visions of grandeur. Just working on improving what we do in the best ways we can, which should be enough; but for me it is a different feeling. I worried that I was losing my edge, my drive.

 

“Dad,” said Tiffani, hopefully prophetically, “that just means the best and most exciting thing of all is actually going to happen. Finally.”

 

I love the future. It is going top be the best thing ever. Have a great week.

 

Your going to have fun on the ride analyst,

 

John Mauldin

John@FrontLineThoughts.com

 

Copyright 2009 John Mauldin. All Rights Reserved

‘THE WEAK DOLLAR WAS SUPPOSED TO FIX EVERYTHING,’ by Michael Pento , chief economist of Delta Global Advisors..

The Weak Dollar Was Supposed To Fix Everything

by Michael Pento November 24, 2009

The inflation redux plan from the Federal Reserve and Washington is based on zero interest rates, massive deficits and quantitative easing, which are designed to bring down the value of the U.S. dollar and create inflation. That is the truth, despite promises from Treasury Secretary Geithner that he really means it this time when he says the United States has a strong dollar policy – the irony being, that he says this while concurrently begging the Chinese to allow the dollar to fall vs. the Renminbi. But their hopes placed in a lower dollar are woefully misguided and all that is being accomplished is to put into place the same conditions that brought the global financial system to its knees.

 

Messrs. Geithner and Ben Bernanke have been successful in bringing down the value of our currency. In fact, many of the negative factors that were in place before the global economic meltdown occurred have returned in full force.

 

The trade deficit for September surged 18% to $36.5 billion. That gap was the largest since the beginning of 2009 and largely due to imports surging 5.8% to $168.4 billion, which was the biggest increase since 1993. The news must have been greeted with cheers in D.C. After all, the deficit would mean more dollar weakness and signaled the return of the borrowing and spending consumer. But the news also meant that the strategy of balancing trade by destroying the dollar was not based on sound economics. The U.S. dollar fell from 78.5 on the DXY to about 77 during the month of September. In fact, the U.S. dollar has lost more than 16% of its value since March of this year. If a weak dollar discouraged imports and boosted exports, then why did imports surge by the most in 16 years?

 

Sorry Ben and Tim, the so-called benefits of a falling dollar didn’t materialize as planned. That’s because the inflation you created to bring the dollar down caused the price of goods made in the United States to become more expensive. Therefore, foreign exporters couldn’t really afford to increase the purchase of American made goods even though their currencies strengthened.

 

The Treasury and the Fed have also been able to bring risk appetites back to 2007 levels. The massive increase in money printing and government guarantees has reduced credit spreads to razor-thin margins. The Libor-OIS spread measures the spread between the London interbank offered rate for dollars over three months and what traders expect the federal funds target rate will be during the term of the contract. The gap fell to 0.10 percentage point this quarter, below the 0.11 percentage point average between December 2001 and July 2007, according to Bloomberg, and substantially below the record high 3.64% in September of 2008.

 

Likewise, the Ted Spread is back to the “good old days” as well. Last November, the gap between the 3-month Treasury securities and 3-month Libor was 199 basis points. Today, it is just 21 basis points. But the mispricing of risk that helped bring the financial sector down in 2007 and 2008 is not boosting bank lending to private industry. Bank lending is plummeting for the creation of capital goods and new businesses. However, a broad measure of the money supply, Money Zero Maturity, is up 8% year-over-year. That’s because banks are lending to the U. S. government, which is the only insatiable entity for borrowing that still exists.

 

So the benefits of a crumbling currency have yet to materialize. However, the ravages of pursuing such a flawed policy have started to arrive. The price of oil has soared and gold is setting new highs every day. Credit spreads are indicating that investors are mispricing risk yet again and the ballooning trade deficit indicates that we once again believe we can consume much more than we produce.

 

The stock market is dancing on top of a $2 trillion monetary base and that latent liquidity has sent commodities higher, while the dollar sinks. My guess is that Wall Street and Washington believes things are getting much better. But I’ve seen this movie already and I don’t like how it ends. As the prints on the consumer price index (CPI) become more and more difficult to ignore, the Fed will be forced to remove the life support provided by their free money policy. When that occurs, we will see the return of economic calamity. And maybe then we will have the courage to finally face and deal with the true problem. News flash to D.C. and Wall Street: It is not the misperception of an overvalued dollar, but rather it is our overriding debt.

 

Michael Pento is chief economist of Delta Global Advisors.

‘YIELD MATTERS. AND WHERE IT COMES FROM,’ in the Wall St. Journal via fidelity.com.

Yield matters. Not that you’d necessarily know it from where some markets are trading.

For instance, at one point last week, U.S. short-dated Treasury bills were said to have had a negative yield. That’s to say, investors were paying the U.S. government to hold its paper.

And 10-year U.S. Treasury notes are yielding just over 3.3% — exactly the average U.S. inflation rate of the past century. In other words, the expected real return of longish-dated U.S. government paper is broadly the actual return of short-dated U.S. government paper. Which is nothing.

Investors have lately been chasing gold, which is another asset with a negative yield (no earnings, but you’ve got to pay to store the stuff).

OK, so there’s a bit on offer from equities. The S&P 500 index  returns 2.4%. That’s a little more than a percentage point more than equities returned during the peak of the tech and telecom bubble. Yipee. But then again, share buybacks also returned about another percentage point back then, and you don’t hear of too many firms spending their recently hard-accumulated cash on something as silly as shares, do you? So the actual percentage payout to shareholders probably isn’t so different from where it was in the craziest of the go-go days. Not so yipee.

You get a little more return from corporate credit, particularly high-yielding paper, and from emerging markets, but even here the spreads have narrowed considerably since the spring. On the other hand, you could also argue that the additional bits of yield are hardly compensation for historic volatility — never mind the market gyrations of the past couple of years.

Indeed, that’s why yield matters. In a world where wildly fluctuating capital values are the norm, investors would do well to look for a safe source of income. Throw in the risk that trend growth will be considerably lower than it has been in this brave new world of massive government, heavy regulation, deleveraging and general consumer uncertainty and the potential sources of that income shrink.

Bill Gross, head of the giant bond fund Pimco, and Warren Buffett of Berkshire Hathaway  have identified utilities as the best source of that guaranteed flow. They yield two to three times more than the overall market index. And if the upside is strictly limited by regulators, it’s also true their returns are as guaranteed as anything in these crazy markets.

Yield matters. And so does the source of that yield.

‘AUDIT WOULD HURT THE FED: BERNANKE, ‘ by Reuters at fidelity.com.

By Mark Felsenthal

WASHINGTON (Reuters) – Federal Reserve Chairman Ben Bernanke said on Friday congressional proposals to audit the Fed and strip it of regulatory powers as part of post-crisis reforms could damage prospects for economic and financial health in the future.

“These measures are very much out of step with the global consensus on the appropriate role of central banks, and they would seriously impair the prospects for economic and financial stability in the United States,” Bernanke wrote in a column posted on the Washington Post’s website.

The rare newspaper column by a Fed chairman comes shortly before Bernanke testifies before a Senate panel on his renomination to serve a second four-year term at the helm of the central bank and answers a series of steps on Capitol Hill that could diminish the central bank’s role.

Lawmakers are angry with the Fed over its emergency bailouts of major financial firms and its failure to prevent the contagion of mortgage delinquencies that crashed the financial system. A proposal to audit the Fed’s monetary policy deliberations won a committee vote recently over the objections of House Financial Services Committee Chairman Barney Frank.

Frank’s Senate counterpart, Banking Committee Chairman Christopher Dodd, is himself the author of a proposal to consign the Fed solely to making decisions about setting benchmark interest rates.

Bernanke, in his column, conceded the Fed had missed some of the riskiest behavior in the lead up to the crisis. But he said the Fed had helped avoid an even more damaging economic meltdown and has stepped up its policing of the financial system.

“The Fed played a major part in arresting the crisis, and we should be seeking to preserve, not degrade, the institution’s ability to foster financial stability and to promote economic recovery without inflation,” he said.

Bernanke acknowledged that lawmakers are responding to public anger over the government’s response to the turmoil.

“The Federal Reserve, like other regulators around the world, did not do all that it could have to constrain excessive risk-taking in the financial sector in the period leading up to the crisis,” he said.

However, the central bank has moved “aggressively” to fix the problems, Bernanke said. The Fed’s knowledge of complex financial institutions is invaluable in supervising them, he said.

The Fed’s ability to slash interest rates to combat a recession without fueling inflation depends on its political independence he said. Allowing audits of its monetary policy — as proposed legislation would do — would increase the perceived influence of Congress on interest rate decisions, he said.

That, in turn “would undermine the confidence the public and the markets have in the Fed to act in the long-term economic interest of the nation,” Bernanke wrote.

Frank has said the audit provision is likely to be revisited as legislation winds through both houses of Congress.

Dodd has said his proposal is a starting point for debate.

‘TAXING THE SPECULATORS,’ by Paul Krugman in the N.Y.Times.

Should we use taxes to deter financial speculation? Yes, say top British officials, who oversee the City of London, one of the world’s two great banking centers. Other European governments agree — and they’re right.

Unfortunately, United States officials — especially Timothy Geithner, the Treasury secretary — are dead set against the proposal. Let’s hope they reconsider: a financial transactions tax is an idea whose time has come.

 

The dispute began back in August, when Adair Turner, Britain’s top financial regulator, called for a tax on financial transactions as a way to discourage “socially useless” activities. Gordon Brown, the British prime minister, picked up on his proposal, which he presented at the Group of 20 meeting of leading economies this month.

 

Why is this a good idea? The Turner-Brown proposal is a modern version of an idea originally floated in 1972 by the late James Tobin, the Nobel-winning Yale economist. Tobin argued that currency speculation — money moving internationally to bet on fluctuations in exchange rates — was having a disruptive effect on the world economy. To reduce these disruptions, he called for a small tax on every exchange of currencies.

 

Such a tax would be a trivial expense for people engaged in foreign trade or long-term investment; but it would be a major disincentive for people trying to make a fast buck (or euro, or yen) by outguessing the markets over the course of a few days or weeks. It would, as Tobin said, “throw some sand in the well-greased wheels” of speculation.

 

Tobin’s idea went nowhere at the time. Later, much to his dismay, it became a favorite hobbyhorse of the anti-globalization left. But the Turner-Brown proposal, which would apply a “Tobin tax” to all financial transactions — not just those involving foreign currency — is very much in Tobin’s spirit. It would be a trivial expense for long-term investors, but it would deter much of the churning that now takes place in our hyperactive financial markets.

 

This would be a bad thing if financial hyperactivity were productive. But after the debacle of the past two years, there’s broad agreement — I’m tempted to say, agreement on the part of almost everyone not on the financial industry’s payroll — with Mr. Turner’s assertion that a lot of what Wall Street and the City do is “socially useless.” And a transactions tax could generate substantial revenue, helping alleviate fears about government deficits. What’s not to like?

 

The main argument made by opponents of a financial transactions tax is that it would be unworkable, because traders would find ways to avoid it. Some also argue that it wouldn’t do anything to deter the socially damaging behavior that caused our current crisis. But neither claim stands up to scrutiny.

 

On the claim that financial transactions can’t be taxed: modern trading is a highly centralized affair. Take, for example, Tobin’s original proposal to tax foreign exchange trades. How can you do this, when currency traders are located all over the world? The answer is, while traders are all over the place, a majority of their transactions are settled — i.e., payment is made — at a single London-based institution. This centralization keeps the cost of transactions low, which is what makes the huge volume of wheeling and dealing possible. It also, however, makes these transactions relatively easy to identify and tax.

 

What about the claim that a financial transactions tax doesn’t address the real problem? It’s true that a transactions tax wouldn’t have stopped lenders from making bad loans, or gullible investors from buying toxic waste backed by those loans.

 

But bad investments aren’t the whole story of the crisis. What turned those bad investments into catastrophe was the financial system’s excessive reliance on short-term money.

 

As Gary Gorton and Andrew Metrick of Yale have shown, by 2007 the United States banking system had become crucially dependent on “repo” transactions, in which financial institutions sell assets to investors while promising to buy them back after a short period — often a single day. Losses in subprime and other assets triggered a banking crisis because they undermined this system — there was a “run on repo.”

 

And a financial transactions tax, by discouraging reliance on ultra-short-run financing, would have made such a run much less likely. So contrary to what the skeptics say, such a tax would have helped prevent the current crisis — and could help us avoid a future replay.

 

Would a Tobin tax solve all our problems? Of course not. But it could be part of the process of shrinking our bloated financial sector. On this, as on other issues, the Obama administration needs to free its mind from Wall Street’s thrall.

 

‘WHAT ARE THE DOLLAR AND GOLD TELLING US?, ‘ from director of research at Fidelity.

The rally in gold and the related decline in the dollar have been hard to miss these past few months. What is this telling us about monetary and fiscal policy, and what might an investor do?

 

The Federal Reserve (Fed) has an incredibly tough job these days. It deserves credit for helping prevent a second Great Depression a year ago, which it did by not only lowering short-term interest rates to near zero but also by expanding the monetary base. But now comes the even harder part: What is the exit strategy? Withdraw the stimulus too soon and the Fed risks triggering another economic relapse, but withdraw too slowly and it risks raising inflationary expectations, not to mention renewed asset bubbles. It’s like threading a needle.

 

Complicating matters even further is that the same thing is playing out on the fiscal side. Congress responded to the crisis with a huge dose of fiscal stimulus. But when does it stop the cycle of deficit spending? How many years of trillion-dollar deficits will our foreign creditors tolerate? Is the United States inflating its way out of trouble by printing money and debasing its currency, as so many countries have unsuccessfully tried to do throughout history?

 

These are difficult questions indeed, and there are no clear answers right now. This is why gold is rallying and the dollar is declining: they smell a policy error.

 

Lessons from the Great Depression

To help understand the choices the Fed is facing, it’s instructive to take a page from past crises, especially the Great Depression. Doing so is especially relevant because Fed Chairman Ben Bernanke is known to be a student of that period in our country’s history. So, if his decisions at the Fed are influenced by what he has learned from the Great Depression, then it’s important for us to know about it as well.

 

The Great Depression was actually two depressions. It started with World War 1, which essentially bankrupted Europe in the 1920s. Via the Fed, the U.S. lent a helping hand by extending easy money to Europe from around 1925 to 1927. However, in a classic example of the “laws of unintended consequences,” some of this easy money ended up in our own stock market, thus contributing to the massive bubble that burst in 1929. This episode shows that the concept of “moral hazard” is not new. It existed as far back as the 1920s.

 

When the bubble burst in 1929, it unleashed a wave of deflationary debt deleveraging onto the U.S. economy, much like that which occurred in 2008 after the housing bubble burst. However, during the 1930s the Fed was on the gold standard, which made it impossible to just open up the liquidity spigot like it did last year. In fact, the gold standard acted somewhat like a straight jacket and the Fed actually raised rates for a while, which is obviously the last thing one should be doing during an economic crisis. This policy error undoubtedly contributed to the 87% blood bath in stocks from 1929 to 1932.

 

Bernanke knows this well, which is probably why he responded with such overwhelming force in the fall of 2008 following the collapse of Lehman. Not only did the Fed lower rates to zero, but it expanded the monetary base. We call this “quantitative easing” or, more simply, “printing money.”

 

The idea behind quantitative easing is that the Fed creates (out of thin air) excess banking reserves. These reserves end up on the balance sheet of banks, which are then supposed to lend out these new reserves to consumers and businesses. That triggers what is known as the money multiplier, which then expands the money supply and brings the economy back to life, and creates inflation (which under these circumstances is a desired outcome).

 

The problem in the early 1930s was that the gold standard prevented the Fed from doing this, until Franklin D. Roosevelt (FDR) came into power in 1933. FDR realized that the gold standard was limiting his ability to respond to the crisis, and in April of 1933 he changed it. He did this by making it illegal to own gold. Holders of gold had to turn in their bullion, receiving the stated conversion price of $20/oz. FDR then changed the conversion price to $35/oz., and with the stroke of a pen he increased the money supply and devalued the dollar at the same time. That was the catalyst for a 150% rally in the stock market and several years of very strong economic growth.

 

Today the Fed doesn’t need to worry about the gold standard. While that gives the Fed more freedom to expand its balance sheet and print money, it also has a consequence. The dollar can go down in value, which is of course what is happening now. And when the dollar goes down, gold goes up. After all, gold is the ultimate currency because unlike a fiat (paper) currency, it is not someone else’s liability. Consequently, it may be useful to view gold less as an inflation barometer and more as a hard currency. This is especially the case because other countries are doing the exact same thing in terms of monetary and fiscal policy.

 

Inflation or deflation?

So here we are with the printing presses running at full speed. Is that inflationary? Not necessarily, or at least not yet. Printing money is only inflationary if the banks end up lending it out via the above mentioned money multiplier. That isn’t happening right now. This is a liquidity trap, because banks haven’t been increasing their lending. As long as we are stuck with this liquidity trap, the velocity of money will stay low and the risk of deflation will outweigh the risk of inflation.

 

What if the banks do start lending out some of these excess reserves at some point? After all, that is what banks are supposed to do for a living. If and when that happens, the money multiplier will start multiplying, which could set the stage for both growth and inflation. At that point, it will be important for the Fed to start withdrawing some of this unprecedented stimulus.

 

To give you a sense of just how high the stakes are, the chart below shows declines in GDP in the bottom panel and the monetary policy response in the top panel. The latter is defined as the ratio of excess banking reserves to required banking reserves (as a proxy for how fast the printing presses are running).

 

 

 

 

Take a look at the left side and then at the right side of the chart. There is no question that the current degree of policy response relative to the decline in the economy is far greater than that which occurred during the 1930s. Whether the current policy response is excessive or necessary is beside the point right now. The question: How do we get out of this when the time comes?

 

Gold and dollar are on the move because some investors are wondering whether or not the Fed has the willingness or ability to exit qualitative easing at just the right time and by the right amount. It’s not so much an issue of inflation, as an issue of confidence in our policy makers. In a way, gold is providing a hedge against mismanagement in Washington.

 

If the Fed is able to thread that needle when the time comes, and that’s a big “if,” then the run-up in gold and the corresponding decline in the dollar could reverse very quickly. If that happens, the dramatic rally in gold will be seen as nothing more than a one-off bubble.

 

But if the Fed finds itself unable or unwilling to exit when the time comes, especially if at the same time Congress continues to run massive deficits, then the moves in gold and the dollar could still have a long way to go.

 

What’s an investor to do?

So how do you play this potentially binary outcome?

 

The immediate impulse might be to buy gold, either physical gold or a gold mutual fund or exchange-traded fund exchange-traded fund (ETF). If you believe we’re headed for a fiscal train wreck, then allocating a small portion to a well-diversified portfolio may make sense. But what if the Fed pulls it off? Then gold could come crashing down. A tough call indeed.

 

Another option might be to allocate a small portion of your portfolio to stocks and bonds of emerging market countries (like China and India) and natural resource-rich countries (like Brazil, Canada, and Australia). This might buy you two things: geographic and currency diversification. As the dollar falls, the appreciation of foreign currencies can provide an extra boost in return to U.S. investors. That’s because foreign securities are worth more when translated back to dollars.

 

‘ NO EXIT,’ by Paul Krugman at The Conscience of a Liberal at the N.Y. Times. Even the Fed expects the recovery to be years and years away. CONTINUE TO HUNKER DOWN.

November 25, 2009, 8:51 AM

No exit

The latest Fed minutes, together with the forecast, are out. What do they tell us?

Well, the Fed expects unemployment to come down only very gradually — over 9 percent at the end of 2010, over 8 percent at the end of 2011, around 7 percent at the end of 2012. Inflation, meanwhile is expected to remain consistently below the Fed’s target.

Which raises the question, why is anyone talking about an “exit strategy”? On the Fed’s own forecasts, the economy will remain seriously depressed three years from now.

If we apply the Rudebusch version of the Taylor rule to the mean Fed forecasts, I get the following for what the Fed funds rate should be:

End 2009: -6.3%

End 2010: -5.4%

End 2011: -3.3%

End 2012: -0.6%

Yep: three years from now, we’re still in a liquidity trap, with no reason to raise rates above zero and a continuing need for quantitative easing and fiscal expansion.

As far as I can tell, what’s going on in monetary policy debate is a policy in search of a justification. Many central bankers just hate, absolutely hate, being in the position of being so accommodating; yet economic analysis offers no justification for tightening. So they’re inventing new policy doctrines on the fly to justify doing what they want to do.

It’s a familiar story: see Japan’s premature exit from the ZIRP in 2000, and also see 1937 — which was a monetary as well as fiscal bungle.

The truth is that policy should be piling on, not looking for the exit. But central bankers can’t wait to pull away the punchbowl, even though the party hasn’t started, and shows no signs of starting for years to come.

‘HOW BIG IS TOO BIG? ,’ by Peter Boone & Simon Johnson at Economix.com.

How Big Is Too Big?

By PETER BOONE AND SIMON JOHNSON

Peter Boone is chairman of the charity Effective Intervention, a research associate at the London School of Economics’ Center for Economic Performance, and a principal in Salute Capital Management Ltd.  Simon Johnson, a senior fellow at the Peterson Institute for International Economic, is the former chief economist at the International Monetary Fund.

As legislation on restructuring the banking industry moves forward, attention on Capitol Hill is increasingly drawn to the issue of bank size. Should our biggest banks be made smaller?

Senator Bernard Sanders, an independent from Vermont, introduced the “Too Big To Fail Is Too Big to Exist” bill in early November; this helped focus attention. Since then, in the legislative trenches where the detailed crafting takes place, Representative Paul E. Kanjorski — the Pennsylvania Democrat who is chairman of the Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises — proposed an amendment to the Financial Stability Improvement Act (currently before the House Financial Services Committee) that

would empower federal regulators to rein in and dismantle financial firms that are so large, inter-connected, or risky that their collapse would put at risk the entire American economic system, even if those firms currently appear to be well-capitalized and healthy.

In a major step forward, this passed the committee on Nov. 18.

The Kanjorski amendment recognizes that the systemic and societal danger posed by banks can be hard to recognize, and it proposes a number of potential objective criteria that could be used by the Financial Services Oversight Council (to be created by legislation in progress) to determine when banks need to be broken up, including the “scope, scale, exposure, leverage, interconnectedness of financial activities, as well as size of the financial company.”

The Kanjorski amendment does not impose a hard size cap on banks, but lawmakers in the House are discussing amendments that would do so.

There is, of course, a strong precedent for capping the size of an individual bank: The United States already has a long-standing rule that no bank can have more than 10 percent of total national retail deposits.

This limitation is not for antitrust reasons, as 10 percent is too low to have pricing power. Rather, its origins lie in early worries about what is now called “macroprudential regulation” or, more bluntly, “don’t put too many eggs in one basket.”

This cap was set at an arbitrary level — as part of the deal that relaxed most of the rules on interstate banking — and it worked well (until Bank of America received a waiver).

Probably the best way forward is to set a hard cap on bank liabilities as a percent of gross domestic product; this is the appropriate scale for thinking about potential bank failures and the cost they can impose on the economy.

Of course, there are technical details to work out — including how the new risk-adjustment rules will be enacted and the precise way that derivatives positions will be regarded in terms of affecting size. But such a hard cap would the benchmark around which all the specifics can be worked out.

What is the right number: 1 percent, 2 percent, or 5 percent of G.D.P.? No one can say for sure, but it needs to be a number so small that we all agree any politician who cares about our future would have no qualm letting it fail, and when doing so have confidence that our entire financial system is not at risk as it fails.

So to us, 2 percent of G.D.P. seems about right. This would mean every bank in our country would have no more than about $300 billion of liabilities.

A large American corporation would still be able to do all its transactions using several banks. They would even be better off — competition would ensure that margins are low and the banks give the corporates a good deal. This would help end the situation where banks take an ever-increasing share of profits from our successful nonfinancial corporations (as seen in the rising share of bank value added in G.D.P. in recent decades).

Indeed, the whole world would soon realize that our banks are more competitive and offer better pricing than others.

If, as might occur, the Europeans subsidized their big banks with cheap finance and implicit subsidies, we should let our nonfinancial corporates benefit and understand that our banks may become ever smaller. We can let Europeans subsidize banking because we all get better deals through their taxpayer subsidies, and then our corporates will have more profits to bring back to America.

Today our politicians and regulators lack credibility. They have bailed out too many banks and need to show they have truly regained the upper hand — by showing that they are installing such a hard size cap rule without exception.

The litmus test is simple.

Does Goldman Sachs continue to grow, and continue to be regarded as almost as good a risk as the United States government (Goldman’s Credit Default Swap spread is only 70 basis points above that of the United States today), because it has demonstrated it is too big to fail? Or, will the government impose a cap on the size of such institutions and require Goldman Sachs to find sensible ways to break itself into pieces – becoming small enough so that it will not be bailed out again next time?

We’ll see. Indeed, by midterm elections, we will have an opportunity to decide. Is the Obama administration in favor of the status quo or, by November 2010 will they have sent a message that “too big to fail” has become “fail if you remain too big”?

‘ARE THE DOLLAR BEARS TOO BULLISH?, ‘ in Barron’s via fidelity.com.

BY RANDALL FORSYTH, BARRON’S — 11/24/09 It would be so simple to follow the playbook of the inflationary 1970s. Today’s deflationary threat is more dangerous, however. Gold set another record Monday while the Dow Jones Industrial Average (.DJI Loading… ) gained 1% to a 13-month high, supposedly based on the cheery thought that the U.S. dollar would inevitably collapse to zero. Investors faced a barrage of bearish articles about America’s fiscal plight, from the front page of the New York Times warning about “Wave of Debt Payments Facing U.S. Government” to the Economist’s cover story, “Dealing with America’s Fiscal Hole” to the Financial Times posing the question, “Is Sovereign Debt the New Subprime?” No wonder they wanted to flee the dollar. As Dennis Gartman observed in his Monday morning missive: “It is almost as if one can hear capital saying aloud, ‘Let me outta here; get me some gold; or get me some euros, at least get me some blue-chip stocks. Get me anything, but get me out.’” With the U.S. Dollar Index falling another 0.7%, to 75.10, gold continued its seemingly unstoppable advance to another peak. The active December futures contract on the Comex settled up $17.90, at $1,164.70 an ounce after trading at almost $1,175. And as if to underscore the public’s interest in the latest gold rush, the five most-read stories on Marketwatch.com were all about gold. (Marketwatch is owned by News Corp. (NWS Loading… ), which also is the publisher of Barrons.com.) There’s no disputing that America’s budget mess poses a long-term threat to the dollar, more so than the Federal Reserve’s low-interest-rate policies. That was pointed out here just last week (“A Foolish View of America’s Debt”, Nov. 18.) So far, however, there seems no shortage of buyers for the U.S. government’s debt, including Monday’s record auction of $44 billion of two-year notes, which will be followed by $42 billion of five-year notes Wednesday and $32 billion of seven-year notes. That would contradict the notion of an imminent rerun of “That Seventies Show”, featuring soaring interest rates and inflation. That is, after all, what sent gold to its then-record of $850 in January 1980, the final year of that benighted decade. (And by the way, notwithstanding all the recently published assessments of this decade, it doesn’t end until Dec. 31, 2010.) Would that we could have that rerun? We’d all have the playbook on how to deal with those travails. Don’t buy any Pintos, avoid polyester and burn disco records. Just buy gold, dump bonds, borrow and borrow and buy the biggest house you can afford. Maybe the last one didn’t turn out so well. Indeed, Albert Edwards, Societe Generale’s global strategist, sees the risks running quite the opposite of the consensus, which has a global recovery on track with a steadily falling dollar. Instead, he looks for a double-dip back into recession leading to a surging greenback, with a collapse of “the China economic bubble” resulting in a double whammy for commodity prices. Writing in his latest Global Strategy Letter, Edwards points to signs of doubts about the U.S. economic recovery, from the labor market remaining “very sick” with the uptick in unemployment rate over 10% plus the Conference Board’s consumer finding showing jobs getting still harder to get. Meanwhile, the ECRI Leading Indicator, which trumpeted recovery earlier in the year, has fallen for five straight weeks. But what’s way out of the consensus is the call for China’s massive trade surplus to turn to deficit by Societe Generale’s Asian economist, Glenn Maguire, who Edwards writes has been “very right on China this year.” “This is a mega-call and will have major implications for the global financial markets,” Edwards declares. China no longer will be accumulating currency reserves at nearly the same pace, leaving less to recycle into U.S. Treasuries. The reduced capital inflow would also slow China’s domestic monetary growth and real output, which track each other. Meanwhile, capital outflows from Japan, another source of global liquidity, could be hampered were there a sharp rise in its government bond yields. A synchronized end to the Chinese and U.S. economic recoveries could play out in increased protectionist pressures, including competitive devaluations, Edwards continues. That could lead to a spike in the dollar as speculative carry trades are unwound, as happened to the yen in 2008. A rise in the dollar would pull up the renminbi, which “may be all too much for a beleaguered Chinese economy.” Then, Edwards says, the U.S. goal of delinking of the RMB from the dollar would be accomplished — with China devaluing rather than revaluing its currency higher. Edwards adds, “I am reassured that my views are not totally bananas when two of the deepest thinkers are also concerned about a Chinese economic crash.” Those include Edward Chancellor, who has written extensively about bubbles, including “The Devil Take the Hindmost: A History of Financial Speculation,” and recently observed the Chinese economy shows symptoms of weakness similar to those after the Greenspan Fed reflated following the bursting of the tech bubble. Meanwhile, Jim Chanos, the famed short seller of Kynikos Associates, thinks he spies manipulated data about China’s economy. Chanos, it should be remembered, sniffed out the phony accounting at Enron. The sort of deflationary crisis, resulting in competitive devaluations, protectionism and contracting world trade, recalls what happened in the 1930s, Edwards concludes. Despite politicians’ solemn vows not to repeat those blunders, “all I see are more and more protectionist measures being implemented, belying the soothing rhetoric.” The 1930s were indeed very different from the 1970s. In the latter decade, you could just buy gold (though that was more difficult before today’s exchange-traded funds) and let your cash earn double-digit yields. The falling dollar battered stocks and especially bonds back then. Now, cash yields absolute zero but stocks benefit from every drop in the dollar while global investors continue to buy Treasuries, seemingly undeterred by the greenback’s steady slide. But recall a year ago; the dollar soared like the yen with the unwinding of carry trades (which involve the borrowing in those low-yielding currBY RANDALL FORSYTH, BARRON’S — 11/24/09 It would be so simple to follow the playbook of the inflationary 1970s. Today’s deflationary threat is more dangerous, however. Gold set another record Monday while the Dow Jones Industrial Average (.DJI Loading… ) gained 1% to a 13-month high, supposedly based on the cheery thought that the U.S. dollar would inevitably collapse to zero. Investors faced a barrage of bearish articles about America’s fiscal plight, from the front page of the New York Times warning about “Wave of Debt Payments Facing U.S. Government” to the Economist’s cover story, “Dealing with America’s Fiscal Hole” to the Financial Times posing the question, “Is Sovereign Debt the New Subprime?” No wonder they wanted to flee the dollar. As Dennis Gartman observed in his Monday morning missive: “It is almost as if one can hear capital saying aloud, ‘Let me outta here; get me some gold; or get me some euros, at least get me some blue-chip stocks. Get me anything, but get me out.’” With the U.S. Dollar Index falling another 0.7%, to 75.10, gold continued its seemingly unstoppable advance to another peak. The active December futures contract on the Comex settled up $17.90, at $1,164.70 an ounce after trading at almost $1,175. And as if to underscore the public’s interest in the latest gold rush, the five most-read stories on Marketwatch.com were all about gold. (Marketwatch is owned by News Corp. (NWS Loading… ), which also is the publisher of Barrons.com.) There’s no disputing that America’s budget mess poses a long-term threat to the dollar, more so than the Federal Reserve’s low-interest-rate policies. That was pointed out here just last week (“A Foolish View of America’s Debt”, Nov. 18.) So far, however, there seems no shortage of buyers for the U.S. government’s debt, including Monday’s record auction of $44 billion of two-year notes, which will be followed by $42 billion of five-year notes Wednesday and $32 billion of seven-year notes. That would contradict the notion of an imminent rerun of “That Seventies Show”, featuring soaring interest rates and inflation. That is, after all, what sent gold to its then-record of $850 in January 1980, the final year of that benighted decade. (And by the way, notwithstanding all the recently published assessments of this decade, it doesn’t end until Dec. 31, 2010.) Would that we could have that rerun? We’d all have the playbook on how to deal with those travails. Don’t buy any Pintos, avoid polyester and burn disco records. Just buy gold, dump bonds, borrow and borrow and buy the biggest house you can afford. Maybe the last one didn’t turn out so well. Indeed, Albert Edwards, Societe Generale’s global strategist, sees the risks running quite the opposite of the consensus, which has a global recovery on track with a steadily falling dollar. Instead, he looks for a double-dip back into recession leading to a surging greenback, with a collapse of “the China economic bubble” resulting in a double whammy for commodity prices. Writing in his latest Global Strategy Letter, Edwards points to signs of doubts about the U.S. economic recovery, from the labor market remaining “very sick” with the uptick in unemployment rate over 10% plus the Conference Board’s consumer finding showing jobs getting still harder to get. Meanwhile, the ECRI Leading Indicator, which trumpeted recovery earlier in the year, has fallen for five straight weeks. But what’s way out of the consensus is the call for China’s massive trade surplus to turn to deficit by Societe Generale’s Asian economist, Glenn Maguire, who Edwards writes has been “very right on China this year.” “This is a mega-call and will have major implications for the global financial markets,” Edwards declares. China no longer will be accumulating currency reserves at nearly the same pace, leaving less to recycle into U.S. Treasuries. The reduced capital inflow would also slow China’s domestic monetary growth and real output, which track each other. Meanwhile, capital outflows from Japan, another source of global liquidity, could be hampered were there a sharp rise in its government bond yields. A synchronized end to the Chinese and U.S. economic recoveries could play out in increased protectionist pressures, including competitive devaluations, Edwards continues. That could lead to a spike in the dollar as speculative carry trades are unwound, as happened to the yen in 2008. A rise in the dollar would pull up the renminbi, which “may be all too much for a beleaguered Chinese economy.” Then, Edwards says, the U.S. goal of delinking of the RMB from the dollar would be accomplished — with China devaluing rather than revaluing its currency higher. Edwards adds, “I am reassured that my views are not totally bananas when two of the deepest thinkers are also concerned about a Chinese economic crash.” Those include Edward Chancellor, who has written extensively about bubbles, including “The Devil Take the Hindmost: A History of Financial Speculation,” and recently observed the Chinese economy shows symptoms of weakness similar to those after the Greenspan Fed reflated following the bursting of the tech bubble. Meanwhile, Jim Chanos, the famed short seller of Kynikos Associates, thinks he spies manipulated data about China’s economy. Chanos, it should be remembered, sniffed out the phony accounting at Enron. The sort of deflationary crisis, resulting in competitive devaluations, protectionism and contracting world trade, recalls what happened in the 1930s, Edwards concludes. Despite politicians’ solemn vows not to repeat those blunders, “all I see are more and more protectionist measures being implemented, belying the soothing rhetoric.” The 1930s were indeed very different from the 1970s. In the latter decade, you could just buy gold (though that was more difficult before today’s exchange-traded funds) and let your cash earn double-digit yields. The falling dollar battered stocks and especially bonds back then. Now, cash yields absolute zero but stocks benefit from every drop in the dollar while global investors continue to buy Treasuries, seemingly undeterred by the greenback’s steady slide. But recall a year ago; the dollar soared like the yen with the unwinding of carry trades (which involve the borrowing in those low-yielding currencies) as stocks and other risk assets fell sharply. Such a rerun seems to be the one potential risk that seems ignored as gold gets bid giddily higher — a significantly more painful deflationary squeeze than the inflationary surge they see. Copyright © 2009 Dow Jones & Company, Inc. All Rights Reserved.encies) as stocks and other risk assets fell sharply. Such a rerun seems to be the one potential risk that seems ignored as gold gets bid giddily higher — a significantly more painful deflationary squeeze than the inflationary surge they see. Copyright © 2009 Dow Jones & Company, Inc. All Rights Reserved.

‘MORGAN STANLEY SPEAKS: AGAINST RELYING ON CAPITAL REQUIREMENTS,’ by Simon Johnson at baselinescenario .com.

 

Morgan Stanley Speaks: Against Relying On Capital Requirements

 

Just when momentum was starting to build for increased capital requirements as the core element of an approach that will reign in reckless risk-taking, Morgan Stanley effectively demolishes the idea.

 

In “Banking – Large & Midcap Banks: Bid for Growth Caps Capital Ask,” (no public link available) Betsy Graseck, Ken Zorbo, Justin Kwon, and John Dunn of Morgan Stanley Research North America dissect the coming demands for more bank capital.

 

“In short, we think the demand for growth and access to credit will trump desire for unprofitable capital levels…

 

For the large cap and midcap banks, we expect normalized median common tier-1 ratios to come in at 8.4% and 10.0% respectively.”

 

That’s less capital than Lehman had just before it failed – 11 percent.  (If you doubt this, read the transcript of the final Lehman conference call – link is in this NYT.com piece or try this direct link; see p.7, for example)

 

The Morgan Stanley logic is strong, up to a point – they are carefully anticipating the likely outcome of the national and G20 regulatory process that will address capital standards in detail over the next two years.  This research report also makes explicit a great deal of the current thinking on Wall Street and explains much – including the attitude towards bonuses.

 

“Banks need and investors require banks to earn a positive return over their cost of equity to fund them…

 

These capital levels [8.4% and 10%]  driven median ROE [return on equity] estimates of 13.7% and 12.0%, sufficiently over normalized cost of equity of 9-12% to attract investors.”

 

In other words, if you don’t allow banks to leverage (the flip side of keeping capital low), they won’t be able to attract investors and won’t be able to make loans – so you’ll get less growth and fewer jobs.

 

This may sound like blackmail but it is not – this is the economics of banking, with spin.  And just to make sure you get their bigger point, Morgan Stanley drives it home:

 

“Contrary to perceptions about [Sheila] Bair’s statements, we do not think there is any willingness to remove implicit support [for big banks].  In particular, we expect the discount window is unquestioned for banks, and TLGP [Temporary Liquidity Guarantee Program] type programs could exist in future crises.  Regulators recognize the need for banks to make returns high enough to attract capital.”

 

And in case you are wondering about the talking points they give their lobbyists and now press upon the White House,

 

“Even with appropriate leverage, the taxpayer has occasionally paid for the benefit of growth when financial shocks occurred.  Repayment comes with subsequent growth.”

 

The bottom line, translated: let us adjust our balance sheets (downwards to some degree) and continue with our existing business models (including unconstrained bonuses), and we will bring you back to growth eventually.  If you mess with us, unemployment will stay high for a long time.  And any future crises that may befall us are just a cost of doing business, and making us whole is just what you have to do.

 

But this is all wrong.  The essential premise of the Morgan Stanley reasoning (heard much more widely on Wall Street) is that the size of our biggest banks cannot be constrained – because it would raise the cost of equity for these smaller units.  This misses three points:

 

If you are sufficiently small, you can take more risk without jeopardizing the system.  So the expected risk/return combination can attract investors and be fine for society.  Most successful venture capital funds, hedge funds, and private equity funds are in the right size range from this perspectives and don’t have trouble attracting capital – except when the big banks blow up.  As long as you are small enough to fail, go for it.

Morgan Stanley’s pricing of risk model implicitly assumes that big banks still exist as a comparison point and an alternative for investors.  But if you put a size cap on the largest banks (e.g., assets cannot exceed 1% of GDP), this defines the asset class available – so investors don’t choose small vs. medium vs. large; they choose small vs. medium.  Yes, this removes a choice for investors, but we routinely constrain investors ability to put money into activities that are potentially dangerous for society (e.g., try proposing a “new” high risk/high return approach to nuclear power).

There will always be financial shocks, but these do not always need to have such devastating effects.  Our financial system worked fine in the post-World War II period, with a great deal of risk-taking and much nonfinancial innovation – our biggest banks were much smaller, in absolute terms and relative to the economy.  The notion of “let us take any risks we want and, if it all goes bad, bail us out so we can make it up to you later” is simply preposterous and completely at odds with the historical record of US economic development.

The big banks’ bonuses undermine their legitimacy.  Every time these banks CEOs speak or write in public, they just underline their hubris and the danger this poses to financial system stability.  And their own research strengthens the case for breaking up the megabanks.

 

By Simon Johnson

‘WANTED: ICONOCLASTS,’ by Martin Hutchinson at prudentbear.com. An interesting take on things to come.

Wanted: Iconoclasts

by Martin Hutchinson November 23, 2009

The publicity and vituperation around the book tour of a middling ex-governor of Alaska seems to have nothing to do with Sarah Palin’s politics, which judging from her term in office are unexceptional and only center-right. The heat derives from her style, which is that of an iconoclast outsider, and from the establishment’s fear that iconoclasm may be the wave of the future. Economically, their fears may be justified, whatever Palin’s future career plans.

 

Historically, iconoclasm was an 8th-century Byzantine movement in opposition to the religious icons central to Orthodox worship. By smashing icons, the iconoclasts hoped to restore the purity of the Church and focus religious belief on the spiritual – they appear to have had similar impulses to those that later inspired Martin Luther to revolt against the decadent Medici papacy. Their opponents, the “iconodules,” did not just love images, they were regarded as enslaved to them.

 

In the economic arena, there would seem to be a good case for iconoclasm. The bipartisan support for the bailout in late 2008 and the lack of action thereafter has left the institutional structure frozen, even a year after the event. Citigroup, AIG, Fannie Mae and Freddie Mac are still in existence, and no plans have been made for their closure or breakup. Wall Street, in the form of Goldman Sachs, is making record profits and will pay even more outrageous bonuses than in the boom year of 2007, yet much of its activity is pure rent-seeking, with no beneficial effect on the outside economy. The U.S. mortgage market is even more hopelessly compromised than it was a year ago, with the combination of the home-buyer tax credit and the Federal Housing Administration’s lax requirements for only a 3% down-payment producing a new $1 trillion pile of mortgages that appear to be toxic.

 

Other damaging policies that were improvised during the crisis are also still in place, and show no signs of being reversed. Interest rates are still close to zero; indeed bank “window dressing” was reported on Friday to have driven interest rates on short-term Treasury bills to below zero. The monetary base was doubled in late 2008, a sharper increase than ever before in the history of the Federal Reserve, yet there is no sign of its decline, while the banking system’s excess reserves pile up at over $1.2 trillion. On the fiscal side, the 2009 budget deficit was $1.4 trillion and the 2010 deficit promises to be still larger. President Obama has vowed to reduce the deficit, but it has become clear that for this administration the mantra should be “Watch what we do not what we say.” In practice, he remains fully committed to a health-care ‘reform” proposal that increases both the costs and the budget deficit, by around $1 trillion over the 2011-2020period.

 

As I have discussed previously, continued worship of these icons, whether in the form of the bankrupt financial institutions, the zero-interest-rate policies, or the trillion-dollar deficits, will drive the U.S. economy into a renewed downturn that will achieve new records both in terms of pain and difficulty of exit. Yet the iconodules Bernanke, Geithner and Obama continue their worship, and the congressional opposition to them seems content only to vary the forms of ceremony, without producing serious proposals that would break the major icons or even chip them.

 

Like the 8th-century Byzantine church, the nexus of Washington and Wall Street has grown corrupt and its corruption has come to exert increasing costs on society as a whole. Wall Street has become excessively concentrated, trading dominated and rent-seeking, while its rewards, like those of the overblown Byzantine hierarchy, have become completely out of proportion to the increasingly impoverished lives led by the rest of the population. Goldman Sachs chairman Lloyd Blankfein claims that his organization is “doing God’s work;” St. John of Damascus, the leading iconodule would doubtless have claimed the same on behalf of the Byzantine Church.  In Washington, eight years in which the ideology that had been sold to the voters in 2000 was replaced with something quite different, there’s a new clerisy even more enthusiastic to expand the power of government without very much regard as to whether that expansion is either cost effective or helpful to the population as a whole.

 

In such an atmosphere, with unemployment above 10% and rising, and U.S. living standards descending inexorably towards those of the Third World, it is not surprising that the public beyond the Washington Beltway is in an iconoclastic mood. Its iconoclasm is rational, economically speaking. The tight oligopoly of Wall Street is profiting excessively from its 2008 bailout by taxpayers, with the payments to Goldman Sachs and others on the AIG credit default swaps coming to seem increasingly misguided and possibly corrupt, given Goldman Sachs’s close connection with the Treasury Secretary Hank Paulson who disbursed taxpayers’ money in such an unproductive manner. AIG and Citigroup remain in business, with even AIG Financial Products, the cause of much of 2008’s pain, still in operation. Fannie Mae and Freddie Mac remain dispensing their guarantees to the housing market, noticed by the media only at the end of each quarter as they tote up their losses and demand further billions of the taxpayers’ money. The economically damaging subsidies to home purchase, diverting as they do scarce U.S. capital towards yet more unproductive housing, have just been extended both in time, for a further six months and in scope, to existing homeowners. The economic recovery, such as it is, appears to producing almost no jobs but only an ever-widening spiral in commodity prices, affecting the costs of everything the public consumes and eroding the value of its meager savings.

 

It’s not surprising given the new public taste for iconoclasm that the iconodules of both political parties have reacted with fear and alarm to Palin, who is no ideologue but through her background and style represents the strongest possible iconoclastic sentiment, opposed to Wall Street, Washington and all their doings. Her own political future is uncertain, as is her capability to take advantage of the new movement. But if she plays her hand cleverly, combining iconoclasm with political centrism, attracting good advisors while maintaining her anti-Washington following, her chances of a major political future at a national level would appear good.

 

With or without Ms. Palin, the iconoclast movement has substantial momentum. The current political-economic system is simply unsustainable; no economy can afford to pay for four giant zombie financial institutions, two substantial military adventures, a zombie-driven housing market, an exploding health-care bill and Goldman Sachs partners’ lifestyle aspirations. While the iconodules remain in charge, U.S. economic performance will consist of anemic growth punctuated by deep, grinding recessions, with new and small business starved of capital, which is instead sucked inexorably into the triple money pits of housing, the federal and state budget deficits and the investment-banking trading fraternity. In such circumstances, mere reform at the edges will not be enough; icons will have to be broken to liberate the U.S. economy from its excessive costs and allow new private sector growth sectors to emerge.

 

An icon-smashing president is probably likely to arrive before an icon-smashing Congress, given the electoral advantages to congressional incumbency. The U.S. economy must thus probably suffer at least another three years with the icons in place. Even a sharp 2010 congressional change would probably produce only legislative gridlock, although a belated conversion to iconoclasm by the Obama administration might produce change sooner. By 2013, the case for iconoclasm will be obvious to all. The current period of low interest rates and bubble creation will have met its inevitable sticky end, and the economic costs of unproductive icons will be fully apparent. The economy will be locked in an inflationary version of 1990s Japan, in which necessary reforms have not been taken and the detritus of old problems clogs up the streams of capital formation. At the same time, the costs of health-care reform will be looming close, and the tax increases necessary to move even partially towards balancing the federal budget will be hurting both taxpayers and the economy.

 

It will thus have become obvious that the housing market needs to be restored to a fully private market state, in which government subsidies are confined to the truly indigent. Zombie banks must be closed down, while the beneficiaries of “too big to fail” must be forced to slim down and divest operations until they are of a size where failure is conceivable. Commercial banks will simply become regional entities, whose failure would damage a regional economy but not the entire financial system. The trading behemoths will be broken into several competitors, whose market share will be too small for them to profit from “insider information” about market flows – a modest transactions tax will also reduce trading’s dominance. Home mortgages will once again be granted locally, with derivatives and securitization technology used only to prevent cost squeezes in high-growth areas. The obvious cost reductions in health-care, eliminating the current system’s cross-subsidizations, will be legislated to reduce the sector’s oppressive cost growth. Public expenditure generally will be put on a strict diet, with expansionist foreign policy ended, both in its belligerent and its globalist forms.  Finally, monetary policy will set interest rates at a level that rewards savers properly and prevents bubbles.

 

Iconodule vested interests will oppose such a program with all their strength. But in the end, the iconoclasts will win – the United States cannot economically afford for them to lose.

 

The Bears Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long ’90s boom, the proportion of “sell” recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.

”A WAVE OF DEBT PAYMENTS FOR U.S. GOVERNMENT,’ in the N. Y. Times. GREAT READ!!

Wave of Debt Payments Facing U.S. Government

By Edmund L. Andrews, the New York Times

WASHINGTON — The United States government is financing its more than trillion-dollar-a-year borrowing with i.o.u.’s on terms that seem too good to be true.

But that happy situation, aided by ultralow interest rates, may not last much longer.

Treasury officials now face a trifecta of headaches: a mountain of new debt, a balloon of short-term borrowings that come due in the months ahead, and interest rates that are sure to climb back to normal as soon as the Federal Reserve decides that the emergency has passed.

Even as Treasury officials are racing to lock in today’s low rates by exchanging short-term borrowings for long-term bonds, the government faces a payment shock similar to those that sent legions of overstretched homeowners into default on their mortgages.

With the national debt now topping $12 trillion, the White House estimates that the government’s tab for servicing the debt will exceed $700 billion a year in 2019, up from $202 billion this year, even if annual budget deficits shrink drastically. Other forecasters say the figure could be much higher.

In concrete terms, an additional $500 billion a year in interest expense would total more than the combined federal budgets this year for education, energy, homeland security and the wars in Iraq and Afghanistan.

The potential for rapidly escalating interest payouts is just one of the wrenching challenges facing the United States after decades of living beyond its means.

The surge in borrowing over the last year or two is widely judged to have been a necessary response to the financial crisis and the deep recession, and there is still a raging debate over how aggressively to bring down deficits over the next few years. But there is little doubt that the United States’ long-term budget crisis is becoming too big to postpone.

Americans now have to climb out of two deep holes: as debt-loaded consumers, whose personal wealth sank along with housing and stock prices; and as taxpayers, whose government debt has almost doubled in the last two years alone, just as costs tied to benefits for retiring baby boomers are set to explode.

The competing demands could deepen political battles over the size and role of the government, the trade-offs between taxes and spending, the choices between helping older generations versus younger ones, and the bottom-line questions about who should ultimately shoulder the burden.

“The government is on teaser rates,” said Robert Bixby, executive director of the Concord Coalition, a nonpartisan group that advocates lower deficits. “We’re taking out a huge mortgage right now, but we won’t feel the pain until later.”

So far, the demand for Treasury securities from investors and other governments around the world has remained strong enough to hold down the interest rates that the United States must offer to sell them. Indeed, the government paid less interest on its debt this year than in 2008, even though it added almost $2 trillion in debt.

The government’s average interest rate on new borrowing last year fell below 1 percent. For short-term i.o.u.’s like one-month Treasury bills, its average rate was only sixteen-hundredths of a percent.

“All of the auction results have been solid,” said Matthew Rutherford, the Treasury’s deputy assistant secretary in charge of finance operations. “Investor demand has been very broad, and it’s been increasing in the last couple of years.”

The problem, many analysts say, is that record government deficits have arrived just as the long-feared explosion begins in spending on benefits under Medicare and Social Security. The nation’s oldest baby boomers are approaching 65, setting off what experts have warned for years will be a fiscal nightmare for the government.

“What a good country or a good squirrel should be doing is stashing away nuts for the winter,” said William H. Gross, managing director of the Pimco Group, the giant bond-management firm. “The United States is not only not saving nuts, it’s eating the ones left over from the last winter.”

The current low rates on the country’s debt were caused by temporary factors that are already beginning to fade. One factor was the economic crisis itself, which caused panicked investors around the world to plow their money into the comparative safety of Treasury bills and notes. Even though the United States was the epicenter of the global crisis, investors viewed Treasury securities as the least dangerous place to park their money.

On top of that, the Fed used almost every tool in its arsenal to push interest rates down even further. It cut the overnight federal funds rate, the rate at which banks lend reserves to one another, to almost zero. And to reduce longer-term rates, it bought more than $1.5 trillion worth of Treasury bonds and government-guaranteed securities linked to mortgages.

Those conditions are already beginning to change. Global investors are shifting money into riskier investments like stocks and corporate bonds, and they have been pouring money into fast-growing countries like Brazil and China.

Articles in this series will examine the consequences of, and attempts to deal with, growing public and private debts.

The Fed, meanwhile, is already halting its efforts at tamping down long-term interest rates. Fed officials ended their $300 billion program to buy up Treasury bonds last month, and they have announced plans to stop buying mortgage-backed securities by the end of next March.

Eventually, though probably not until at least mid-2010, the Fed will also start raising its benchmark interest rate back to more historically normal levels.

The United States will not be the only government competing to refinance huge debt. Japan, Germany, Britain and other industrialized countries have even higher government debt loads, measured as a share of their gross domestic product, and they too borrowed heavily to combat the financial crisis and economic downturn. As the global economy recovers and businesses raise capital to finance their growth, all that new government debt is likely to put more upward pressure on interest rates.

Even a small increase in interest rates has a big impact. An increase of one percentage point in the Treasury’s average cost of borrowing would cost American taxpayers an extra $80 billion this year — about equal to the combined budgets of the Department of Energy and the Department of Education.

But that could seem like a relatively modest pinch. Alan Levenson, chief economist at T. Rowe Price, estimated that the Treasury’s tab for debt service this year would have been $221 billion higher if it had faced the same interest rates as it did last year.

The White House estimates that the government will have to borrow about $3.5 trillion more over the next three years. On top of that, the Treasury has to refinance, or roll over, a huge amount of short-term debt that was issued during the financial crisis. Treasury officials estimate that about 36 percent of the government’s marketable debt — about $1.6 trillion — is coming due in the months ahead.

To lock in low interest rates in the years ahead, Treasury officials are trying to replace one-month and three-month bills with 10-year and 30-year Treasury securities. That strategy will save taxpayers money in the long run. But it pushes up costs drastically in the short run, because interest rates are higher for long-term debt.

Adding to the pressure, the Fed is set to begin reversing some of the policies it has been using to prop up the economy. Wall Street firms advising the Treasury recently estimated that the Fed’s purchases of Treasury bonds and mortgage-backed securities pushed down long-term interest rates by about one-half of a percentage point. Removing that support could in itself add $40 billion to the government’s annual tab for debt service.

This month, the Treasury Department’s private-sector advisory committee on debt management warned of the risks ahead.
Wave of Debt Payments Facing U.S. Government

By Edmund L. Andrews, the New York Times

WASHINGTON — The United States government is financing its more than trillion-dollar-a-year borrowing with i.o.u.’s on terms that seem too good to be true.

But that happy situation, aided by ultralow interest rates, may not last much longer.

Treasury officials now face a trifecta of headaches: a mountain of new debt, a balloon of short-term borrowings that come due in the months ahead, and interest rates that are sure to climb back to normal as soon as the Federal Reserve decides that the emergency has passed.

Even as Treasury officials are racing to lock in today’s low rates by exchanging short-term borrowings for long-term bonds, the government faces a payment shock similar to those that sent legions of overstretched homeowners into default on their mortgages.

With the national debt now topping $12 trillion, the White House estimates that the government’s tab for servicing the debt will exceed $700 billion a year in 2019, up from $202 billion this year, even if annual budget deficits shrink drastically. Other forecasters say the figure could be much higher.

In concrete terms, an additional $500 billion a year in interest expense would total more than the combined federal budgets this year for education, energy, homeland security and the wars in Iraq and Afghanistan.

The potential for rapidly escalating interest payouts is just one of the wrenching challenges facing the United States after decades of living beyond its means.

The surge in borrowing over the last year or two is widely judged to have been a necessary response to the financial crisis and the deep recession, and there is still a raging debate over how aggressively to bring down deficits over the next few years. But there is little doubt that the United States’ long-term budget crisis is becoming too big to postpone.

Americans now have to climb out of two deep holes: as debt-loaded consumers, whose personal wealth sank along with housing and stock prices; and as taxpayers, whose government debt has almost doubled in the last two years alone, just as costs tied to benefits for retiring baby boomers are set to explode.

The competing demands could deepen political battles over the size and role of the government, the trade-offs between taxes and spending, the choices between helping older generations versus younger ones, and the bottom-line questions about who should ultimately shoulder the burden.

“The government is on teaser rates,” said Robert Bixby, executive director of the Concord Coalition, a nonpartisan group that advocates lower deficits. “We’re taking out a huge mortgage right now, but we won’t feel the pain until later.”

So far, the demand for Treasury securities from investors and other governments around the world has remained strong enough to hold down the interest rates that the United States must offer to sell them. Indeed, the government paid less interest on its debt this year than in 2008, even though it added almost $2 trillion in debt.

The government’s average interest rate on new borrowing last year fell below 1 percent. For short-term i.o.u.’s like one-month Treasury bills, its average rate was only sixteen-hundredths of a percent.

“All of the auction results have been solid,” said Matthew Rutherford, the Treasury’s deputy assistant secretary in charge of finance operations. “Investor demand has been very broad, and it’s been increasing in the last couple of years.”

The problem, many analysts say, is that record government deficits have arrived just as the long-feared explosion begins in spending on benefits under Medicare and Social Security. The nation’s oldest baby boomers are approaching 65, setting off what experts have warned for years will be a fiscal nightmare for the government.

“What a good country or a good squirrel should be doing is stashing away nuts for the winter,” said William H. Gross, managing director of the Pimco Group, the giant bond-management firm. “The United States is not only not saving nuts, it’s eating the ones left over from the last winter.”

The current low rates on the country’s debt were caused by temporary factors that are already beginning to fade. One factor was the economic crisis itself, which caused panicked investors around the world to plow their money into the comparative safety of Treasury bills and notes. Even though the United States was the epicenter of the global crisis, investors viewed Treasury securities as the least dangerous place to park their money.

On top of that, the Fed used almost every tool in its arsenal to push interest rates down even further. It cut the overnight federal funds rate, the rate at which banks lend reserves to one another, to almost zero. And to reduce longer-term rates, it bought more than $1.5 trillion worth of Treasury bonds and government-guaranteed securities linked to mortgages.

Those conditions are already beginning to change. Global investors are shifting money into riskier investments like stocks and corporate bonds, and they have been pouring money into fast-growing countries like Brazil and China.

Articles in this series will examine the consequences of, and attempts to deal with, growing public and private debts.

The Fed, meanwhile, is already halting its efforts at tamping down long-term interest rates. Fed officials ended their $300 billion program to buy up Treasury bonds last month, and they have announced plans to stop buying mortgage-backed securities by the end of next March.

Eventually, though probably not until at least mid-2010, the Fed will also start raising its benchmark interest rate back to more historically normal levels.

The United States will not be the only government competing to refinance huge debt. Japan, Germany, Britain and other industrialized countries have even higher government debt loads, measured as a share of their gross domestic product, and they too borrowed heavily to combat the financial crisis and economic downturn. As the global economy recovers and businesses raise capital to finance their growth, all that new government debt is likely to put more upward pressure on interest rates.

Even a small increase in interest rates has a big impact. An increase of one percentage point in the Treasury’s average cost of borrowing would cost American taxpayers an extra $80 billion this year — about equal to the combined budgets of the Department of Energy and the Department of Education.

But that could seem like a relatively modest pinch. Alan Levenson, chief economist at T. Rowe Price, estimated that the Treasury’s tab for debt service this year would have been $221 billion higher if it had faced the same interest rates as it did last year.

The White House estimates that the government will have to borrow about $3.5 trillion more over the next three years. On top of that, the Treasury has to refinance, or roll over, a huge amount of short-term debt that was issued during the financial crisis. Treasury officials estimate that about 36 percent of the government’s marketable debt — about $1.6 trillion — is coming due in the months ahead.

To lock in low interest rates in the years ahead, Treasury officials are trying to replace one-month and three-month bills with 10-year and 30-year Treasury securities. That strategy will save taxpayers money in the long run. But it pushes up costs drastically in the short run, because interest rates are higher for long-term debt.

Adding to the pressure, the Fed is set to begin reversing some of the policies it has been using to prop up the economy. Wall Street firms advising the Treasury recently estimated that the Fed’s purchases of Treasury bonds and mortgage-backed securities pushed down long-term interest rates by about one-half of a percentage point. Removing that support could in itself add $40 billion to the government’s annual tab for debt service.

This month, the Treasury Department’s private-sector advisory committee on debt management warned of the risks ahead.

“Inflation, higher interest rate and rollover risk should be the primary concerns,” declared the Treasury Borrowing Advisory Committee, a group of market experts that provide guidance to the government, on Nov. 4.

“Clever debt management strategy,” the group said, “can’t completely substitute for prudent fiscal policy.”

http://www.nytimes.com/2009/11/23/business/23rates.html?_r=1&hp

“Inflation, higher interest rate and rollover risk should be the primary concerns,” declared the Treasury Borrowing Advisory Committee, a group of market experts that provide guidance to the government, on Nov. 4.

“Clever debt management strategy,” the group said, “can’t completely substitute for prudent fiscal policy.”

http://www.nytimes.com/2009/11/23/business/23rates.html?_r=1&hp

‘BLAMING IT ON OBAMA,’ by James Kwak at baselinescenario .com.

Blaming It on Obama

Posted: 23 Nov 2009 07:42 AM PST

Last week I wrote a post about “government debt hysteria” that has gotten a lot of attention because of a link from Paul Krugman. (As Felix Salmon, said, “blogging is a lottery on the individual-blog-entry level.”) The main point of last week’s post was not that it’s wrong to be concerned about the national debt (I think everyone is concerned about it — the question is what to do about it and when), but that it’s irresponsible to title a column “Could America Go Broke?” and talk about hyperinflation without providing some evidence, or at least a logical argument that goes beyond tautology, that hyperinflation is something we should be worrying about it.

Here’s something else that’s irresponsible. In that same column, Robert Samuelson says, “The Congressional Budget Office reckons the Obama administration’s planned budgets would increase the debt-to-GDP ratio from 41 percent in 2008 to 82 percent in 2019″ (emphasis added).

Let’s take a look at that claim. I’m going to work with two versions of the CBO’s Budget and Economic Outlook, published in January 2008 (before we knew we were in a recession) and August 2009, and I’m going to use their baseline numbers, which show debt-to-GDP growing from 40.8% to 67.0% in 2018 and 67.8% in 2019. (I’m guessing Samuelson is citing the CBO’s additional analysis that assumes certain tax cuts will be extended; I’m not using that one because I can’t find the tables in sufficient detail.) I’m not contesting that debt-to-GDP will go up by a lot; I want to see why it’s going up. I’m also only going out through 2018 because the 2008 CBO report only went that far.

According to the 2008 report (Table 1-3), the budget from 2009 through 2018 shows an aggregate surplus of $0.3 trillion. The 2009 report (Table 1-2, PDF page 20) shows an aggregate deficit of $8.0 trillion, for a difference of $8.3 trillion.*  Where does that come from?

In the 2008 report, discretionary outlays for 2009-18 are $12.4 trillion. In the 2009 report, that figure is now $13.7 trillion, for a difference of $1.3 trillion; that’s the most you can credibly blame on “the Obama administration’s planned budgets” — and even that includes the stimulus package from earlier this year, which was a response to a severe recession.

So where do the other $7.0 trillion come from? Increases in mandatory spending are $0.8 trillion. Increases in net interest payments are $1.5 trillion. But the big whopper is on the revenue side, where revenues are projected to be $4.6 trillion lower.** That is, you get a picture like this:

So far, of the $8.3 trillion change in our projected fiscal situation, 16.1% is due to discretionary spending. 56.0% is due to lower revenues caused by … the recession and the financial crisis.

But wait, that’s not all. The increase in the national debt would only be from 40.8% to 60.9% (not 67.0%) of GDP if 2018 GDP remained where it was projected in 2008. However, between the 2008 and 2009 CBO reports, projected 2018 GDP has fallen from $22.4 trillion to $20.3 trillion. That’s also due to the recession and the financial crisis. A smaller denominator means the same debt becomes a larger proportion of GDP.

In short, the problem is that the economy collapsed. Blaming our increasing debt problems on “the Obama administration’s planned budgets,” when they are responsible for one-sixth (or one-fifth, if you read footnotes) of part of the problem (the part not due to a shrinking denominator), is deeply misleading. It also leads to the wrong conclusion: cut spending.

What’s the right conclusion? Simon, my co-author, has been going around saying that the real cost of the financial crisis would be an increase in government debt of 40 percentage points of GDP. I’ve been telling him that I’m nervous about that number, because the long-term debt problem has always been with us, and it’s called Medicare. Well, it turns out Simon was right. The 2008 CBO report projected that by 2018, debt held by the public would be only 22.6% of GDP. The 2009 report projects 67.0%, for an increase of 44.4 percentage points. (I guess I should have trusted Simon; he is on the CBO’s advisory panel, after all.) What happened between those reports? The financial crisis and a severe recession. And if we want to prevent that from happening again, we need to reform our financial system.

* Baseline Scenario readers are likely to have noticed that $8.3 trillion is a lot more than 26% of GDP (even in 2018), yet the debt figure only goes up by 26 percentage points. The reason is that the CBO’s debt figure only counts debt held in public hands; the rest of the increase in the debt is absorbed by Social Security and other government accounts. My point here is only to show the proportional contributions to the increase in the debt.

** You could argue that the Obama budgets should be charged a portion of the change in net interest expense. Since discretionary spending is responsible for about 20% of the change other than net interest, it should be charged 3.6 percentage points of the change in net interest, bringing discretionary spending’s total contribution to 19.7% of the $8.3 trillion.

By James Kwak

RALPH WALDO EMERSON ON FRIENDSHIP…….

“Let the soul be assured that somewhere in the universe it should rejoin its friend, and it would be content and cheerful alone for a thousand years. I awoke this morning with devout thanksgiving for my friends, the old and the new. My friends have come to me unsought. The great God gave them to me. By oldest right, by the divine affinity of virtue with itself, I find them, or rather not I, but the Deity in me and in them, both deride and cancel the thick walls of individual character, relation, age, sex, circumstance, at which he usually connives, and now makes many one. I must feel pride in my friend`s accomplishments as if they were mine, – wild, delicate, throbbing property in his virtues .We over-estimate the conscience of our friend. His goodness seems better than our goodness, his nature finer, his temptations less. Every thing that is his, his name, his form, his dress, books and instruments, fancy enhances. Our own thought sounds new and larger from his mouth. Thus every man passes his life in the search after friendship, and if he should record his true sentiment, he might write a letter like this to each new candidate for his love. The laws of friendship are great, austere and eternal.  let us approach our friend with an audacious trust in the truth of his heart .

 

There are two elements that go to the composition of friendship, each so sovereign that I can detect no superiority in either, no reason why either should be first named. One is Truth. A friend is a person with whom I may be sincere. Before him I may think aloud. I am arrived at last in the presence of a man so real and equal that I may drop even those most undermost garments of dissimulation, courtesy, and second thought, which men never put off, and may deal with him with the simplicity and wholeness with which one chemical atom meets another. But a friend is a sane man who exercise not my ingenuity, but me. My friend gives me entertainment without requiring me to stop, or to lisp, or to mask myself. A friend therefore is a sort of paradox in nature. I who alone am, I who see nothing in nature whose existence I can affirm with equal evidence to my own, behold now the semblance of my being, in all its height, variety and curiosity, reiterated in a foreign form; so that a friend may well be reckoned the masterpiece of nature.

 

The other element of friendship is Tenderness . Can another be so blessed and we so pure that we can offer him tenderness? When a man becomes dear to me I have touched the goal of fortune. Let him not cease an instant to be himself. Friendship demands a religious treatment. We must not be wilful, we must not provide.Treat your friend as a spectacle. Of course if he be a man he has merits that are not yours, and that you cannot honor if you must needs hold him close to your person. Stand aside. Give those merits room. Let them mount and expand . Why should we desecrate noble and beautiful souls by intruding on them? Why insist on rash personal relations with your friend? Let him be to me a spirit. A message, a thought, a sincerity, a glance from him, I want, but not news, nor pottage.

 

Worship his superiorities. We must be our own before we can be another`s. There can never be deep peace between two spirits, never mutual respect, until in their dialogue each stands for the whole world.What is so great as friendship, let us carry with what grandeur of spirit we can. Let us be silent, – so we may hear the whisper of the gods. Let us not interfere.Wait, and thy soul shall speak. We walk alone in the world. Friends such as we desire are dreams and fables. But a sublime hope cheers ever the faithful heart, that elsewhere, in other regions of the universal power, souls are now acting, enduring and daring, which can love us and which we can love. I fear only that I may lose them receding into the sky in which now they are only a patch of brighter light. It would indeed give me a certain household joy to quit this lofty seeking, this spiritual astronomy or search of stars, and come down to warm sympathies with you; but then I know well I shall mourn always the vanishing of my mighty gods. So I will owe to my friends this evanescent intercourse. I will receive from them not what they have but what they are. They shall give me that which properly they cannot give me, but which emanates from them. But they shall not hold me by any relations less subtle and pure. We will meet as though we met not, and part as though we parted not. The essence of friendship is entireness, a total magnanimity and trust. It must not surmise or provide for infirmity. It treats its object as a god, that it may deify both.”   R W Emerson

‘AMERICA’S SCARY ECONOMIC PREDICAMENT , ‘ by Amb. Felix Rohatyn in the N.Y. Daily News.

Since WWII, America has been the wellspring of market capitalism. During my time as ambassador to France, I saw how fascinated most Europeans were by the economic freedom that is fundamental to our system.

 

Until the 1980s, American capitalism and European social democracy created reasonably similar economic outcomes. But by the 1990s, accelerating changes in our corporate culture and the functioning of our markets, together with cheap money and easy speculation, resulted in the creation of astounding wealth which, in turn, led to ethical and legal abuses in the business world.

 

Today, America is facing five major challenges, each one risky on its own and in the aggregate a challenge to democratic society:

 

1. The weakness of the dollar and the debt crisis

 

2. The spreading wars and their escalating costs in blood and treasure

 

3. The growing level of unemployment

 

4. The worsening fiscal posture of most of the states

 

5. The short-term horizon for most politicians

 

The debt crisis resulted from the failure of regulation, a culture of greed and speculation in many of our financial institutions and the failure of senior managers to properly assess risk.

 

The losses incurred by the government to deal with the crisis, the current estimates for the costs of a comprehensive health care program and the cost of wars in Iraq and Afghanistan, are awesome. At the same time, the U.S. in particular and the world in general are more and more beholden to China for their solvency. As China and Russia control more and more sources of energy and other raw materials, as well as ever-growing currency reserves, this is great cause for concern.

 

For the countries of the West, in order to maintain control over their finances and reduce their deficits, competitive protectionism may seem politically desirable. The result will be higher interest rates and lower growth, at best.

 

While this is a grim outlook, we must recognize that we have used up much of our capabilities for economic shock absorbers.

 

President Obama has called for a jobs summit in December in order to review the options available to both the private and the public sectors.

 

He must understand this: The single most important economic issue facing us today is the issue of fairness. The stock market boom of the past decades, and its inevitable bust, has created ever wider gaps between the very wealthy and the rest of Americans. The outrageous compensation packages of many corporate managers, and the symbols of abuse, have shaken our faith in the fairness of our system. It has convinced many of our overseas critics that American-style capitalism and globalization exploit the less fortunate.

 

I have always believed that an advanced, democratic, capitalistic system was founded on three principles: freedom, fairness and the creation of wealth. I believe that market capitalism is the best economic system ever invented but it must be fair, it must be regulated and it must be ethical. Only capitalists can kill capitalism. But our system cannot stand much more abuse of the type we have witnessed recently; nor can it stand much more of the financial polarization we are seeing today.

 

Raising this issue does not mean engaging in “class warfare.” It means raising the most serious issues of modern capitalism. Theodore Roosevelt said: “A great democracy must be progressive or it will soon cease to be great or a democracy.” T.R., as often, was right on the mark.

 

Rohatyn, president of FGR Associates LLC, served as U.S. ambassador to France from 1997 to 2000.

‘WHAT IF A RECOVERY IS ALL IN YOUR HEAD?, ‘ by Robert J. Shiller in the N.Y. Times.

Beyond fiscal stimulus and government bailouts, the economic recovery that appears under way may be based on little more than self-fulfilling prophecy.

Consider this possibility: after all these months, people start to think it’s time for the recession to end. The very thought begins to renew confidence, and some people start spending again — in turn, generating visible signs of recovery. This may seem absurd, and is rarely mentioned as an explanation for mass behavior late in a recession, but economic theorists have long been fascinated by such a possibility.

 

The notion isn’t as farfetched as it may appear. As we all know, recessions generally last no more than a couple of years. The current recession began in December 2007, according to the National Bureau of Economic Research, so it is almost two years old. According to the standard schedule, we’re due for recovery. Given this knowledge, the mere passage of time may spur our confidence, though no formal statistical analysis can prove it.

 

Certainly, people did not always believe that there is a regular “business cycle” that starts and stops in a definite pattern. The idea began to spread in the popular consciousness in the 1920s and reached full bloom in the ’30s — with one major complication, the Great Depression, which received its name in midcourse, from a 1934 book with that title by Lionel Robbins.

 

“There have been many depressions in modern economic history, but it is safe to say that there has never been anything to compare with this,” Mr. Robbins wrote. In his narrative, the Great Depression was an extreme event, compared with ordinary “depressions.”

 

“Recession,” a kinder, gentler term, began to be used around the time of the 1937-38 contraction to refer to a normal downturn in the business cycle. In January 1938, The Chicago Daily Tribune offered a wry definition of a recession, calling it “a new word for depression, coined by those who don’t like to admit that we’re still in one.”

 

People joked so much about the euphemism that in 1938 President Franklin D. Roosevelt said, “It makes no difference to me whether you call it a recession or a depression.”

 

The proliferation of the idea of a more-or-less predictable business cycle intersected with a rapidly growing public interest in psychology. Choice of words can matter greatly for the psychologically aware, and the new word “recession” had a much softer sound than its predecessor. Recessions, as the term came to be used, implied timetables that mark their expected end. Uttering the word does not risk damaging confidence, at least not fundamentally. A diagnosis of a recession can be shrugged off as something from which you will recover, as though your doctor had just diagnosed an illness as a common cold. A depression came to be another matter entirely.

 

Back in 1931, for example, The New York Times attributed the emerging economic cataclysm to a “mood of pessimism which had been carried to grotesque extremes.” In 1932, it compared reckless talk about “depression” to shouting “fire” in a crowded theater.

 

President Roosevelt is widely remembered for saying, in 1933, that “the only thing we have to fear is fear itself.” But he was only repeating an oft-told message.

 

It wasn’t until 1948 that the Columbia University sociologist Robert K. Merton wrote an article in The Antioch Review titled “The Self-Fulfilling Prophecy,” using the Great Depression as his first example. He is often credited with having invented the “self-fulfilling prophesy” phrase, but by the 1930s the idea was already as commonplace as the breakfast toast made with modern electric toasters. (Interestingly, the same Robert Merton documented the tendency for important ideas to be falsely attributed to celebrities.)

 

In fact, in 1937, “Think and Grow Rich,” a book by Napoleon Hill, urged readers to adopt a positive mental attitude and to channel the power of the subconscious mind so that real wealth would follow. It became a runaway best seller. Faddish interest had already emerged not only in Freud’s theory of the unconscious mind, but also in the theories of the psychologist Émile Coué, who urged people to recite that “every day in every way I’m getting better and better.” He said this “autosuggestion” would bolster the unconscious self.

 

In important ways, we are still using that 1930s pattern of thinking. We are instinctively fearful of reckless talk about depressions, and we try to support one another’s confidence. We like the idea that modern scientific economics seems to show that all recessions end in due course.

 

For now, our common efforts at building confidence appear to be working somewhat. But the economy has still not recovered, by any means.

 

COUÉISM has been discredited generally, as has much of the old business-cycle theory, but they live on in our popular notions about recessions. We may hope that our resorting to euphemism and belief in timetables of business-cycle recoveries work better to restore confidence than they did in the ’30s.

 

The problem might be put this way: There is still a nagging doubt afloat that the current event is really just another example in that long sequence of recessions. In which mental category does the current contraction belong: recession or depression? We may still be at a tipping point. To the extent that the theory of the self-fulfilling prophecy is correct, there is a case for continued vigilance, to ensure that adverse events don’t encourage widespread talk of the second category.

 

Robert J. Shiller is professor of economics and finance at Yale and co-founder and chief economist of MacroMarkets LLC.

‘WHEN COMMON SENSE SAYS “SELL”, ‘ by James B. Stewart at MarketWatch via fidelity.com.

Just a year ago, as conversations inevitably turned to the plunging stock market, I felt like the odd man out. Most people doing the talking were boasting that they’d bailed out, cut their losses, moved into cash, hunkered down. And then I’d say I was buying. Most people looked at me like I was crazy. The deeper the market fell and the longer the correction persisted, the more isolated I felt. So I stopped talking about it, just nodding enigmatically when the subject arose.

 

Now, with the market continuing to set new highs for the year, most recently on Monday, I’m again feeling isolated. That’s because I’ve been following the Common Sense system, which calls for selling after large gains like the one we’ve just experienced. So while everyone else is celebrating their gains, I’m thinking about what to sell. Don’t get me wrong. I’m as delighted as everyone else by the market’s rise, since I’m always net long the market. But I’m not buying when the market hits new highs. Instead, I’m locking in some gains, raising cash for the day when a correction ultimately arrives.

 

Over the years I’ve been doing this, I’ve come to understand why this doesn’t make me all that popular with certain kinds of investors. Many people equate a decision to sell with a prediction the market is going down. Who am I to dampen the festive atmosphere of a big rally? But I don’t try to predict short- or even medium-term moves in the market. All I’m trying to do is sell higher, buy lower, and thereby outperform a strict buy-and-hold approach. So far it has been working. Earlier this year I was exhorting people to buy (see my Feb. 24 column, “Why right now is a good time to buy,” which includes a detailed description of the Common Sense system, and my March 10 column, “3 Stocks on my shopping list”), as I did myself. As luck would have it, I bought on March 9, which turned out to be the bottom.

 

My next selling target is 2220 on the Nasdaq Composite , and the index has come close on several occasions, most recently on Monday, when it hit 2205 midafternoon. This was close enough for my purposes, so I took advantage of the rally to sell my few remaining banking positions. As I discuss in SmartMoney magazine’s December issue, I remain concerned about continued deterioration in the commercial real estate market and its impact on bank earnings and balance sheets. This is a theme Federal Reserve Chairman Ben Bernanke addressed in his speech to the Economic Club of New York on Monday, when he noted that “Demand for commercial property has dropped as the economy has weakened, leading to significant declines in property values, increased vacancy rates and falling rents. These poor fundamentals have caused a sharp deterioration in the credit quality of CRE [commercial real estate] loans on banks’ books and of the loans that back commercial mortgage-backed securities (CMBS). Pressures may be particularly acute at smaller regional and community banks that entered the crisis with high concentrations of CRE loans.”

 

These problems are so well known that they should already be reflected in stock prices. But the efficient market theory was dealt a blow last year, when the well-known woes of residential real estate turned out not to have been reflected in bank stock prices. I expect something similar to happen again when there’s a big default in the commercial sector.

 

Also weighing on bank stocks have been various proposals in Congress to rein in supposedly abusive consumer banking policies, such as overdraft penalties on debit cards. Some kind of consumer protection legislation seems likely to pass, which may wreak havoc on bank earnings, at least in the short term. Bank stocks have been notably absent from the past month’s rally, especially the regional banks. But most have rallied strongly from their lows of the year, making them good candidates to divest now, in my view.

 

At some point bank stocks will again be a buy. But as this rally enters the equivalent of old age, and seems increasingly momentum driven, I’m avoiding the financial sector entirely.

 

Speaking of momentum, the luxury sector I recommended last week has been on a tear. Last Wednesday night Sotheby’s  auctioned an Andy Warhol silk screen of 200 one-dollar bills for nearly $44 million, almost four times its high estimate. (That’s roughly $220,000 per bill.) Sotheby’s stock was at $17.50 last week; Monday it closed at $20.07. Luxury goods maker Compagnie Financiere Richemont reported on Friday earnings that beat expectations and sales rising in Asia. Its shares were up nearly 5% on Monday. These shares have now gotten too rich for my taste, but the trend should continue, making them good candidates to buy in a correction.

 

And while I don’t predict short-term moves, that’s one prediction I’m confident about: Someday a correction will come.

 

‘REVISITING THE FED WALTZ WITH A.I.G., ‘ in the N.Y.Times. THE BANKERS WANT TO THANK THE TAXPAYERS FOR THEIR BILLIONS OF BAILOUT. MERCI!!

By GRETCHEN MORGENSON

Published: November 21, 2009

A RAY of sunlight broke through the Washington fog last week when Neil M. Barofsky, special inspector general for the Troubled Asset Relief Program, published his office’s report on the government bailout last year of the American International Group.

It’s must reading for any taxpayer hoping to understand why the $182 billion “rescue” of what was once the world’s largest insurer still ranks as the most troubling episode of the financial disaster. And it couldn’t have come at a more pivotal moment.

Many in Washington want to give more regulatory power to the Federal Reserve Board, the banking regulator that orchestrated the A.I.G. bailout. Through this prism, the actions taken in the deal by Treasury Secretary Timothy F. Geithner, who was president of the Federal Reserve Bank of New York at the time, grow curiouser and curiouser.

Of special note in the report: the Fed failed to develop a workable rescue plan when A.I.G., swamped by demands that it pay off huge insurance contracts that it couldn’t make good on as the economy tanked, began to sink. The report takes the Fed to task as refusing to use its power and prestige to wrestle concessions from A.I.G.’s big, sophisticated and well-heeled trading partners when the government itself had to pay off the contracts.

The Fed, under Mr. Geithner’s direction, caved in to A.I.G.’s counterparties, giving them 100 cents on the dollar for positions that would have been worth far less if A.I.G. had defaulted. Goldman Sachs, Merrill Lynch, Société Générale and other banks were in the group that got full value for their contracts when many others were accepting fire-sale prices.

On the question of whether this payout was what the report describes as a “backdoor bailout” of A.I.G.’s counterparties, Mr. Barofsky concluded: “The very design of the federal assistance to A.I.G. was that tens of billions of dollars of government money was funneled inexorably and directly to A.I.G.’s counterparties.” The report noted that this was money the banks might not otherwise have received had A.I.G. gone belly-up.

The report zaps Fed claims that identifying banks that benefited from taxpayer largess would have dire consequences. Fed officials had refused to disclose the identities of the counterparties or details of the payments, warning “that disclosure of the names would undermine A.I.G.’s stability, the privacy and business interests of the counterparties, and the stability of the markets,” the report said.

When the parties were named, “the sky did not fall,” the report said.

Finally, Mr. Barofsky pokes holes in arguments made repeatedly over the past 14 months by Goldman Sachs, A.I.G.’s largest trading partner and recipient of $12.9 billion in taxpayer money in the bailout, that it had faced no material risk in an A.I.G. default — that, in effect, had A.I.G. cratered, Goldman wouldn’t have suffered damage.

In short, there’s an awful lot jammed into this 36-page report.

Even before publishing this analysis, Mr. Barofsky had made a name for himself as one of the few truth tellers in Washington. While others estimate how much the taxpayer will make on various bailout programs, Mr. Barofsky has said that returns are extremely unlikely.

His office has also opened 65 cases to investigate potential fraud in various bailout programs. “When I first took office, I can’t tell you how many times I’d be having a sit-down and warning about potential fraud in the program and I would hear a response basically saying, ‘Oh, they’re bankers, and they wouldn’t put their reputations at risk by committing fraud,’ ” Mr. Barofsky told Bloomberg News a little over a week ago, adding: “I think we’ve done a good job of instilling a greater degree of skepticism that what comes from Wall Street isn’t necessarily the holy grail.”

Mr. Barofsky says the Fed failed to strong-arm the banks when it was negotiating payouts on the A.I.G. contracts. Rather than forcing the banks to accept a steep discount, or “haircut,” the Fed gave the banks $27 billion in taxpayer cash and allowed them to keep an additional $35 billion in collateral already posted by A.I.G. That amounted to about $62 billion for the contracts, which the report describes as “far above their market value at the time.”

Mr. Geithner, who oversaw those negotiations, said in an interview on Friday that the terms of the A.I.G. deal were the best he could get for taxpayers. He considered bailing out A.I.G. to be “offensive,’ he said, but deemed it necessary because a collapse would have undermined the financial system.

“We prevented A.I.G. from defaulting because our judgment was that the damage caused by failure would have been much more costly for the economy and the taxpayer,” Mr. Geithner said. “To most Americans, this looked like a deeply unfair outcome and they find it hard to see any direct benefit. But in fact, their savings are more valuable and secure today.”

‘WHERE THE WILD THINGS ARE,’ by John Mauldin at Frontline Thoughts. Trial subscription woth it…….and FREE!

Where the Wild Things Are

by John Mauldin

November 20, 2009

 

In this issue:

Where the Wild Things Are

It Is Not Just Japan

The Euro-Yen Cross and the Dollar Carry Trade

New York, London, and Switzerland

 

From ghoulies and ghosties

And long-leggedy beasties

And things that go bump in the night,

Good Lord, deliver us!

 

–Old Scottish Prayer

 

Where the Wild Things Are is a beloved children’s book and now a beautiful movie. But in the investment world there are really scary wild things lurking about in the hidden recesses of the economic landscape. Today we look at one of the unintended consequences of the Federal Reserve’s low interest rate policy.

 

For quite some time, I have been arguing that we are faced with no good choices, not just in the US but in the entire “developed” world. I see a low-growth, Muddle Through world over the next years (with a double-dip recession just to liven things up). However, that does not mean that we will lack for volatility. Things could get volatile rather quickly. Let’s quickly set the background.

 

It Is Not Just Japan

 

Let’s look at today’s interest rate picture. Yesterday, we had the bizarre occurrence of banks actually paying the government to hold their cash. Three-month treasuries yield a miniscule 0.01% in interest. If you opt to buy a one-year bill you get all of 0.26%. You can see the entire spectrum below.

 

 

 

Look at the graph of the yield curve below. It is as steep as we have seen it in a long time. But that is almost the point. Banks are essentially getting free money. If you are a banker and can’t make money in this environment, you need to quit and find meaningful employment.

 

 

 

And that is part of the rationale that the Fed espouses with its low interest rate regime. Not only does it allow banks to repair their balance sheets, it also encourages investors to put money into riskier assets in order to get some return on their investments. Over $260 billion has gone into bond funds this year, and just $2.6 billion into stock funds. However, you have to balance that with the fact that some $400 billion has left money market funds paying less than 0.2%. So there is some movement to capture yield.

 

But is it just banks that are getting cheap money? And is encouraging investors to find riskier assets a sound policy? Maybe not.

 

The Euro-Yen Cross and the Dollar Carry Trade

 

I wrote a great deal in the past few years about the strong correlation of the euro-yen cross to stock markets all over the world in general. (The euro-yen cross is the exchange rate of the euro and the Japanese yen.) This was a proxy for the Japanese carry trade. The stock markets of the world rose and fell in synchronization with the yen versus the euro.

 

A currency carry trade is a strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used.

 

The Japanese drove their rates down to essentially zero in the 1990s. By early 2007, it was estimated that the yen carry trade was over $1 trillion. But when the world credit crisis hit, the world wanted dollars. They paid back the yen and bought dollars, driving the yen higher and killing the yen carry trade. Who wants to borrow in a currency that continues to rise, even if the costs are low? And often, large leverage was used, so small movements in the currency could destroy outsized amounts of capital.

 

But now, there are some who are beginning to ask whether there is a dollar carry trade. In the last nine months, the correlation between the dollar and the stock market has gone to about 90%. If the dollar rises, the stock markets and other risk assets tend to fall, and vice-versa. It would appear that investors and funds are borrowing cheap dollars on a short-term basis and investing in all sorts of risk assets. Not only have stock markets risen, but so have high-yield bonds, commodities, and so on.

 

We have seen the steepest rise in US stock markets coming out of a recession since the end of the last world war. The market is “discounting” a 5% GDP next year and a profit rebound beyond anything in past experience. Depending on the quarter, operating earnings are expected to rise by anywhere from 30-40%. P/E ratios are back at 23, well above the 17 we saw in the summer of 2007 (I am using 4th quarter 2009 estimates so as to not have to take into account the disastrous 4th quarter of last year.)

 

Worrying about a dollar carry trade is not just a preoccupation of my friends Nouriel Roubini or David Rosenberg or Frank Veneroso. Look as this story from Bloomberg:

 

“China’s Liu Says U.S. Rates Cause Dollar Speculation

 

“Nov. 15 (Bloomberg) — The decline of the dollar and decisions in the U.S. not to raise interest rates have caused “huge” speculation in foreign exchange trading and seriously affected global asset prices, said Liu Mingkang, chairman of the China Banking Regulatory Commission.”

 

“The continuous depreciation in the dollar, and the U.S. government’s indication, that in order to resume growth and maintain public confidence, it basically won’t raise interest rates for the coming 12 to 18 months, has led to massive dollar arbitrage speculation,” he told reporters in Beijing today at the International Finance Forum.

 

“Liu said this has ’seriously affected global asset prices, fuelled speculation in stock and property markets, and created new, real and insurmountable risks to the recovery of the global economy, especially emerging-market economies.’

 

“His view echoes that of Donald Tsang, the chief executive of Hong Kong, who said the Federal Reserve’s policy of keeping interest rates near zero is fueling a wave of speculative capital that may cause the next global crisis.”

 

“‘I’m scared and leaders should look out,’ Tsang said in Singapore Nov. 13. ‘America is doing exactly what Japan did last time,’ he said, adding that Japan’s zero interest rate policy contributed to the 1997 Asian financial crisis and U.S. mortgage meltdown.”

 

It is not just China. Brazil has moved to impose a tax (or tariff) on investment money coming into the country on a shorter-term basis, as they are worried about both a bubble in their markets and in their currency. Russia is openly considering similar policies.

 

I have been doing a lot of speaking in the last month. In almost every speech, I warn of the significant imbalance in the dollar. I walk to the very end of the stage to help illustrate that the world now has on a massive ABD trade. By that I mean Anything But Dollars. Everyone is now on the same side of the boat. They have borrowed dollars to buy other risk assets, assuming that the dollar, like the yen in the glory days of the yen carry trade, will continue to fall. Dollar bears are everywhere.

 

Explanations abound for why the dollar is a trash currency. It is Fed policy, or the Obama administration’s willingness to run massive deficits, or the trade deficit or our health-care policy or (pick any number of issues). But I wonder.

 

Global trade collapsed last year and well into this year. Global trade was essentially done in dollars. If global trade is down 20% or more, then there is less need for companies in various countries to hold dollars and more need for local currency because of the crisis. Thus, after a rush to safety in the credit crisis, there is a rational selling of dollars by business.

 

 

 

Look at the above chart. Notice that the dollar is roughly where it was 20 years ago. And notice the recent jump during the credit crisis. We are not even back to where we were before the crisis.

 

What happens if world trade picks back up, as it appears to be doing? Admittedly, it is not a robust recovery as yet, but it is rising. That means more need for dollars. And dollars which are being borrowed (and probably leveraged!) on the assumption the dollar will continue to fall.

 

And I agree that, over time, the case for the dollar is not as good as I would like. But in the meantime, we could have one very vicious dollar rally, which would take equity markets down worldwide, along with other risk assets. Why? Because it would be a major short squeeze.

 

Barron’s just did a survey. It revealed that the bullish sentiment on stocks is quite high and almost everyone hates US treasuries (graph courtesy of David Rosenberg of Gluskin, Sheff)

 

 

 

Whenever sentiment gets too strong in one way or the other, it is usually setting up the markets for a rally in the despised asset. Mr. Market like to do whatever he can to cause the most pain to the largest number of people.

 

I am not predicting a near-term crash or imminent precipitous bear, although in this environment anything can happen. I am merely noting that there is an imbalance in the system. The longer this imbalance goes on, the more likely it is that it will end in tears. And the irony is that a recovering world economy could be the catalyst.

 

The Wild Things? They may be hiding in a portfolio near you. Just food for thought. Stay nimble.

 

New York, London, and Switzerland

 

I am going to hit the send button on what may be the shortest e-letter I have ever done. The travel is catching up with me and I need some rest.

 

I am looking forward to Thanksgiving next week. It may be my favorite holiday. Family, friends, food, and football. My usual pattern is to get up very early Thursday and start the prime slow-cooking, and then turn to the side dishes. It will be no different this year. My brother will bring the smoked turkeys, which he has down to an art form. And then there are the over-the-top wines I was so graciously given this past birthday by so many friends. I will bring a few of those bottles out.

 

The next weekend I am in New York for Festivus with the crowd from Minyanville, and then I am home for over a month before I go to London and Switzerland in late January. Then not much is currently scheduled until April, although it always does seem to change. After the recent hectic schedule (15 cities and even more speeches in just a little over three weeks), I look forward to some home time.

 

I wish those of you in the US the best of Thanksgivings, and the rest of you a great week. And thanks for all the very kind words of late about Tiffani. She seems to be doing better. She is due in a month, so she is still moving slowly, but you can sense the excitement in her and Ryan. I find it all very pleasant.

 

Your “there’s no place like home” analyst,

 

 

John Mauldin, Best-Selling author and recognized financial expert, is also editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. For more information on John or his FREE weekly economic letter go to: http://www.frontlinethoughts.com/learnmore

‘THE WORLD IS A BETTER PLACE,’ by MarketWatch via fidelity.com.

Stock markets outside the United States are recuperating much faster from the bear’s mauling. Accordingly, many investors have been pouring money overseas, which is one reason why non-U.S. stocks have been advancing so strongly.

 

The Dow Jones Global Total Stock Market Index, which includes 11,745 stocks in 64 countries, jumped 29% this year through Oct. 30. That advance reflected a 23.5% decline from the beginning of the year through March 9 and a following lift-off rally of 68.7%.

 

By contrast, the 10-month gain for the U.S. market was 18.4%. (All performance figures are on a total return basis, which means dividends are included.) The early-year decline was just a shade worse in the U.S., and the subsequent jump trailed the global recovery by 12 percentage points.

 

“Global,” however, includes the United States. By excluding that market, the discrepancy becomes even more pronounced: “Ex-U.S.” markets sank 22.7% in the first part of the year — two percentage points less than U.S. stocks — and then rocketed 77.8% to post a 10-month increase of 37.4%, or more than double that of U.S. stocks.

 

‘Ex’ marks the spot

Investors don’t necessarily realize the effect their investments have had on these markets. Ex-U.S. (a.k.a. international) markets are divided into two main types, developed and emerging. The former are fewer in number (29) but bigger in market capitalization ($14 trillion), while the latter are in exactly the opposite condition (35 countries with $2.8 trillion in market cap).

 

Emerging markets tend to be among the most volatile because investment capital surging in and out can move prices a lot, largely because liquidity is lower. Despite that tendency, the DJ emerging market index fell just 15% in the first couple months of the year, or roughly eight-to-10 percentage points less than its counterparts.

 

Partly because of that resilience, perhaps, the next eight months brought a literal doubling of returns — up 100.3%. The result: emerging markets logged a 10-month return of 70.2%, luring investors out of domestic tranquility to roam the globe.

 

Developed markets showed far less pep, but still beat U.S. performance. They dropped a more-typical 23.8% early in the year, and then jumped 74% for a 10-month gain of 32.5%.

 

The biggest gainers among developed markets — mostly because of large-stock outperformance — were Cyprus (90.7% higher), Norway (up 79.8%) and Sweden (a 71.1% gain). Bringing up the rear were Iceland (slipping 0.3%), Japan (up 7.1%) and Malta (15% higher).

 

Emerging markets leaders include Sri Lanka (up 140.46%, driven by big gains in all three size categories), Indonesia (116.98% higher, propelled by surges in both large- and mid-sized stocks) and Brazil (a 111.57% advance, mainly in large stocks). On the back end were Slovakia (down 24.7%), Jordan (6.8% lower), and Bahrain (off 3.9%).

 

Small scores big

Small stocks were the best performers in both developed and emerging markets by wide margins over mid-sized and large stocks. That is a departure from the U.S. pattern in which mid-sized stocks did better than large or small.

 

On Oct. 30, small stocks were 48% higher than at the start of the year among developed countries and a stunning 87.7% higher among emerging markets. By contrast, mid-sized stocks were up 39.5% (developed) and 72.9% (emerging), while large stocks gained 30.5% (developed) and 67.5% (emerging).

 

Leading the small-stock surge among emerging markets were Russia (a 193.4% surge), the Philippines (up 156.4%) and Sri Lanka (128.9% higher). Laggards were Jordan (down 8.5%), Kuwait (5% lower) and Morocco (up 5.3%).

 

In the developed-market camp, the best performers were Israel (up 131%), Hong Kong (a 108.6% gain) and Austria (104.5% higher). The stragglers were Cyprus (down 1.4%), Malta (off 1%) and Iceland.

 

Strong sectors

Basic Materials was the big winner among ex-U.S. industries, jumping 50.4% in developed countries and 106.6% in emerging markets. Industrial metals and mining were the hottest sectors.

 

Utilities did the worst among the 10 industries in developed countries, edging up just 0.03% in the 10 months. Among emerging markets, Telecommunications took the hindmost with “only” a 27.81% gain.

 

Looked at another way, though, Health Care was in the best position as of Oct. 30 because it was down only about 10% from the market peak in 2007. In a near-tie for second and third by this measure were Oil & Gas (roughly 18% below peak) and Consumer Goods (about 19% lower).

 

Beleaguered Financials, of course, remain farthest (40% lower) from the market’s 2007 high, followed by Industrials (down 32%) and Technology (off 31%). The remaining industries — Basic Materials, Consumer Services, Telecommunications and Utilities — are all 20% to 28% lower.

 

If capital continues to pour into ex-U.S. markets, it could flow to those countries and industries that have not risen as far or fast as the 10-month winners. If capital starts to pour out, the big gainers thus far are the most vulnerable.

 

‘CRA BASHING. Nth GENERATION, ‘ by James Kwak at baselinescenario .com.

CRA Bashing, Nth Generation

Posted: 19 Nov 2009 09:00 AM PST

The Community Reinvestment Act is a law originally passed in 1977 that directed federal regulatory agencies to ensure that the banks they supervised were not discriminating against particular communities in making credit available.The onset of the subprime mortgage crisis triggered a flood of sloppy, lazy attacks on the CRA claiming that since the crisis was created by excess lending to the poor, and the CRA was intended to increase lending to the poor, the CRA must have caused the crisis. These arguments suffered from a mistaken premise (subprime lending had a modest negative correlation with income, but many subprime loans were used by the middle class to buy expensive houses in the suburbs and exurbs of California and Nevada) and a failure to check their facts (“Only six percent of all the higher-priced loans were extended by CRA-covered lenders to lower-income borrowers or neighborhoods in their CRA assessment areas, the local geographies that are the primary focus for CRA evaluation purposes.” — Randall Kroszner, former Fed governor appointed by President George W. Bush, in a Federal Reserve study that also found that subprime loan performance was no worse in CRA-covered zip codes than in slightly more affluent zip codes not covered by the CRA.)

Yesterday at a Cato Institute conference, Edward Pinto, chief credit officer at Fannie from 1987 to 1989 and currently a real estate financial services industry consultant (according to recent Congressional testimony), rolled out the new line. The new argument is a curious mirror image of the old argument (which Pinto himself may not have made): now the subprime explosion did not cause the housing bubble, but was caused by the housing bubble and … wait for it … the CRA caused the housing bubble, along with the affordable housing goals of Fannie and Freddie.

Before going further, it’s time for my favorite lesson on correlation and causality.

The idea that the housing bubble caused the explosion in subprime lending is not crazy. The worst excesses in mortgage lending happened in 2003-06, after housing prices had already reached historical highs. The idea is that with prices so high, lenders had to offer exotic mortgages (and stop checking for documentation) in order to make the houses affordable for new borrowers. (Of course, there should have been stronger safeguards against those exotic mortgages — consumer protection enforcement, better credit rating agencies, etc. — but that’s another topic.)

But the weirder part of the argument is that the CRA caused the housing bubble. A policy could push housing prices up by increasing the availability of credit in a way that increases borrowers’ buying power. However, that can only contribute to a bubble if (a) it increases the number of loans that cannot be paid off, making price rises unsustainable and (b) there is some continually-increasing aspect to the policy, without which prices should simply reset at a higher level.

Pinto gets into an argument with the Federal Reserve study (cited above) on the performance of CRA-covered loans, claiming that those loans are doing worse than the Fed claims; I can’t judge that without seeing something in more detail. But even so, there are a few missing elements to the causal chain. One is that the CRA should only have an effect in low-income communities, and unless the people buying houses in the Nevada desert were all people who had been priced out of low-income communities by the CRA, it’s hard to blame the real housing price craziness on the CRA. Another is that the CRA itself has provisions that say that lenders do not have to make loans that are unprofitable. A third is that if the CRA was forcing banks to make unprofitable loans, then you would expect the nonbank lenders to stay out of those market segments; in fact, we saw just the opposite.

Back in 2000, Cato had a different line on the CRA. Jeffrey Gunther wrote an article in a Cato journal arguing that the CRA should stand for “Community Redundancy Act” because competitive forces in the market made it unnecessary — lenders seeking profits would not discriminate against particular communities. Gunther cited subprime lending as an example of the type of profit-seeking innovation that made the CRA unnecessary. He noted exactly what CRA defenders argue today:

“If CRA were the driving force behind the recent increases in home-purchase lending in low-income neighborhoods, we would see evidence of a treatment effect. Lenders subject to the ‘CRA treatment’ [regulated banks] would have refocused their activity toward CRA objectives to a greater extent than lenders in the untreated control group [nonbank lenders]. However, there is little evidence of such a treatment effect. To the contrary, it was lenders in the control group that refocused their efforts in line with the mid-1990s boom in lending in low-income neighborhoods. In fact, lending in low-income neighborhoods grew faster than other types of lending at institutions not covered by CRA, whereas low-income lending grew at the same rate as other types of lending activity for CRA-covered lenders.”

Gunther’s optimism about subprime lending seems naive in hindsight, although it was shared by many prominent economists and policymakers from Alan Greenspan on down.

For the CRA to be the problem, the causal factor would have to be availability of credit in low-income communities. But from what I’ve read, it seems like today’s problem is no longer redlining — plenty of lenders were willing to lend to the poor. It’s predatory lending — they found that for various reasons it was easier to steer poor people into unnecessarily high-cost loans. Now, I’m no fan of policies to encourage homeownership in general. I think we have too many of them. But the CRA is primarily a policy to discourage discrimination, and that is something we unfortunately still need.

By James Kwak

‘A MARKET “MELTUP”. WHICH WAY WILL YEAR-END GO?,’ by SmartMoney at fidelity.com.

The suspense is growing. As traders enter the homestretch of the year, is there room for one last rally?

Another run could depend on a so-called “meltup,” a term you’ve probably heard spouted repeatedly on business television. Although it’s not a tool in the belt of individual investors, it can influence their portfolios and their investing decisions.

A meltup is a self-perpetuating rise in stocks that occurs as institutional investors chase returns. It’s a game of catch-up they play after waiting too long to go long and, as a result, underperforming the major averages. As these investors pour money into the market to catch last-minute gains, stocks rally to levels that fundamentals rarely seem to support.

“What happens is you’ll see people sitting on the sidelines, buy-side firms, they’ll let the market take its course by hedge funds and momentum traders,” says Anu Sharma, managing director of the market intelligence desk at Nasdaq. “But if they start to lag performance, these buy-side firms will come in aggressively.”

Whether we see another meltup will be dictated by what we see in the next month or so, Sharma says. “It will be the hedge funds and momentum traders – whether they are driving performance, while the buy side sits on their hands.”

So just how likely is it? There’s a strong possibility, according to Ryan Detrick, senior technical strategist at Schaeffer’s investment research. “We still know we’re up significantly year to date,” he says. “Nonetheless, we know the majority of mutual funds and hedge funds are trailing [performance].”

And the timing is right. Over the past six months, every time the major averages have dipped to their 50-day moving averages, buying followed that led them to new highs. Notably, in the past few weeks, the major averages have broken below this metric.

Sure, it looks like the same old trend, Sharma says. “I think we’ve seen the retracement that we’ve needed to see, and now the market is going to try to make another run for it. But the market is slowly running out of steam, and the volumes aren’t dictating that we can make another big run.”

There’s also some concern because the averages didn’t just come near the lows, they broke through them, which alone could trigger a break in the pattern and could mean the major averages aren’t due for another round of highs just yet.

“While we believe that the primary uptrend in stocks remains intact, our analysis now suggests that the market may not be able to handle the truth in the short term and should test support at lower levels,” Richard Ross, chief technical strategist for Auerbach Grayson, wrote in a note earlier in the week. “The important violation of the 50-day moving average has earned our respect.”

Factor in a 57% increase in the CBOE volatility index, which is considered a reading on fear in the market, and Ross believes a more cautious approach is warranted.

A recent poll showed only 22% of individual investors surveyed were bullish, the lowest number of bulls in eight months, says Schaeffer’s Detrick. But his firm uses that poll as a “contrarian indicator,” which means it expects those individual investors will be wrong. So a meltup, or even an increase on fundamentals, may yet be on the way, he says. The last time the poll showed investors to be this bearish was March 5, and “we all know March was a really good time to be long,” Detrick says.

“As long as we can stay above the October lows on the S&P 500 , you have to give the bulls the benefit of the doubt,” he says.

‘CORPORATE INSIDERS BETTING ON RALLY CONTINUING,’ Mark Hulbert at Marketwatch via fidelity.com.

Most investors expected the stock market’s October correction to be much deeper and last much longer.

 

Not corporate insiders, however. Soon after that correction began, they markedly picked up the pace of their buying. And this trend has continued since then.

 

The stock market neatly obliged, by almost immediately bringing that correction to an end. The Dow Jones Industrial Average  is now trading comfortably at a 52-week high.

 

Consider the ratio of insider selling to insider buying that is calculated each week by the Vickers Weekly Insider Report, published by Argus Research. In the week ending last Friday, according to the latest issue of the service, this ratio stood at 1.96-to-1. Three weeks ago, in contrast, this ratio stood at 4.52-to-1.

 

As David Coleman, Vickers’ editor, wrote earlier this week, “Insiders … seem to think that there is long-term value still to be found in the shares of their companies.”

 

You might wonder why a 1.96-to-1 sell-to-buy ratio is considered to be bullish, since it means that insiders sold 1.96 shares for every one that they bought.

 

The answer lies in the reasons why insiders will sometimes sell their companies’ shares, which not infrequently have nothing to do with their opinions of those shares’ prospects — such as paying a down payment on a house, or a child’s college tuition. As a result, the insiders’ historical sell-to-buy ratio has averaged between 2-to-1 and 2.5-to-1, according to Vickers.

 

In relation to that historical average, therefore, the current 1.96-to-1 ratio is slightly below average — and to that extent bullish.

 

Furthermore, according to research conducted by University of Michigan finance professor Nejat Seyhun, the average sell-to-buy ratio in recent years has been closer to 6.5-to-1. This can be traced in large part to the increasing share of insider compensation that has come from equity grants from their companies.

 

Since the insiders did not acquire these shares by purchasing them, they will never show up in the sell-to-buy ratio. But insider sales of those shares most definitely will show up, skewing that ratio towards increasingly negative readings.

 

In light of Seyhun’s findings, of course, the current sell-to-buy ratio of 1.96-to-1 is even more bullish.

 

Regardless, Vickers is most definitely not using the recent positive trend of insider behavior to throw caution to the winds. Its two model portfolios on average currently have a healthy 50% cash position, in fact.

 

This also is consistent with the recommended equity exposure of the other insider-oriented newsletter monitored by the Hulbert Financial Digest: Jonathan Moreland’s Insider Insights.

 

The bottom line for those inclined to follow the lead of the insiders: Don’t give up on this rally yet.

 

‘VITAMIN D SHOWS HEART BENEFITS,’ in the N.Y. Times.

Vitamin D Shows Heart Benefits in Study

By RONI CARYN RABIN

Vitamin D lowered the risk of heart disease in a new study.

Got vitamin D? It may protect you from heart disease.

 

Vitamin D, of milk fame, is known for helping with calcium absorption and for building strong bones, which is why it’s routinely added to milk. But there is more and more evidence that vitamin D is a critical player in numerous other aspects of metabolism. A new study suggests many Americans aren’t getting anywhere nearly enough of the vitamin, and it may be affecting their heart health.

 

In the study, researchers looked at tens of thousands of healthy adults 50 and older whose vitamin D levels had been measured during routine checkups. A majority, they found, were deficient in the vitamin. About two-thirds had less vitamin D in their bloodstreams than the authors considered healthy, and many were extremely deficient.

 

Less than two years later, the researchers found, those who had extremely low levels of the vitamin were almost twice as likely to have died or suffered a stroke than those with adequate amounts. They also had more coronary artery disease and were twice as likely to have developed heart failure.

 

The findings, which are being presented today at an American Heart Association conference in Orlando, don’t prove that lack of vitamin D causes heart disease; they only suggest a link between the two. But cardiologists are starting to pay increasing attention because of what they’re learning about vitamin D’s roles in regulating blood pressure, inflammation and glucose control — all critical body processes in cardiovascular health.

 

Earlier experiments in mice that were genetically altered not to respond to vitamin D found that the animals developed high blood pressure and a heart condition called left ventricular hypertrophy. And population studies of humans found higher rates of coronary heart disease and hypertension the further people live from the equator. Vitamin D deficiency is rare in tropical settings because of the strong sunlight, which promotes creation of the vitamin in the skin.

 

“What we were taught in medical school about vitamin D is that it’s associated with rickets and calcium metabolism,” said Dr. Joseph B. Muhlestein, a researcher with Intermountain Medical Center in Murray, Utah, and one of the authors of the new study. “We cardiologists didn’t worry about it; and we certainly didn’t order vitamin D levels.”

 

That, however, is changing. “What’s been discovered in the last few years is a significantly greater role for vitamin D,” Dr. Muhlestein said. “There are perhaps 200 different important metabolic processes that use vitamin D as a co-factor.”

 

The study involved 27,686 patients at the Intermountain Medical Center based in Salt Lake City. Low tobacco and alcohol use rates in that patient population made it easier for researchers to focus on the effects of vitamin D on heart health.

 

Patients were divided into three groups based on their vitamin D levels: “normal,” for those who had over 30 nanograms per milliliter of blood, “low” for those with levels of 15 to 30, and “very low” for those with levels less than 15.

 

Those with the lowest vitamin D levels were 77 percent more likely to die during the follow-up, 78 percent more likely to have a stroke and 45 percent more likely to develop coronary artery disease than those with normal levels. They were twice as likely to develop heart failure as those with normal levels. And even those who had moderate deficiencies were at higher risk, the researchers said.

 

People who were vitamin D deficient were also twice as likely to have diabetes and tended to have more high blood pressure. But being vitamin D deficient was an independent risk factor for poor outcomes, regardless of other risk factors like diabetes, Dr. Muhlestein said.

 

The next step for researchers is to figure out whether vitamin D deficiency actually causes disease. It’s possible that people who already have an underlying illness spend more time indoors and aren’t exposed to the sun, where they can absorb vitamin D through the skin. It’s also possible that disease processes already under way may affect vitamin D levels.

 

A clinical trial that randomly assigns participants to take vitamin D supplements or a placebo might be the next step, Dr. Muhlestein said. Researchers at Harvard and Brigham and Women’s Hospital are starting a large trial in January that will test the effects of vitamin D and omega-3 fatty acid supplements on men and women in their 60s.

 

Dr. Thomas Wang, an associate professor of medicine at Harvard who published an earlier trial on vitamin D deficiency and heart disease, said that whether treating vitamin D deficiency will have a beneficial effect on heart health is still an open question.

 

“If that does turn out to be the case, it would have pretty profound public health implications,” he said. “Vitamin D deficiency is very common in this country and other developed countries in northern latitudes, where people don’t get much sunlight and spend most of their time indoors.”

 

Doctors warn that anyone concerned about vitamin D levels should check with a doctor and have blood tests run. Vitamin D supplements are inexpensive and sold over the counter, but excessive amounts of vitamin D can be toxic.

 

The Institute of Medicine recommends adults under 50 who aren’t getting vitamin D from the sun get 200 international units of vitamin D a day, and that those 50 to 70 get 400 I.U. a day. Elderly people need even more. There is some controversy, however, over optimal amounts. Many doctors are advising their patients to take much higher amounts, such as 1,000 I.U. a day. The American Academy of Pediatrics has already increased its recommendation for supplementing breastfeeding infants to 400 I.U. — vitamin D is one nutrient breast milk doesn’t provide enough of — and the Institute of Medicine will issue updated recommendations in May 2010.

‘BANKING IN A STATE,’ by Simon Johnson at baselinescenario .com . GREAT READ!!!!!!!!!

Banking In A State

Posted: 17 Nov 2009 05:14 AM PST

 

“Banking on the State” by Andrew Haldane and Piergiorgio Alessandri is making waves in official circles.  Haldane, Executive Director for Financial Stability at the Bank of England, is widely regarded as both a technical expert and as someone who can communicate his points effectively to policymakers.  He is obviously closely in line – although not in complete agreement – with the thinking of Mervyn King, governor of the Bank of England.

 

Haldane and Alessandri offer a tough, perhaps bleak assessment.  Our boom-bust-bailout cycle is, in their view, a “doom loop”.  Banks have an incentive to take excessive risk and every time they and their creditors are bailed out, we create the conditions for the next crisis.

 

Any banker who denies this is the case lacks self-awareness or any sense of history, or perhaps just wants to do it again.

 

The Haldane-Alessandri “doom loop” is fast becoming the new baseline view, i.e., if you want to explain what happened or – more interestingly – what can happen going forward, you need to position your arguments relative to the structure and data in their paper.

 

For example, at Mr. Bernanke’s reconfirmation hearing, these issues will come up in some fashion.  The contrast between the hard-hitting language of the “doom loop” and Ben Bernanke’s odd statements on the dollar yesterday could not be more striking.  Still, there is no reason to regard the Haldane-Alessandri version of the doom loop as the final word; in fact, this where the debate now heads.  (This link gives as useful introduction to relevant aspects of banking theory, as well as Eric Maskin’s insightful personal take.)

 

To help move the discussion forward, here are some issues for Banking on the State raised in discussions with top experts (who prefer to remain anonymous):

 

The authors say that it is clear, in retrospect, that banks were excessively leveraged.  But how did regulators/supervisors miss the implications of this at the time?  Banks’ balance sheets started expanding from 1970 onwards (page 3) and by 2000 “balance sheets were more than five times annual UK GDP.”  This was not an overnight development – see the last sentence on page 8 which says “Higher leverage fully accounts for the rise in UK banks’ return on equity up until 2007″.  It may be difficult for a central banker to come clean on who convinced whom that modern banking in this form is safe – but at a minimum the authors should draw lessons from earlier failures of regulators/supervisors when discussing prospective changes in the framework of regulation. Could some of the changes being proposed suffer the same fate as all previous attempts to regulate big banks? It seems the authors answer is that just moving things to Pillar I (from Pillar II) will help.  This sounds like wishful thinking.

The author are right that US banks faced a leverage ratio constraint, which European banks did not.  But US banks circumvented this by setting up SIVs – see the damage at Citi for details.  Again, what were the regulators/supervisors thinking when they allowed this?

The authors assume that the equity owners of banks are almost always protected and therefore “the rational response by market participants is to double their bets”. This does not seem to have been true in practice.  For example, why was it so difficult for banks to raise capital after the initial flurry of new capital from Sovereign Wealth Funds (SWFs)? Why did some banks share prices fall so much (Citi, Merrill Lynch, Morgan Stanley, etc)? This cannot not be characterized as a rational response by markets if equity holders were implicitly protected. In fact, new capital (either from the state, or even in some cases from SWFs) came in the form of (expensive) preferred stock and diluted existing holders.  The doom loop is surely more about what happens to insiders (rich and powerful bank executives, with strong political connections) and creditors (investment funds run by rich and powerful nonbank executives, with strong political connections).

Part of the (relatively) reasonable performance of hedge funds was due to them being forced quite early on to reduce leverage and asset holdings because banks were short of capital and tightened lending conditions. This fortuitously allowed hedge funds to reduce exposure before the crisis became most acute.  Haldane and Alessandri seem a little too inclined to believe the hedge funds’ own rhetoric at this stage.  This is worrying – the intellectual origins of our last crisis lie with central bankers believing that the private financial sector has evolved into a safer form.

To be clear, and a little contrary to what the authors imply: Most hedge funds do not operate with unlimited liability.  Often they have “watermark” provisions, limiting their fees while the fund shows losses.  But it is a simple matter to close down a failing fund and, a week or so later, open another (how many funds has John Meriwether closed?).  This will feed the next doom loop.

The private sector is unlikely to be able to self insure (e.g., various proposals discussed on page 18) because of the potential size of losses in a systemic event. We know there was private insurance for a large portion of the assets (CDOs insured through monolines, for example) but these insurers did not have credible resources. Similarly, implicit state guarantees may also not be sufficient (e.g., Iceland). This suggests strict controls on size of the financial system relative to the economy (and the tax base) may be necessary.

The paper is also relatively weak on the role of monetary policy in fuelling the doom loop.  But that is relatively easy to add on.

The overall conclusion of the paper follows uneasily from the main analytical thrust.  How can we believe that for the regulators, “next time is different“?  Most likely, next time will be exactly the same, with different terminology: the financial sector “innovates”, regulators buy their story that risks are now properly managed, and the ensuing bailout (again) breaks all records.

 

It’s all politics.  Unless and until you break the political power of our largest banks, broadly construed, we are going nowhere (or, rather, we are looping around the same doom).

 

Barney Frank points out that small banks have political clout also, and of course he’s correct that this drives some issues.  But how many small banks spend their time (and lobbying dollars) on Capitol Hill insisting that large banks must not be broken up?

 

Our core problem is that we now have banks that are Too Big To Fail; if you don’t agree, read and publicly refute Haldane.  In theory, these big banks could be effectively regulated, but this is a leap of faith that experienced policymakers (e.g., Mervyn King and Paul Volcker) are increasingly unwilling to make.

 

The biggest banks must be broken up.  This is not sufficient to end the doom loop, but it is necessary.

 

By Simon Johnson

‘SMART YEAR-END TAX MOVES,’ from the Wall St. Journal at fidelity.com.

Year-end tax planning always makes sense, but this year it’s especially vital.

 

Convulsions in the markets and the economy have shifted the ground beneath many taxpayers, and next year may bring major tax changes as lawmakers confront the record deficit.

 

Bottom line: review your taxes before it’s too late. “Too often, I can’t do anything for people who come to me in February,” says Douglas Stives, an accountant with Curchin Group in Red Bank, N.J.

 

Here are areas especially relevant now. (For more details, go to www.irs.gov.)

 

First-time home-buyer tax credit

Congress has just extended and altered this benefit, making it more generous for many. The new rules took effect on Nov. 6. The provision is a true dollar-for-dollar tax credit of up to $8,000 for 10% of the cost of a home. The credit is also refundable, meaning that even if a buyer doesn’t owe $8,000 of tax, she can claim the full benefit and receive a refund check.

 

The new law has more generous phase-outs. The credit now begins to disappear for single taxpayers with modified adjusted gross incomes of $125,000 and married couples with incomes of $225,000. It is available for purchases through July 1, 2010 if the buyer has a contract in place before May 1, 2010. Unlike the prior law, however, this credit is capped: those buying homes for more than $800,000 get no credit at all, as of Nov. 6.

 

The new law also authorizes a similar $6,500 credit for buyers who already own a home. It too is a refundable credit for 10% of the purchase price of a house costing no more than $800,000. To qualify the buyer has to have owned and lived in the same home for five of the eight years preceding the new home purchase, and the new home must become the buyer’s principal residence.

 

There are interesting twists. Two or more unmarried people buying a house together may be able to allocate the credit as they wish, say to the lowest earner. Taxpayers who buy this year may also claim the credit on either a 2008 or 2009 return, and those who buy in 2010 can claim the credit either in 2009 or 2010. Some people claim the credit in one year rather than another to avoid phase-outs.

 

Unemployment benefits

Alas, these are subject to income tax. But this year there is an exemption of $2,400 per individual. Still, many unemployed taxpayers receiving benefits may need to estimate and pay quarterly taxes or risk penalties when they can least afford them. IRS spokesmanEric Smith points out that all recipients can choose to have 10% of benefits withheld by the payer. “That should protect many,” he says.

 

American opportunity credit

In the roster of fiendishly complex and highly limited education incentives, this one is more useful than most. It is a tax credit for as much as $2,500, generated by spending on tuition and other education expenses (books, possibly a computer) up to $4,000. Currently this credit is available for 2009 and 2010 to single taxpayers with less than $80,000 of modified adjusted gross income and married couples earning less than $160,000. Amounts paid in 2009 for the spring of 2010 are eligible for a 2009 credit.

 

New car purchases

Taxpayers who buy a new car before Jan. 1, 2010, may deduct sales and excise taxes and other fees on as much as $49,500 of the purchase price. This provision has generous phase-outs: It disappears between $250,000 and $260,000 of modified adjust gross income for married couples and $125,000 and $135,000 for singles.

 

Retirement savings

Have you just started a job? Remember that you can still put in an entire year’s 401(k) contribution, which is $16,500 ($22,000 if you’re over 50). “Some workers who begin a job in the last quarter arrange to have an entire paycheck or two go into the plan,” says Melissa Labant, an attorney with the American Institute of CPAs.

 

Charitable gifts

Unless Congress acts, this will also be the last year for taxpayers over 70 1/2 to make a charitable contribution directly from an IRA. This provision is useful: without it, the donation would have to be withdrawn from the IRA, claimed as income and then deducted as a donation. That, in turn, can trigger deduction limits or jack up Medicare premiums in the future.

 

Investments

Take losses! Even after the run-up following the lows of last March, many investors still have long-term capital losses on investments held longer than one year. Taxpayers may deduct up to $3,000 of these losses per year against ordinary income, with the excess carried forward for use in future years. The assets must be held in cash accounts, as opposed to IRAs and other tax-sheltered retirement plans.

 

Capital losses also may be matched dollar-for-dollar against long-term capital gains — so if you have $20,000 of long-term losses on some investments and $15,000 of gains on others, after the $3,000 deduction, you’d only have a net loss of $2,000 to carry forward. What’s more, if you are bullish on an investment with gains and you sell it to soak up losses, you may buy the winner back right away. The tax code’s “wash sale” rules only apply to losers, which can’t be purchased for 30 days either before or after a sale. Note: The IRS also prohibits selling a loser from a regular account and then repurchasing it within an IRA inside of 30 days.

 

The current top capital-gains tax rate of 15% is the lowest in decades, and it is almost certain to rise at some point as the government scrambles to pay down the deficit. “If you have a buyer and a decent price, think about selling,” suggests Mr. Stives of the Curchin Group.

 

Medical expenses

This has long been one of the least useful deductions in the tax code, unless a taxpayer is seriously ill or in a nursing home, because the taxpayer must spend more than 7.5% of adjusted gross income to claim any deduction. But rising insurance costs and diminishing coverage plus this year’s economic tumult may qualify more people for this deduction.

 

In general, taxpayers may deduct all un-reimbursed medical expenses recognized by the IRS. This category includes after-tax dollars spent on insurance premiums, Medicare Part B and D premiums, and co-payments for drugs and treatments. It also extends to costs that insurance almost never covers- such as weight-loss plans (if prescribed for a medical condition), lead abatement, bandages, wigs after chemotherapy, acupuncture, and medical travel (24 cents per mile). But it typically does not cover expenses for over-the-counter drugs such as aspirin or antihistamines, which some Flexible Spending Plans reimburse.

 

Copyright © 2009 Dow Jones & Company, Inc. All Rights Reserved.

‘THE WORST IS YET TO COME. UNEMPLOYED AMERICANS SHOULD HUNKER DOWN FOR MORE JOB LOSSES ,’ by Nouriel Roubini in the N.Y. Daily News.

The worst is yet to come: Unemployed Americans should hunker down for more job losses

BY NOURIEL ROUBINI

Think the worst is over? Wrong. Conditions in the U.S. labor markets are awful and worsening. While the official unemployment rate is already 10.2% and another 200,000 jobs were lost in October, when you include discouraged workers and partially employed workers the figure is a whopping 17.5%.

While losing 200,000 jobs per month is better than the 700,000 jobs lost in January, current job losses still average more than the per month rate of 150,000 during the last recession.

Also, remember: The last recession ended in November 2001, but job losses continued for more than a year and half until June of 2003; ditto for the 1990-91 recession.

So we can expect that job losses will continue until the end of 2010 at the earliest. In other words, if you are unemployed and looking for work and just waiting for the economy to turn the corner, you had better hunker down. All the economic numbers suggest this will take a while. The jobs just are not coming back.

There’s really just one hope for our leaders to turn things around: a bold prescription that increases the fiscal stimulus with another round of labor-intensive, shovel-ready infrastructure projects, helps fiscally strapped state and local governments and provides a temporary tax credit to the private sector to hire more workers. Helping the unemployed just by extending unemployment benefits is necessary not sufficient; it leads to persistent unemployment rather than job creation.

The long-term picture for workers and families is even worse than current job loss numbers alone would suggest. Now as a way of sharing the pain, many firms are telling their workers to cut hours, take furloughs and accept lower wages. Specifically, that fall in hours worked is equivalent to another 3 million full time jobs lost on top of the 7.5 million jobs formally lost.

This is very bad news but we must face facts. Many of the lost jobs are gone forever, including construction jobs, finance jobs and manufacturing jobs. Recent studies suggest that a quarter of U.S. jobs are fully out-sourceable over time to other countries.

Other measures tell the same ugly story: The average length of unemployment is at an all time high; the ratio of job applicants to vacancies is 6 to 1; initial claims are down but continued claims are very high and now millions of unemployed are resorting to the exceptional extended unemployment benefits programs and are staying in them longer.

Based on my best judgment, it is most likely that the unemployment rate will peak close to 11% and will remain at a very high level for two years or more.

The weakness in labor markets and the sharp fall in labor income ensure a weak recovery of private consumption and an anemic recovery of the economy, and increases the risk of a double dip recession.

As a result of these terribly weak labor markets, we can expect weak recovery of consumption and economic growth; larger budget deficits; greater delinquencies in residential and commercial real estate and greater fall in home and commercial real estate prices; greater losses for banks and financial institutions on residential and commercial real estate mortgages, and in credit cards, auto loans and student loans and thus a greater rate of failures of banks; and greater protectionist pressures.

The damage will be extensive and severe unless bold policy action is undertaken now.

Roubini is professor of Economics at the Stern School of Business at New York University and Chairman of Roubini Global Economics.

Top economic prognosticator says job seekers

must face grim economic facts

Read more: http://www.nydailynews.com/opinions/2009/11/15/2009-11-15_the_worst_is_yet_to_come_unemployed_americans_should_hunker_down_for_more_job_lo.html#ixzz0X8Dn9OO3

‘DON’T DUMP MUNIS, BUT BE CAREFUL,’ in Barron’s at fidelity.com.

New York state may be broke by Christmas. New Jersey’s governor-elect reportedly is mulling a fiscal emergency. And California’s budget deficit is widening again. Nationwide, state tax revenues are down more than any time in nearly a half century.

 

How could anybody buy municipal bonds under these dire circumstances? The answer is, very carefully. It is possible to avoid the budget landmines and earn attractive returns through careful selection of credits and broad diversification.

 

In the week’s Barron’s Current Yield column, colleagueTom Sullivan reports that famed short-sellerJames Chanos advised investors to flee munis. “State and local municipal finances are a mess and going to get worse,” Chanos declared.

 

Since that column was published, the bad news has kept piling up. New York Gov.David A. Paterson told a joint session of the state legislature Monday that drastic steps are needed to close a $4.1 billion deficit in the current fiscal year ending March 31. Shortfalls of $7.8 billion and $15.1 billion loom in the next two years. “We are going to run out of cash in four-and-a-half weeks,” Paterson warned.

 

Meanwhile, New Jersey Governor-electChris Christie may declare a fiscal emergency to close an $8 billion deficit, the Newark Star-Ledger reported. And California Gov.Arnold Schwarzenegger told The Fresno Bee that the state’s budget faces a gap of $5 billion to $7 billion in the current fiscal year ending June 30 in addition to a $7.4 billion gap the following year.

 

The budget woes are spread across the nation. According to the Rockefeller Institute of Government, state tax revenues suffered a record decline in the second quarter of 16.6% from a year. That’s the biggest year-over-year decline in the institute’s record going back to 1963.

 

What’s stunning is that states’ revenues are getting hit much harder than localities’ collections, which were down only 2.8% over the same period. That’s because states tend to be more dependent on income-tax revenues than cities and towns, which mainly collect sales and property taxes. Of the latter, they were actually up a surprising 3.1% despite the collapse in house prices.

 

Still more surprisingly, withheld income-tax payments in the second quarter were down only 4%. The really big hit came from a steep fall-off in non-withheld taxes, a big chunk of which comes from capital gains. After 2008’s market meltdown, gains were few and far between.

 

Even given the dire budgetary straits in which states find themselves,George Friedlander, the veteran muni-bond market analysts at Morgan Stanley Smith Barney, contends the potential for defaults is greatly exaggerated. He notes that 49 out of 50 states are constitutionally required to balance their budgets. Moreover, any default by a state would shut it out from borrowing for years and severely crimp its ability to raise capital for vital projects. In any case, state governments cannot file for Chapter 9 bankruptcy, although local entities can.

 

That said, investors can suffer steep losses even if a state doesn’t default. During California’s budget crisis last summer, some of the state’s general obligation bonds plunged to 80 cents on the dollar. Sellers at the lows took hits, but opportunistic buyers are sitting on handsome profits now that the bonds have rebounded.

 

But muni-bond buyers are looking for stability and steady income to counter the volatility in other parts of their portfolio, such as stocks. To accomplish that, Friedlander suggests investors reduce their exposure to vulnerable credits, such as the GOs of states that have generated the dire headlines.

 

Instead, he recommends higher-grade bonds, with an emphasis on essential-service revenue bonds. People who lose their job stop having income taxes withheld, but they typically continue to pay their water and sewer bills, for instance. Local school districts will continue to collect property taxes as well. Bondholders, moreover, usually have first dibs on those monies.

 

Friedlander advises investors diversify into bonds issued out of state to spread risks. Many individuals stick to issuers in their own state to get the advantage of exemption of interest payments from their state’s income tax as well as federal levies. But putting all your eggs in the same geographical basket has obvious risks.

 

The muni maven recommends investors not rush to dump their possibly vulnerable bonds because they may get lousy bids going into the end of the year. Dealers may be loath to take on bonds, especially dicey credits, he says. Meanwhile, Friedlander suggests that buyers look to new issues, which are apt to be priced to sell.

 

Muni-bond fund holders have it easier; they can usually switch easily and at no cost. For instance, even if you bought a muni fund with a load, you typically can swap it for another member of the same fund family without paying a second sales charge.

 

Of course, if you’re in a no-load fund, there’s usually no cost to switch to any another fund. (There may be a redemption fee for funds held for only a short term. There also may be transaction fees, even at discount brokers, although most offer non-transaction-fee funds.)

 

So, if you own a California-only fund, the easiest thing would be to swap it for the same fund family’s national fund. Or you could split the money up among short-, intermediate- and long-term national funds to limit the risk from rising interest rates, even though that would result in lower yields. You could also consider adding a high-yield muni fund, which ironically might be less prone to the risks facing higher-grade GO bonds. Again, it would provide another measure of diversification.

 

One last alternative, closed-end muni funds, should be kept in mind. Bargains frequently appear near the end of the year as investors sell for tax losses, but discounts currently aren’t terribly compelling. The biggest discounts currently are in Michigan, New York and Delaware funds, the sites of some of the worst fiscal problems. When the going gets tough, real bargains may appear for opportunistic buyers ready and able to pounce.

 

Meantime, the news is bad for states’ finances and their GO bonds. That doesn’t mean investors should flee munis altogether.

 

‘CHINA’S SPRINT FOR THE GOLD,’ in the N.Y.Times / Week in Review.

PRESIDENT OBAMA’s first official visit to China brings him this weekend to a country that, despite the global downturn, is increasingly wealthy, confident, ambitious — and perplexing.

 

Over the past decade, even as China’s exports have soared, the nation has begun transforming itself from a global font of low-priced goods fueled by cheap labor into a much more diverse and complex economic power. Along with that, it has developed huge disparities of wealth.

 

“There are a lot of billionaires, but there’s also a lot of poverty in China,” says C. Fred Bergsten, director of the Peterson Institute for International Economics in Washington. “It’s a very bipolar society. People have to recognize that both elements are there.”

 

Per capita income, for example, is still small — about $3,200, which is less than 10 percent that of the United States and slightly more than that of Iraq — and many farmers earn less than a dollar a day. Yet China is also home to the fastest-growing number of billionaires.

 

China doesn’t just dominate trade; it scours the globe for resources; doles out multibillion-dollar loans to other developing nations; and holds stakes in Wall Street giants like Morgan Stanley and the Blackstone Group.

 

A nation that sold about 600,000 cars in 2000 is now poised to eclipse the United States and is on course to sell nearly 15 million vehicles in 2009. No country has ever accumulated larger foreign exchange reserves ($2.2 trillion). No country has more Web surfers (338 million).

 

And China leads the world in initial public stock offerings.

 

Ask the world’s luxury brands where sales are holding up, and where they are expanding, and they will tell you here, in China. Every big city is building five-star hotels and the country’s newest airports make America’s look shabby.

 

In Washington, China is now viewed as both an economic rival and an increasingly important partner in trying to address some of the world’s most pressing problems. China is not just America’s biggest trading partner; it’s also America’s biggest foreign lender, buying up Treasury bonds and helping to finance the national debt. So American leaders talk about “strategic dialogues,” “strategic and economic dialogues,” and now “strategic reassurance.”

 

But even leading economists confess to difficulty at fully understanding the role of a nation dominated by state-owned companies.

 

For instance, while some argue that China’s low-cost manufacturing hurts America by draining away American jobs, other economists say that exporting those jobs to China allows companies to become more profitable in America, and expand their better-paying advertising, service and development departments at home. They also point out that Chinese factories hold down the price of everyday goods for Americans. One study, cited in “China: The Balance Sheet” (Public Affairs, 2006), said that, on average, America is about $70 billion a year richer because of trade with China.

 

Through all the arguments and counterarguments, one thing seems clear: China’s momentous shift is creating the need for armies of analysts, economists and experts to explain and forecast how China’s rise will remake the world, and the lives of ordinary Americans. At right are a few indicators of this country’s seemingly unparalleled rise, just over 30 years after the death of Mao.

 

‘WHO’S AFRAID OF A FALLING DOLLAR?, ‘ by Joseph Gagnon at baselinescenario .com.

Who’s Afraid Of A Falling Dollar?

Posted: 14 Nov 2009 03:05 AM PST

 

This guest post was submitted by Joe Gagnon, a senior fellow at the Peterson Institute for International Economics.  Joe is an expert on international economics has spent a great deal of time studying the effects of exchange rate depreciation.  Even if the dollar depreciates sharply in the near term, he argues that is unlikely to have adverse effects – primarily because inflation will stay low.

 

Pundits and policymakers around the world are wringing their hands over the possibility of further declines in the foreign exchange value of the dollar.  Predicting exchange rates is notoriously difficult; there is almost as much chance of the dollar rising next year as of it declining.  But if the dollar were to fall further, should we be concerned?

 

A lower dollar is good news for US exporters and foreign importers and bad news for foreign exporters and US importers.  However, if policymakers respond appropriately, there is no reason to fear overall harm either to the US economy or to foreign economies.  Indeed, a lower dollar could jumpstart the long-overdue rebalancing of the global economy away from excessive US trade deficits and foreign reliance on export-led growth, putting the world on track for a more sustainable expansion.

 

The fear in economies that are appreciating against the United States is that a falling dollar will choke off exports and hobble economic recoveries.  The correct response is to ease monetary policy and temporarily delay fiscal contraction.  As I explain here, even in economies with short-term interest rates near zero, there is plenty of scope for central banks to stimulate aggregate demand, and doing so will help to limit the extent to which the dollar falls.

 

For the United States, the benefits of a falling dollar are obvious: stronger exports and a faster recovery.  The fear is that a falling dollar would be inflationary.  However, as I have shown in two recent papers, even very large currency depreciations in developed economies have no effect on inflation unless they are caused by policies that attempt to hold an economy’s unemployment rate below its equilibrium level.  With US unemployment currently at 10 percent, there is no chance that inflation will rise in the near term.  Whether inflation rises in the longer run will depend on whether US monetary and fiscal policy stimulus is withdrawn appropriately as the economy recovers (and tighter macroeconomic policies would tend to support the dollar).  Many believe that US policymakers erred in not withdrawing stimulus soon enough in 2003-05, but policymakers now seem to be keenly aware of this mistake and have expressed their determination not to repeat it.  Only time will tell, but my own view is that the Federal Reserve, at least, will not allow runaway inflation.

 

For economies that peg their currencies to the dollar (notably China) the costs and benefits of a falling dollar are the same as those facing the United States and so is the policy dilemma:  how fast to tighten macroeconomic policy as the economy recovers?  These economies differ on several dimensions, including financial market development and capital controls, strength of economic ties to the United States, and prospects for economic slack and inflation.  These differences will determine the appropriate policy stance.  To some extent these economies have forfeited the freedom to adjust monetary policy, but they retain the option of adjusting the levels of their dollar pegs.  In some cases, a further decline in the dollar may represent an opportune moment to move to a floating exchange rate.

 

By Joseph E. Gagnon

‘BUFFET SAYS HIS BUSINESSES BOTTOMED, ‘ at Reuters via fidelity.com.

 

NEW YORK (Reuters) – Billionaire Warren Buffett said that while his businesses have bottomed after the worst financial crisis in decades, he saw few upticks and ruled out a buoyant holiday season.

Consumer demand will recover and it is likely that the economy would come back in two years rather than in one, Buffett said during an interview with Charlie Rose.

“Our businesses, they’ve bottomed … (there are) very few upticks,” said Buffett, the world’s second richest man, in response to Rose’s question about whether the “economic panic” is over.

Last month, preliminary government data showed the U.S. economy expanded in the third quarter, the first three-month period of growth since the second quarter of 2008.

Nonetheless, the U.S. unemployment rate last month reached 10.2 percent, the first double-digit reading in 26 years.

Buffett last week made a big bet on the U.S. economy when his Berkshire Hathaway Inc agreed to pay about $26.4 billion for the 77 percent of railroad company Burlington Northern Santa Fe Corp that it did not already own.

Buffett, perhaps the world’s most admired investor, estimated the U.S. dollar will depreciate as the U.S. government prints more dollars.

“The question is how much it depreciates in value,” said Buffett, 79.

The dollar has declined around 15 percent against a basket of six major currencies .DXY> from the highs set in March and is down more than 37 percent from a peak in 2001.

Buffett estimated the U.S. Congress will have to raise taxes and close the budget gap, which hit a record $1.4 trillion in the fiscal year closed at the end of September.

“In the end, Congress is the one that determines the value of the dollar over time. If they follow policies that require us printing too much of it, monetizing debt and all that sort of thing, dollars will become worth a lot less,” Buffett said.

“They’ve got to raise taxes now that income will go up as the recession ends anyway, but they’re going to have to close the gap between expenditures,” Buffett said.

Massive budget deficits could unnerve investors, worried that they spell additional government bond issuance to finance the funding gap, and the White House has said it plans to use the 2011 budget as a blueprint to improve the fiscal position.

“We cannot keep running fiscal deficits like we are currently without having a lot of consequences over time,” Buffett said.

‘NO TEARS FOR WEAK GREENBACK,’ by Melvyn Krauss in the N.Y.Times.

 

By MELVYN KRAUSS

Published: November 13, 2009

Washington’s policy, devaluing the U.S. dollar to increase U.S. exports, is clearly a “beggar-my-neighbor” policy. Yet no one’s been complaining.

Why not? Because the world thinks the greenback’s fall is good for global recovery. Even in Europe, the “neighbor” most “beggared” by the greenback’s fall, the silence has been deafening.

Europe is right for staying mum. The declining dollar — or strong euro — is helping European authorities restore health to the ailing banking sector — and that’s critical for Europe’s recovery.

According to senior officials in Frankfurt, the strong euro is allowing the European Central Bank to keep interest rates at crisis lows even though the crisis is passing. E.C.B. President Jean-Claude Trichet has made it clear in recent communications he is no hurry to raise interest rates.

The reason he can get away with this relaxed posture, without raising inflationary expectations in the euro zone, is that the euro has been surging on the foreign exchanges.

Indeed, with the kind of good economic numbers Europe has been posting lately, the E.C.B., most likely, already would have started raising interest rates were it not for the strong currency.

Even some of the southern-tier countries of the euro zone, traditionally uncomfortable with a strong currency, understand the strong euro is in their immediate interests.

With banks in such fragile condition, they would rather deal with a strong currency than higher interest rates, which might put some of their more challenged banks over the brink at the present time.

European policymakers are right to give the banks a chance to recover before interest rates start going up again. They understand Mr. Trichet is not going to allow inflationary expectations to become unglued simply to save some tottering European banks from going over the edge.

That is why they have turned a blind eye to the greenback’s decline. Washington’s currency policy may be “beggar-my-neighbor” when it comes to exports, but it clearly is helping Europe restore health to its ailing banking sector — and that is what really counts if Europe is to avoid sinking back into the economic abyss.

Actually, even when it comes to its exports, Europeans appear quite relaxed about Washington’s currency policy.

Perhaps they have come to realize that foreign exchange movements are less important for their overall macro-economic health than they thought they would be.

The majority of European trade flows, after all, are coming from intra-euro zone trade, which is not affected by the dollar’s decline. It also may be true that Europe’s export industries are more competitive than many thought.

German exports, in particular, have shown themselves to be resilient in the face of the surging euro.

It is good news that Europeans are showing a sense of proportion and common sense about the export dislocations caused by the dollar’s devaluation.

In the total scheme of things, they have been small potatoes relative to the other problems they have had to confront during the crisis. Why make a big deal out of them?

When you are in good health and you break a toe, it’s a big deal. When you are fighting cancer and you break a toe, it’s minor.

The help the declining dollar is giving to Europe’s banks is far more important for European recovery than any damage it might be doing to Europe’s exports.

Melvyn Krauss is a senior fellow at the Hoover Institution, a think tank at Stanford University.

‘FREE TO LOSE, ‘ by Paul Krugman in the N.Y.Times.

Consider, for a moment, a tale of two countries. Both have suffered a severe recession and lost jobs as a result — but not on the same scale. In Country A, employment has fallen more than 5 percent, and the unemployment rate has more than doubled. In Country B, employment has fallen only half a percent, and unemployment is only slightly higher than it was before the crisis.

Don’t you think Country A might have something to learn from Country B?

This story isn’t hypothetical. Country A is the United States, where stocks are up, G.D.P. is rising, but the terrible employment situation just keeps getting worse. Country B is Germany, which took a hit to its G.D.P. when world trade collapsed, but has been remarkably successful at avoiding mass job losses. Germany’s jobs miracle hasn’t received much attention in this country — but it’s real, it’s striking, and it raises serious questions about whether the U.S. government is doing the right things to fight unemployment.

 

Here in America, the philosophy behind jobs policy can be summarized as “if you grow it, they will come.” That is, we don’t really have a jobs policy: we have a G.D.P. policy. The theory is that by stimulating overall spending we can make G.D.P. grow faster, and this will induce companies to stop firing and resume hiring.

 

The alternative would be policies that address the job issue more directly. We could, for example, have New-Deal-style employment programs. Perhaps such a thing is politically impossible now — Glenn Beck would describe anything like the Works Progress Administration as a plan to recruit pro-Obama brownshirts — but we should note, for the record, that at their peak, the W.P.A. and the Civilian Conservation Corps employed millions of Americans, at relatively low cost to the budget.

 

Alternatively, or in addition, we could have policies that support private-sector employment. Such policies could range from labor rules that discourage firing to financial incentives for companies that either add workers or reduce hours to avoid layoffs.

 

And that’s what the Germans have done. Germany came into the Great Recession with strong employment protection legislation. This has been supplemented with a “short-time work scheme,” which provides subsidies to employers who reduce workers’ hours rather than laying them off. These measures didn’t prevent a nasty recession, but Germany got through the recession with remarkably few job losses.

 

Should America be trying anything along these lines? In a recent interview in The Washington Post, Lawrence Summers, the Obama administration’s highest-ranking economist, was dismissive: “It may be desirable to have a given amount of work shared among more people. But that’s not as desirable as expanding the total amount of work.” True. But we are not, in fact, expanding the total amount of work — and Congress doesn’t seem willing to spend enough on stimulus to change that unfortunate fact. So shouldn’t we be considering other measures, if only as a stopgap?

 

Now, the usual objection to European-style employment policies is that they’re bad for long-run growth — that protecting jobs and encouraging work-sharing makes companies in expanding sectors less likely to hire and reduces the incentives for workers to move to more productive occupations. And in normal times there’s something to be said for American-style “free to lose” labor markets, in which employers can fire workers at will but also face few barriers to new hiring.

 

But these aren’t normal times. Right now, workers who lose their jobs aren’t moving to the jobs of the future; they’re entering the ranks of the unemployed and staying there. Long-term unemployment is already at its highest levels since the 1930s, and it’s still on the rise.

 

And long-term unemployment inflicts long-term damage. Workers who have been out of a job for too long often find it hard to get back into the labor market even when conditions improve. And there are hidden costs, too — not least for children, who suffer physically and emotionally when their parents spend months or years unemployed.

 

So it’s time to try something different.

 

Just to be clear, I believe that a large enough conventional stimulus would do the trick. But since that doesn’t seem to be in the cards, we need to talk about cheaper alternatives that address the job problem directly. Should we introduce an employment tax credit, like the one proposed by the Economic Policy Institute? Should we introduce the German-style job-sharing subsidy proposed by the Center for Economic Policy Research? Both are worthy of consideration.

 

The point is that we need to start doing something more than, and different from, what we’re already doing. And the experience of other countries suggests that it’s time for a policy that explicitly and directly targets job creation.

‘MEDICINES TO PREVENT SOME CANCERS ARE NOT TAKEN,’ by Gina Kolata in the N. Y. Times.

Many Americans do not think twice about taking medicines to prevent heart disease and stroke. But cancer is different. Much of what Americans do in the name of warding off cancer has not been shown to matter, and some things are actually harmful. Yet the few medicines proved to deter cancer are widely ignored.

Take prostate cancer, the second-most commonly diagnosed cancer in the United States, surpassed only by easily treated skin cancers. More than 192,000 cases of it will be diagnosed this year, and more than 27,000 men will die from it.

And, it turns out, there is a way to prevent many cases of prostate cancer. A large and rigorous study found that a generic drug, finasteride, costing about $2 a day, could prevent as many as 50,000 cases each year. Another study found that finasteride’s close cousin, dutasteride, about $3.50 a day, has the same effect.

Nevertheless, researchers say, the drugs that work are largely ignored. And supplements that have been shown to be not just ineffective but possibly harmful are taken by men hoping to protect themselves from prostate cancer.

As the nation’s war on cancer continues, with little change in the overall cancer mortality rate, many experts on cancer and public health say more attention should be paid to prevention.

But prevention has proved more difficult than many imagined. It has been devilishly difficult to show conclusively that something simple like eating more fruits and vegetables or exercising regularly helps. And, as the response to the prostate drugs shows, people are not enthusiastic about taking anticancer pills, or are worried about side effects or not really convinced the drugs work. Others are just unaware of them.

And prostate cancer is not unique. Scientists have what they consider definitive evidence that two drugs can cut the risk of breast cancer in half. Women and doctors have pretty much ignored the findings.

Companies have taken note, saying that it makes little economic sense to spend decades developing drugs to prevent cancer. The better business plan seems to be looking for drugs to treat cancer. That is a sobering lesson, said Dr. Ian M. Thompson Jr., chairman of the urology department at the University of Texas Health Science Center in San Antonio.

“A scientific discovery that is very clear cut and that is not implemented by the public is a tragedy,” he said.

Few Sure Things

A few ways are known for sure to prevent cancer; the biggest is to avoid cigarette smoking. That alone would drop the cancer death rate by a third. No other measure comes close.

Another huge success, for breast cancer, is to avoid taking estrogen and progestin at menopause. Sales of those drugs plummeted in 2002 after a federal study, the Women’s Health Initiative, concluded that they did not prevent heart disease and might increase breast cancer. The next year, the breast cancer rate dropped by 15 percent after having steadily increased since 1945.

The vaccine for human papilloma virus, protects against most strains of the virus, which causes cervical cancer.

But other measures that are often assumed — and marketed — as ways to prevent cancer may not make much difference, researchers say.

For example, public health experts for years recommended eating five servings of fruits and vegetables a day to prevent cancer, but the evidence is conflicting, at best suggestive, and far from definitive.

Low-fat diets were long thought to prevent breast cancer. But a large federal study randomizing women to a low-fat or normal diet and looking for an effect in breast cancer found nothing, said its director, Ross L. Prentice of the Fred Hutchinson Cancer Research Center in Seattle.

Fiber, found in fruits, vegetables and grains, is often thought to prevent colon cancer, even though two large studies found no effect.

“We thought we would show relationships that were strong and true,” said Dr. Tim Byers, professor of epidemiology at the Colorado School of Public Health, “particularly for dietary choices and food and vegetable intake. Now we have settled into thinking they are important but it’s not like saying you can cut your risk in half or three-quarters.” Others wonder whether even such qualified support is misplaced.

There has to be a reason the research disappointed, said Colin B. Begg, chairman of the department of epidemiology and biostatistics at Memorial Sloan-Kettering Cancer Center. Perhaps the crucial time to intervene is early in life.

“That’s one possibility,” Dr. Begg said. “The other is that it’s all sort of nonsense to begin with.”

Many hold out hope for exercise or weight loss. Studies have associated strenuous exercise with less cancer. But that is the same sort of evidence that misled scientists about aspects of diet.

“I think it’s wishful thinking,” said Dr. Susan Love, a breast surgeon and president of the Dr. Susan Love Research Foundation. “We would like things to be more in our control. I think that’s part of it. And in the absence of anything else, what do we tell women about how to prevent breast cancer? We tell them to exercise and eat a good diet.”

As for obesity, researchers differ. Studies that observed large numbers of people often found that fatter people have more cancer. But many of the correlations are weak, and different studies have pointed to different cancers, raising questions about whether some of the effects are real.

Dr. Otis W. Brawley, chief medical officer of the American Cancer Society, said he was convinced. The strongest link, he and others say, is with obesity and breast cancer. But there, Dr. Brawley says, the crucial period may occur early in life — girls who gain weight when they are young, he said, tend to start menstruating earlier, which increases their breast cancer risk because it adds years of exposure to the body’s estrogen. It may be that weight loss in adulthood does not help.

‘DOLLAR DOOM LOOP,’ by Peter Boone & Simon Johnson at baselinescenario .com. ” EVERYTHING POINTS TO A CHEAPER DOLLAR.”

Dollar Doom Loop

Posted: 12 Nov 2009 05:07 AM PST

 

The American dollar is in the midst of a large fall in its value, or depreciation, as measured against other major currencies. The decline has been steady since 2002 and our currency is down about 35 percent from that peak. After strengthening slightly more than 10 percent during the global financial crisis of the past 18 months, the dollar is again falling back toward its pre-crisis lows, representing its weakest international value since 1967.

 

But there is a definite possibility that the dollar could soon decline further or faster.

 

At the level of general economic strategy, the American government has responded to a financial sector crisis with an expansionary fiscal policy, and the Federal Reserve is implementing loose monetary policy. Andrew Haldane, responsible for financial stability at the Bank of England, puts it this way:

 

“For the authorities, [excessive risk-taking by the financial sector] poses a dilemma. Ex-ante, they may well say “never again.” But the ex-post costs of crisis mean such a statement lacks credibility. Knowing this, the rational response by market participants is to double their bets. This adds to the cost of future crises. And the larger these costs, the lower the credibility of “never again” announcements. This is a doom loop.” (link to the paper)

 

In addition to a financial crisis, we also have a large current account deficit, meaning that we buy more from the world than we sell. The deficit was $100 billion in the latest available (second quarter) data, which is around 3 percent of gross domestic product, and we finance that with capital inflows from abroad. (The current account deficit is down from around 6 percent, but two-thirds of the decline is due to the lower price of oil).

 

In the past, many of those inflows have been private investments of various kinds, but as investors around the world question whether United States government debt, and its dollars, are really worth the paper, it is increasingly difficult for us to finance our deficit with the outside world.

 

What does this mean for the dollar?

 

Treasury Secretary Timothy F. Geithner continues to repeat that a strong dollar is “very important” for the American economy, but United States fiscal and monetary policy pushes toward depreciation. To bail out our banks, we need cheap money, and this implies some inflation. To finance our current account deficit, investors need to think they are buying inexpensive assets from us. EVERYTHING POINTS TO A  CHEAPER DOLLAR ((emphsis mine/Al H.)). (The same thing is happening in Britain, but the Bank of England is increasingly explicit about this point and the unsavory broader situation.)

 

A “hard landing” scenario for the dollar could be painful.

 

The 1980s classic, Stephen Marris’s “Deficits and the Dollar: The World Economy at Risk,” stresses that a rapidly falling dollar would push up United States inflation, resulting in higher interest rates and a deep recession (pp. lx-lxi). Writing in the latest edition of Foreign Affairs, Fred Bergsten emphasizes that such outcomes are still possible today. A weakening dollar will cause inflation fears, so yields on long-term government bonds will rise to compensate investors for inflation, and we will need to pay more and more to finance our large debts.

 

The idea that the American dollar might follow emerging markets such as Russia in 1998 and Argentina in 2002, or Britain in the 1970s — and so depreciate by 50 percent or more in a relatively short time — is certainly implausible now. But such a “doom scenario” is not unrealistic in the future without change.

 

In this context, the American government needs to control its budget deficit to keep this adjustment on track, and to stop confidence in the dollar from falling further. Our government collects far too little in taxes for what it spends. There is no choice but to raise taxes soon and rein in spending.

 

Short-term rates (controlled by the Fed) will stay low, while long-term rates (market-determined and affected by trust in our Treasury and Fed to keep the value of dollar strong) will rise as people fear their dollar investments will be debased. There is no doubt that both the Fed and the Bank of England know what is happening. The spread between short- and long-term rates (known as the “yield curve”) will rise, and banks will benefit; would-be home buyers and people with overdrafts or outstanding credit card balances pay more, while savers get little.

 

This is how the public pays for the past losses of our financial system.

 

We don’t have to do this again and again. We could start by changing our financial system from the roots. We need to credibly remove the promise to bail out our large banks each time they fail. This means forcing them to hold more capital, dividing them up so they are smaller, and then letting them fail when they make poor gambles.

 

The Treasury’s past and current close connections to Goldman Sachs, Citigroup and other major investment banks illustrate how our own doom machine functions. We need to break up these “banks” so they are small enough to fail, and also ensure that no bank, regardless of its connections, is able to demand that the Fed and the Treasury support its solvency in the future to prevent financial collapse.

 

In this context, a weakening dollar helps the administration to put an unstable financial system back on its feet — and to crank up our “doom machine.”

 

By Peter Boone and Simon Johnson

‘THE DOLLAR IS WEAK BECAUSE…..,’ by CNN MONEY at fidleity.com.

Here’s the latest twist on the timeless chicken versus the egg debate. Which came first: the stock and commodities rally or the weaker dollar?

 

There is no denying that the dollar has lost a fair amount of ground over the past few months while at the same time, stocks, oil and gold have skyrocketed.

 

But is there a real cause and effect relation here? And if so, what exactly is it? Has the greenback slid against other currencies because stocks and commodities are surging or is it the other way around?

 

It’s an important distinction.

 

If you believe that the main reason the dollar has weakened is because investors are embracing riskier assets on the hopes that the global economy is rebounding, then you probably aren’t too concerned about the shrinking dollar.

 

Even though it may seem like a bit of perverse logic, a weak dollar could be viewed as a good sign, an indication that investors around the world are no longer worried about an impending meltdown of the global financial system.

 

Remember, the dollar rallied sharply between mid-September of last year and the beginning of March when it was thought to be one of the few safe havens around.

 

“What drove the dollar before was that the rest of the world looked like it was in the same situation as we were. That’s no longer the case. This is the end of the Armageddon trade,” said Douglas Roberts, chief investment strategist for ChannelCapitalResearch.com, an investment research firm based in Shrewsbury, N.J.

 

So the weak dollar may merely be a consequence, a price we have to pay for better economic times ahead.

 

“What’s really happening is that people are selling dollars and using that money to recycle back into stocks even though there are some concerns about the sustainability of the U.S. economy,” said Kathy Lien, director of currency research at GFT, a foreign exchange and futures brokerage firm in New York. “Everything is related and lately what’s good for stocks is bad for the dollar.”

 

On the other hand, if you think that the upward move in stocks and commodities is a result of the dollar doldrums, you might be more inclined to think that this rally will end badly.

 

That’s because you may be worried that the decline in the dollar is a portent of rampant inflation in the future and potentially even an end to the days of the United States being an economic superpower.

 

The dollar’s weakness, according to this argument, is punishment by the rest of the world for the trillions of dollars being pumped into the economy by Washington in the form of stimulus and bailouts.

 

After all, as sharp as the U.S. stock rally has been since March, stocks in emerging markets such as China and Brazil have fared even better. That could be a sign that investors believe the United States will lag the rest of the world in a recovery.

 

The dollar weakness may also be artificially boosting corporate profits for the overseas operations of big U.S. companies and lifting the price of oil and other commodities priced in dollars. But sooner or later, the easy money will dry up. And look out below when it does.

 

“People are selling the dollar and investing overseas where rates and returns are likely to be higher. It’s more of a dollar issue,” said Paul Nolte, managing director with Dearborn Partners, an investment firm in Chicago with about $1.7 billion in assets under management. “This is good as long as it lasts but when it goes bad it could go bad fast.”

 

So will this phenomenon, the so-called carry trade, come crashing to a halt anytime soon? Nolte thinks that most money managers are likely to keep dumping dollars and buying stocks until at least the end of the year.

 

Roberts agreed. He said that as long as U.S. interest rates remain near zero, big institutional investors will continue to ride the hot hand — regardless of how they really feel about the economy.

 

“Money managers are going to continue chasing performance,” he said. “You have some reluctant bulls being dragged kicking and screaming into this rally.”

 

If Nolte and Roberts are right, that may be good news for bulls in the short-term. But it could also pose a bigger long-term problem. People can only shrug off the effects of a weak dollar for so long.

 

Lien said that while she does not think the dollar is weak enough yet to be a cause for concern, she doesn’t believe the dollar has to fall that much further before it could pose a risk to the global economic recovery.

 

She estimated that if the dollar fell about another 7% from current levels against the euro, yen and a basket of other major currencies, that would be the point where central bankers around the world would “cry uncle and no longer want to sit idly and watch the dollar weaken.”

 

“If the dollar weakens so much that it really hurts the economies of our trading partners to the degree that they are no longer willing to purchase U.S. exports or if protectionism becomes an issue, that’s a problem,” she said. “That could happen. It’s not an unrealistic situation.”

‘LOW SAVINGS, BAD INVESTMENTS,’ by James Kwak at baselinescenario .com. GREAT READ, ESP. THE PARAGRAPH THAT STARTS, ‘THE AVERAGE INVESTOR….’.

The article below first appeared in our Washington Post column yesterday. I’m reproducing it in full here because there is an important correction, thanks to a response by Andrew Biggs. I’ve fixed the mistake and added notes in brackets to show what was fixed. Also, I want to append some additional notes about the data and some issues that didn’t fit into the column.

 

Recent volatility in the stock market (the S&P 500 Index losing almost 50% of its value between September and March) has led some to question the wisdom of relying on 401(k) and other defined-contribution plans, invested largely in the stock market, for our nation’s retirement security. For example, Time recently ran a cover story by Stephen Gandel entitled “Why It’s Time to Retire the 401(k).”

 

However, the shortcomings of our current retirement “system” predate the recent fall in the markets, will not be solved by another stock market boom. The problems are more basic: we don’t save enough, and we don’t invest very well.

 

We ran several scenarios of what a typical two-adult household that entered the job market last year at age 22 might expect to receive on retirement at age 65 in 2051. For each scenario, we assumed that our household would earn the median amount for its age group every year. We began with data from the U.S. Census Bureau on 2008 earnings by age group, and assumed that real incomes would grow by 0.7% per year (the average growth rate for the 1967-2008 period). According to analysis by Andrew Biggs, medium earners typically accumulate Social Security benefits equivalent to 52% of their pre-retirement income, which comes to $40,265 per year. (All figures are in 2008 dollars.) For our scenarios, we used different estimates of the household’s savings rate and of the rate of return it would earn on its savings. [Correction: I initially used the online Social Security Social Security benefits calculator, which says it provides estimates in "today's dollars," but actually uses wage-indexed dollars. See Biggs's explanation of the difference.]

 

For the first scenario, we assumed the average economy-wide savings rate of 2.4% over the last ten years (1999-2008) and a real rate of return of 6.3% — the long-term average real return for the stock market. (In his book Stocks for the Long Run, Jeremy Siegel calculates the annual real rate of return from 1871 to 2006 as 6.7%; updating that figure through 2008, we get 6.3%.) At retirement, this yields accumulated savings of $298,064. Today, a 65-year old couple could convert $298,064 into a joint life annuity of $18,467 (we did an online search for annuity rates), meaning that they would receive that amount each year (not indexed for inflation, however) as long as either person were still alive. (Anything other than buying an annuity is gambling that you won’t outlive your money.) $18,467 is only 24% of the household’s income at age 64. Combined with Social Security, the couple would receive $58,732 per year, or a respectable 76% of its pre-retirement income of $77,432. [Correction: Originally this was 59%; all later figures were also 17 percentage points too low.]

 

Savings were unusually low over the past decade. The current savings rate (first three quarters of 2009) is 3.6%. Plugging this into our spreadsheet, we get an annuity of $28,092 and retirement income of $68,357, or 88% of pre-retirement income.

 

But this overlooks the fact that people do not earn the rate of return of the stock market. Even assuming that people are investing in stocks, most do so via stock mutual funds which, on average, do worse than the stock market as a whole. For example, in the 1990s the average diversified stock fund had an annual return 2.4 percentage points lower than the Wilshire 5000 Index (which reflects the performance of the overall market). The main reason for this underperformance is that mutual funds have to pay fees to their managers — who, on average, do not earn those fees through superior stock-picking (to put it mildly).

 

If we use a 3.9% annual return instead of a 6.3% annual return, now our annuity is only worth $15,347 per year, and combined with Social Security our household is only earning 72% of its pre-retirement income. But wait — it gets worse.

 

The average investor in mutual funds does not even do as well as the average mutual fund. The reason is that investors tend to chase returns. They take money out of funds that have recently done badly and move it into funds that have recently done well. Because of mean reversion (the tendency for trends away from the average to return back to the average), this means they take money out of funds that are about to go up and put it into funds that are about to go down. Among large blend stock funds (the category that includes S&P 500 index funds), research from Morningstar shows that the gap between mutual fund performance and investor performance ranges from 0.9 to 2.2 percentage points, depending on fund volatility. (It can be much higher — over 10 percentage points — for other types of funds.)

 

Taking an average gap of 1.6 percentage points, our expected annual returns are now just 2.3%. Now our cumulative savings are only $172,853 and our annuity is only $10,709; combined with Social Security our household is only earning 66% of its pre-retirement income.

 

Now, you can get close to that 6.3% expected return through a simple strategy: buy a stock index fund and don’t touch it. But this has another problem — you are 100% invested in stocks, the riskiest of the major asset classes. Whatever your expected cumulative savings, there is a 50% chance that your actual savings will be lower, and they could be a lot lower.

 

Since we’re talking about survival in old age, ideally our household would not take any risk at all. The closest you can get to this is to invest in inflation-protected Treasury bonds. 20-year TIPS (Treasury Inflation-Protected Securities) currently yield 1.96% on top of inflation. [Note: In the Post column I used 2.4%, the yield at the latest auction; however, that was back in July, and long-term bond yields have come down since then, so this is the current yield according to Bloomberg.] This provides a final annuity of $9,925; combined with Social Security, that’s 65% of pre-retirement income. That’s not very much. And the only way to get higher returns is by taking on risk.

 

Bear in mind that we’re assuming that Social Security will be around in its current form, as will Medicare (or else seniors will have sharply higher health care costs than they do today). Also, we’ve made a number of optimistic assumptions along the way: that life expectancies do not increase by 2051 (this would reduce the annuity you can get with the same savings); that median-income households save money at the average rate for all households, which is untrue (richer households save at a higher rate, making the average savings rate higher than the median savings rate); and that the savings rate is constant over age (since older people in fact save at a higher rate, the money has less time to build up). In addition, we haven’t started talking about below-median households, who save at a lower rate. [Note: I assumed you can get an annuity yielding 6.2%, from this online site; Biggs, who probably knows better than I, uses 5.4%, which yields lower annuities for the same amount of savings.]

 

The problems, in short, are that we don’t save enough and we don’t invest very well. One could argue that these are a matter of choice. People could save more, and they could make smarter investing decisions. But given that they don’t, we could very well see tens of millions of seniors without enough money to live decently in retirement. Given that prospect, perhaps we should question leaving retirement security to individual choices and free markets.

 

***

 

Andrew Biggs argues that the numbers show that the retirement system is doing OK. After all, if you assume just a 2.4% savings rate and a 6.3% real return, you get 76% of your pre-retirement income. The system is doing better than I thought it was before Biggs pointed out my error, but that’s almost entirely due to Social Security. Social Security is replacing 52% of pre-retirement income (not 35% as I initially calculated) and private savings are replacing anywhere from 13% to 24%, depending on the scenario. I think the 13% scenario is the most accurate, since is the lowest-risk option; anything else is not retirement saving, it’s retirement gambling.

 

Biggs also thinks (email to me) that my savings rates are too low, especially with auto-enrollment into 401(k)s on the rise. This is a plausible point; we don’t really know where the savings rate will end up after this recession. If the median worker is auto-enrolled in a 401(k) — and, even better, if he gets an employer match — he may be OK. Then we may be talking about a problem that affects a significant number of lower-income households (who are less covered by 401(k)s and employer matches than higher-income households), though not the median household.

 

This is the spreadsheet with the scenarios. WordPress.com won’t let me upload an Excel file, so I embedded it in a Word file and uploaded that.

 

There’s a legitimate question about 2008 vs. 2051 living standards. For example, in our most pessimistic scenario, we still end up with an annuity of $50,190 in 2008 dollars. That might not seem so bad. After all, median income in 2008 was only $53,303, and this is all in real terms, right? However, I don’t think that’s the right approach to take. Living standards will improve on average between now and 2051, and therefore an income of $50,190 2008 dollars will feel very different in 2051 than it felt in 2008. This is why I think the right comparison is to pre-retirement income; that tells you the drop in living standards that people will suffer at retirement. (In practice, most people probably won’t buy annuities, and won’t adjust their living standards down immediately — but that just means they have a higher chance of outliving their money.)

 

Another possible objection is that we’re leaving out capital gains from housing. Even if the average return that investors get from stock mutual funds is only 2.3%, the fact is that many people invest in their houses and seem to get higher returns. However, I think that we can’t count on these higher returns. First, these returns are largely a product of leverage and subsidized interest rates; real housing prices underperform the stock market. Second, a given house doesn’t really change in real value (the utility it provides to people), even if its price changes; in general, its value goes down, unless you put money into it for maintenance and improvements. If the price of equivalent houses goes up in real terms, that just means that (on average) one generation of home owners is taking money from the next generation of home buyers in the form of higher prices. In other words, it’s a multi-generational Ponzi scheme that can’t go on forever. Third, of course, not everyone owns a house.

 

In doing the research for this column I came across a paper by Andrea Frazzini and Owen Lamont called “Dumb Money: Mutual Fund Flows and the Cross-Section of Stock Returns.” They find that, at least when looking at historical data, you can make money by doing the opposite of what investors do with their mutual funds. That is, money flowing into mutual funds is a valid predictor that the stocks in those funds will, on average, go down relative to the market. The real beneficiaries are corporate issuers of stock, who are able to issue stock at high prices when demand for it is high. I also like the way they put their findings into context: “These facts pose a challenge to rational theories of fund flows.  Of course, rational theories of mutual fund investor behavior already face many formidable challenges, such as explaining why investors consistently invest in active managers when lower cost, better performing index funds are available.”

 

Finally, I hate making mistakes. So I wholeheartedly endorse Biggs’s call for the Social Security Administration to fix its misleading calculator.

 

By James Kwak

 

‘GLOBAL BUBBLES: THE GEITHNER-BROWN SPLIT,’ by Simon Johnson at baselinescenario .com.

Global Bubbles: The Geithner-Brown Split

Posted: 10 Nov 2009 02:40 AM PST

 

There are two broad views on our newly resurgent global bubbles – the increase in asset prices in emerging markets, fuelled by capital inflows, with all the associated bells and whistles (including dollar depreciation).  These run-ups in stock market values and real estate prices are either benign or the beginnings of a major new malignancy.

 

The benign view, implicit in Secretary Geithner’s position at the G20 meeting last weekend, is most clearly articulated by Frederic (Ric) Mishkin, former member of the Fed’s Board of Governors and author of ” The Next Great Globalization: How Disadvantaged Nations Can Harness Their Financial Systems To Get Rich”, in the Financial Times this morning.

 

“The second category of bubble, what I call the ‘pure irrational exuberance bubble, is far less dangerous because it does not involve the cycle of leveraging against higher asset values.  Without a credit boom, the bursting of the bubble does not cause the financial system to seize up and so does much less damage”

 

In other words: keep monetary policy right where it is, and don’t worry about financial regulation.

 

The second view is much more skeptical that “benign” bubbles stay that way.  Remember that most damaging bubbles – or debt-based over-exuberance, if you prefer – during the past 40 years have involved two elements.

 

Borrowers in emerging markets (Latin America and Eastern Europe in the 1970s; Mexico in the early 1990s; Russia, Ukraine, East Asia, Brazil and many others in the early-mid 1990s; Eastern Europe in the 2000s).

Citibank (and its descendants), i.e., a bank that was large and global before any other US institution was so inclined.  Rather than bringing us the wonderful benefits of financial globalization, Citi has almost failed at least twice – and been rewarded for its incompetence with gold-plated bailouts at least four times.

Of course, other banks from other countries have become involved at various moments, but the point is that the lending organizations behind every bubble come from more “developed” financial markets – even when the origin of the capital flows is elsewhere (e.g., recycling oil surpluses in the 1970s).  And the borrowers are always in places where the rules become lax during a boom – in this sense, the US became just like a classic emerging market after 2001 (and arguably earlier).

 

After months of painful procrastination, Gordon Brown has finally recognized that Adair Turner – head of the UK Financial Services Authority (FSA) and astute critic of Big Finance – is on to something in this regard.

 

At St. Andrews on Saturday, Brown actually proposed (and his mandarins briefed in private) on the need for a tax on financial transactions – a version of the “Tobin tax”.

 

Brown knows full well that such a tax is unlikely to get traction in the current environment, partly as it would be hard to implement (i.e., the scope for evasion through off-shore financial centers is enormous).

 

But the point of his announcement was to shock and awe finance ministers – and this worked.  Secretary Geithner was provoked into uncharacteristically sharp pushback, which came across as the sort of rebuke that a minister of finance seldom directs at a head of government.

 

Brown and his team have at last understood that reigning in the financial sector needs to be front and center of the international agenda – and the troika structure of the G20 allows them (as outgoing chairs) to keep this issue hot.

 

It also provides political cover for the IMF, which is working hard on a tax for “excess risk taking” in finance.  Dominique Strauss-Kahn (head of the IMF and leading candidate of the left for the next French presidential election) astutely provided more details in the aftermath of the Brown remarks – thus making it harder for the US to oppose the IMF technocrats (and the French), who now seem so very moderate compared to Brown.

 

And how we will measure “excess risk taking”?  Volumes of technical papers are being written, much math has already been wasted, and ponderous reports will soon appear.  But, at the end of the day (which is the G20 summit in June 2010) there is one central criterion around which you can get your hands: size.

 

Bigger banks pose more system risk, mega-banks pose the most risk, and all bubbles can quickly go bad in the presence of such gigantic institutions.  They must face appropriately higher taxes — in fact, so high that the biggest voluntarily break-up in anticipation.

 

The ideas underlying Bernie Sanders’s bill are becoming mainstream.

 

By Simon Johnson

‘A FOUR-LEGGED BULL MARKET?,’ by Jurrien Timmer, director of investment research at Fidelity.

The stock market has rallied 65% in about eight months, truly one of the strongest rallies ever recorded. What’s an investor to do? Is there still time to jump in, or is this just a giant sucker’s rally that is about to collapse?

 

To me, there are four legs holding up this bull:

 

1. Improving fundamentals: “V-Shaped Recovery”

2. Unprecedented stimulus: “Don’t Fight the Fed”

3. Strong technicals: “Don’t Fight the Tape”

4. Favorable sentiment: “The Rally Everyone Loves to Hate”

 

While the weight of the evidence suggests that the bull market is still alive, I think the “technical” and maybe even the “sentiment” legs are starting to get a little wobbly. That suggests that we are transitioning from the “straight-up” part of this bull to a more challenging and volatile two-sided market environment.

 

Let’s take these four legs one at a time.

 

1. ‘V-Shaped Recovery’

First the fundamentals. The economy shows signs of the beginning of a V-shaped recovery. You can see this in the leading indicators, the Purchasing Managers Surveys, and a host of other indicators such as credit spreads and industrial commodities. And it’s not just the U.S. economy. It’s across the global economic landscape, especially in the Far East. Inventories have been depleted, workers have been laid off, and now orders are returning. That means inventories need to be restocked, which will boost gross domestic product (GDP) growth.

 

At the same time, a lack of confidence in the economy combined with the high unemployment rate suggests that companies filling orders and rebuilding inventories will initially do so with fewer workers. That means rising profit margins and therefore better earnings growth. We are seeing this in the third quarter earnings reports.

 

Put strong economic newsflow and strong earnings together and what do you get? A bull market for risk assets like stocks and high-yield bonds. Whether or not this V-shaped inventory cycle turns into a “W” because the consumer isn’t spending is of course a legitimate concern, but one that I think we can worry about later. (V-shaped describes the visual created by charting a severe downturn in the economy followed by a strong upturn in economic activity. W-shaped is where the economy may dip down again in 2010 after the boost from inventory restocking has been realized.) For now, the inventory cycle suggests that we may see several quarters of robust GDP growth.

 

2. ‘Don’t fight the Fed’

The second leg is the Fed’s “Quantitative Easing” mode. Quantitative Easing is a fancy way of saying “printing money.” The Federal Reserve (Fed) rarely prints money because it is usually fighting inflation, which requires the opposite approach (i.e., raising interest rates and shrinking the money supply). The Fed resorts to money printing when it has to fight deflation, as it is doing now. The problem with deflation is that once the Fed has lowered interest rates to zero, it has run out of ammo. That’s when it starts tinkering with its balance sheet.

 

The idea is that these “excess reserves” which the Fed has created end up at the banks, and the banks then lend this money out to consumers and businesses. This process then puts what is known as the “money multiplier” to work, and the result is an expanding money supply, more economic growth, and inflation (which in those circumstances is a desired outcome).

 

However, the money supply is currently not multiplying because the banks aren’t lending. This is called a liquidity trap, and while it is bad for the economy, in a twisted way it is helping the market go higher. Why? Because Quantitative Easing creates an environment that is conducive to risk taking (i.e., speculation). Think about it: The Fed has lowered short-term interest rates to zero and has engineered a very steep yield curve. It’s basically handing out free money for speculators to invest. This is why the dollar has been going down and commodities and stocks going up. They’re all related to each other in what is called the “reflation trade.”

 

The challenge for the Fed is to reflate just enough but not to over inflate. That, after all, is what happened the last two times the Fed took this approach. An over-easy policy in late 1998 after the collapse of Long-Term Capital Management is considered by many to have been a contributing factor leading to the dot-com bubble in 2000. The monetary response to the collapse of that bubble is considered a contributing factor to the burst of the housing bubble. An endless cycle of bubbles that burst and then get reflated again — it’s why gold has been rallying; it’s hedging against a policy error.

 

For now at least, Quantitative Easing is a plus for risk assets. While there have been a few rogue Fed hawks calling for it to end, the Federal Open Market Committee (FOMC) press releases have made it clear that the Fed will stay easy for some time. After all, the banks aren’t lending, the unemployment rate is high, and there is a huge wave of mortgage resets happening in 2010.

 

3. ‘Don’t fight the tape’

The old saying “don’t fight the tape” is very much in force today. Market breadth — the relationship between advancing and declining stocks—has confirmed every new price high for the major averages. Often at price tops there will be a breadth divergence, but this hasn’t happened yet.

 

Also, the 50-day and 200-day moving averages have still been rising, and every high in the S&P 500 Index  has been higher than the previous high, and every low has been higher than the previous low. These are the very definitions of a bull market.

 

Furthermore, a massive head and shoulders bottom remains in effect for the S&P 500, triggered by the March low and subsequent rise above 956 last summer. (A head and shoulders bottom is considered a bullish signal because it indicates a possible reversal of the current downtrend into a new uptrend.) This opens up a technical price target of 1,200-1,250, which is still some 150-200 points away.

 

Finally, we have broad confirmation from high-yield spreads, industrial commodities, and most emerging markets. These markets bottomed early (in December 2008) and have remained strong for the most part.

 

That said, recent price action has started to look technically “tired.” If the market falls below recent lows, that would interrupt the series of higher lows and higher highs and would be a cause for concern.

 

Clearly the technicals show that this bull market is maturing. That’s not the end of the world per se, but a potential early warning. The stock market tends to form V bottoms and rounding tops. Perhaps we’re beginning to map out such a top now.

 

4. ‘The rally everyone loves to hate’

The fourth leg is sentiment. There are just so few signs of bullish capitulation — investors who have not wanted to buy stocks finally caving in and buying at high prices — that it’s hard to imagine a top of importance occurring now. Normally everyone is bullish at the top.

 

At the March bottom everyone was bearish and no one was bullish. That’s no longer the case. There are very few bears left, but that doesn’t mean that the majority is now bullish. Sentiment in general seems to be “skeptical” for lack of a better word.

 

Whether you look at sentiment surveys such as the Investors Intelligence or the American Association of Individual Investors, or fund flows, hedge fund leverage, or the general mood among investors and the media, they all more or less reveal the same thing: Investors don’t trust this rally. They either missed it and figure that they are too late to climb aboard, or they are waiting for the other shoe to drop with regard to the economy. While that may be a valid concern, for now it seems to be part of a “wall of worry” that the market likes to climb.

 

Sentiment has always swung from one extreme to the other. We had one extreme in March, and my sense is that we’ll get to the other one before this rally is over.

 

The weight of the evidence

The bottom line is that all four legs remain bullish, but they’re not quite as bullish as they were a few months ago. The V-shaped recovery looks good and the Fed should remain easy, but sentiment is not as compelling as it was before, and the technicals are starting to look tired. So, this is no longer the “just close your eyes and buy” market that it was in the spring and summer. It‘s a more challenging and tactical environment in which there is still upside potential but also more downside risks.

‘HOW TO PLAY THE DECLINING DOLLAR,’ in SmartMoney via fidelity.com.

The U.S. dollar is looking pretty downtrodden these days, and investors are split over whether the world’s reserve currency has reached a bottom.

 

Since March, the dollar has lost about 15% of its value against a basket of foreign currencies. (Gold, which tends to move in the opposite direction as the dollar, rose to a record $1,092 an ounce on Wednesday.) Safety-seeking investors tend to flock to the dollar in troubling times, and the currency generally underperforms during economic recoveries. Exacerbating this normal pattern are today’s super-low interest rates. Short-term rates of 0% to 0.25% have encouraged the dollar’s use in the carry trade, an investment where traders borrow in a low-yielding currency (in this case, the dollar) and invest the proceeds in a higher-yielding one. This in turn creates more downward pressure on the dollar, says Michael Woolfolk, senior currency strategist at Bank of New York Mellon. The Federal Reserve indicated Wednesday that it intends to keep short-term rates low for “an extended period” so the carry trade will likely continue for some time.

 

Woolfolk expects the dollar to continue its slide against the euro through the end of this year and possibly into 2010, but begin to strengthen as the Federal Reserve raises rates. Others say that the dollar could turn around quicker on good news like lower-than-expected inflation numbers (inflation causes prices to rise and lowers the purchasing power of each dollar). “Pessimism is almost at a peak,” says Rocky White, senior quantitative analyst for Schaeffer’s Investment Research. When it happens, the reversal in the dollar’s trajectory could be sharp, White notes.

 

Why should investors care about the dollar’s fate? A weak dollar makes U.S. exports cheaper abroad, helping export-driven businesses. But consumer spending, not exports, really drives economic growth in this country, so a weak dollar won’t necessarily aid our recovery, some analysts warn. By contrast, a strong dollar helps the U.S. maintain a larger deficit, Woolfolk says, which in turn helps stimulate growth and job creation. Foreign investors are more inclined to buy Treasury bonds when the dollar is strong. Over 60 percent of worlds’ central bank reserves are in dollars, Woolfolk says. And despite much rhetoric out of China, the largest foreign holder of Treasurys, suggesting that its appetite for U.S. debt might have its limits, the dollar isn’t going to lose its status as the world’s reserve currency any time soon, experts say.

 

Even so, the pros recommend that investors have some international exposure in their portfolios. Aaron Gurwitz, head of global investment strategy for Barclays Wealth, says investors should keep at least 20% of their portfolios in non-dollar assets and says the easiest way to do this is by buying foreign companies’ stocks. Foreign bond funds also look attractive these days, as countries like Australia have been quicker to raise interest rates than the U.S., pushing their bonds’ yields up.

 

‘THE TOUGH-GUY HIPPIE WHO HELPED DEFINE AN ERA, ‘ in the Globe & Daily Mail in Toronto.

The information age may not yet have completely killed mystique, but it has done the concept serious harm.

 

In 1978, when Bob Dylan dedicated his Street Legal album to the late Emmett Grogan, it was more than just a salute from a counterculture icon to a far less famous fellow traveller. It was one master of self-reinvention recognizing another. But reading Ringolevio: A Life Played for Keeps, Grogan’s 1972 third-person autobiography (long lost and now revived by NYRB’s impeccably discerning Classics imprint), a question raised by Dylan’s Chronicles: Volume One rears its head again: Are such lives even possible in a world laid bare by Google and Facebook and Twitter?

 

The odyssey of the book itself, and how it got into one reader’s hands, is a good case in point. As a teenage Dylan fan, when I saw that dedication (pretty much the only redeeming thing about Street Legal, by the way), it was a reminder of a name I’d first come across at random intervals in my older sister’s back issues of Rolling Stone. At 12, intrigued by Ringolevio ’s title – I may well have thought it had something to do with the Beatles; in fact, it refers to a no-holds-barred street game popular in the New York of Grogan’s childhood – I snapped up a used paperback copy in a local Wee Book Inn.

 

Ringolevio: A Life Played for Keeps, by Emmett Grogan, NYRB Classics (2008), 512 pages, $19.95

I had read 100 pages or so, and, though sensing that it was all a little above my pre-pubescent head, was nonetheless engrossed. Then I forgot it on a bus, and for 30 years or so, despite intermittent attempts to track down another copy, that was that. Pre-Internet, and pre-reissue, there was simply no source.

 

Had I read as far as the period of Grogan’s life for which he was legendary – his time as the secretive head of San Francisco’s anarchist-philanthropist Diggers during the height of the hippie era – my subsequent years of infatuation with that time and place might never have happened. Grogan’s account, told in crystal-clear prose bearing not the slightest trace of flower-power whimsy, is nothing if not demystifying. Though an NYC Irish street tough to the bone, Grogan still counted himself a part of the “generation utterly separated from their parents by the unbreachable gap of acid.” As such, he couldn’t help but feel compassion for the incoming hordes of Haight-Ashbury pilgrims, “thousands of young, foolish kids who fell for the Love Hoax and expected to live comfortably poor and take their place in the district’s kingdom of love.”

 

His response was to organize the daily serving of free food in a park, as well as a “Free Store” where the very notions of value and exchange would be tested on a daily basis. In these endeavours, he was adamant that anonymity was essential: He wanted no part of the personality-cult hucksterism he perceived in the likes of Abbie Hoffman, Jerry Rubin and Timothy Leary, and dismissed the epochal Human Be-In as no more than a “costume party” where the new hippie aristocracy could exploit the popular mood.

 

“ If he had managed to survive, he might well be a feted figure now, sort of a non-singing Dylan ”

Such myth-busting may partly explain why Ringolevio failed to find a sizable audience on first publication; it was the early 1970s, and plenty of people still had a strong emotional investment in the ethos Grogan was dismantling. But those many non-readers also passed up on a first half – of the book and of Grogan’s life – that was already epic in scope. A junkie at 12, an ex-con at 13, Grogan improbably won a scholarship to a prestigious private school, but decided he preferred robbing the Park Avenue homes of his classmates’ parents.

 

That got him quite a stake together, until he got on the wrong side of some bigger thieves and fled to Europe, where for a time he lived like a real-life teenage version of Patricia Highsmith’s Ripley, scamming various identities and even studying film in Rome. Black clouds formed there and he fled to Ireland, where he fell in with a faction of the IRA and helped blow up a couple of bridges. From there he went to pre-swinging London, where he dabbled in porn, attempted a last big heist, and once again fled just ahead of the law.

 

All this happened before Grogan was 22, and all is recounted in a voice – by turns self-effacingly hardboiled and self-promotingly swaggering – that places the author firmly in the American tradition of Twain, London, Hemingway and Kerouac, with a touch of Jean Genet reprobate criminal-as-poet thrown in for spice.

 

Back in the United States, Grogan got creative, avoiding the draft before washing up on the West Coast, where conditions proved perfect for him to attempt – whether consciously or not is never made clear – to make atonement for some of the more egregious acts of his past. One thing he could never quite shake was the allure of heroin, and in 1978, after a long wilderness period as a legend without a meaningful context, he was found dead in a subway car on the F line in Brooklyn, victim of a heart attack assumed to be drug-induced.

 

If he had managed to survive, he might well be a feted figure now, sort of a non-singing Dylan. The mere fact that he wrote Ringolevio, a book whose many jaw-dropping claims have been the subject of doubt and debate for decades, means he couldn’t have been as averse to a possible shot of fame as he had always claimed.

 

Well, he didn’t survive. But his myth and mystique now look set to run and run. Ringolevio makes the 1960s feel as vivid as this very moment, yet also impossibly, irretrievably distant. Can there ever be a life, or a life story, like Grogan’s again? It’s hard to imagine how.

 

Ian McGillis grew up in Edmonton and lives in Montreal. His debut novel, A Tourist’s Guide to Glengarry, was a Globe and Mail Best Book of 2003. A follow-up is nearing completion.

 

‘THE UNCOMFORTABLE DANCE BETWEEN U’ERS & V’ERS,’ by Paul Mc Culley at PIMCO. Via John Mauldlin’s Outside the Box Newsletter.

The Uncomfortable Dance Between V’ers and U’ers by Paul McCulley

 

Around the world, in investment committee meetings and on trading floors (and at the Fed!), one question dominates discussion and debate:

 

How can it be that risk assets, notably common stocks, have been roaring ahead, presumably discounting a robust V-shaped economic recovery, while Treasury bonds are holding their own with a bull flattening bias, presumably rejecting the V-shaped hypothesis, instead discounting a U-shaped recovery as the base case, with a W-shaped outcome the dominant risk case?

 

One of these markets is wrong, it is commonly argued; the only question is which one. In the longer run, we here at PIMCO certainly agree, siding with the U-shaped camp. But that does not necessarily mean that one of the markets must necessarily capitulate to the other in the months immediately ahead. And the unifying explanation is simple: The Fed is committed to maintaining “exceptionally low levels of the Federal funds rate for an extended period.” The Fed is also openly committed to being extraordinarily careful in reducing its elevated balance sheet, implying that a very elevated level of excess reserves/liquidity will be sloshing through the financial system for a long time.

 

To be sure, the Fed has been communicating repeatedly, with academic flourish, the technical details of its ability to eventually hike its policy rate, even with a bloated balance sheet and massive excess reserves:

 

Hiking, via its newly-granted powers of last fall, the interest rate it pays on excess reserves (IOER), which should act as a floor for the more visible Fed funds rate; and

 

Reducing excess reserves directly through massive reverse repurchases, including using tri-party repo arrangements, effectively augmenting the universe of counterparties beyond the capital-constrained primary dealers, to include liquidity flush end users.

But the Fed has also gone out of its way to communicate that discussions are about the “how” of its exit strategies, not a signal as to the “when,” in the phraseology of the Financial Times’ Krishna Guha. Thus, not only is the price of Fed liquidity set to hover near zero for an extended period, but the sheer volume of Fed-supplied liquidity is also likely to be flush for an extended period. In turn, as long as the Fed retains ownership of its longer-dated assets, sterilizing their liquidity effect via reverse repos, the Fed will remain not just the arbitrator of the Fed funds rate, but will also be a holder of market risk previously borne by the private market.

 

Thus, while rich risk asset prices can certainly be viewed as a consensus expectation for a strong recovery, such lofty valuations can also be viewed as a consensus expectation about the Fed’s commitment to erring on the side of being too late, rather than too early, in starting a Fed funds tightening cycle. Indeed, one could actually be agnostic, even antagonistic, about a big-V recovery and still be favorably disposed to risk assets, in the short run. Historically, what pounds risk asset prices is either a recession or unexpected Fed tightening; or worse, both. Right now, it is hard to get wrapped around the axle about recession, since we’ve just had one, which might not even be over.

 

To be sure, the economy could have back-to-back recessions, as was the case in 1980 and 1981–1982. But that episode was associated with massive Fed tightening in 1979–1980, followed by massive easing in the middle months of 1980, followed by massive Fed tightening yet again, as Paul Volcker waged a two-step war against inflation. Presently, the Fed is openly declaring that it will maintain near-zero short rates for an “extended period,” in the context of inflation below its implicit target.

 

Thus, as long as economic recovery appears underway, even if stoked primarily by (1) policy stimulus and (2) a turn in the inventory cycle, there is no urgent reason for investors to run from risk assets. Put differently, investors can be agnostic about (3) the strength of private demand growth until the one-off forces supporting growth exhaust themselves, as long as they don’t have fear of Fed tightening.

 

In turn, a bull flattening bias of the Treasury curve, with longer-dated rates falling toward the near-zero Fed policy rate, can be viewed as a consensus view that the level of the output/unemployment gap plumbed during the recession is so great that disinflationary forces in goods and services prices, and perhaps even more important, wages, will be in train, even if growth surprises on the upside. Accordingly, Treasury players, like their equity brethren, need not fear the Fed, as there is no economic rationale for an early turn to a tightening process.

 

Thus, both rich risk markets and the lofty Treasury market can be viewed as rational in their own spheres, even if they are seemingly irrational when compared to each other. The tie that binds them, that allows them to co-exist, need not be a common view regarding the prospective strength of the recovery, but rather a common view as to the Fed’s friendly intent and reaction function.

 

But, you retort, this can’t go on forever – at some point, risk assets will have to capitulate to reality if the big-V does not unfold, no? Yes, but it is not quite as simple as that. Without the big-V, Treasuries will tend to bull flatten, soothed by rational expectations of an extended period of the Fed funds rate pinched against zero. In turn, such a path for Treasuries would provide valuation support for risk assets. How so?

 

All risk asset prices are analytically the Net Present Value of expected growth in cash flows, discounted by the appropriate-duration risk-free rate plus a risk premium. Thus, expectations of a friendly-for-longer Fed policy would be supportive of risk assets, as they (1) tend to pull down long-duration risk-free rates, while also (2) pulling down the market-required risk premium (which moves inversely with investors’ animal-spirited risk appetite, which moves inversely with fears of Fed tightening).

 

To be sure, this fundamental valuation framework – known as the Gordon Model – also implies that in real terms, the positive P/E effect of low long-term risk-free rates is moderated to the extent that the non-big-V scenario also implies lower growth in real profits. There are no free lunches. But since real long-term Treasury rates trade in real time, while “new-normalized” real growth rates are uncertain, subject to animal-spirited conjecture, friendly real long-term interest rates will tend to dominate the formulation of P/Es.

 

Thus, ironically, the biggest intermediate-term risk for risk assets is not that the big-V doesn’t unfold, but that it does, inciting the Fed to bring the extended period of a near-zero policy rate to a close. But again, you retort, doesn’t that imply that in the absence of the big-V, risk asset prices could levitate into bubble valuation space? Yes, it does mean that. And that is a very, very uncomfortable proposition for those grounded in fundamental analysis, as I am.

 

The Efficient Market Hypothesis in Retreat

But such discomfort is likely to be an enduring fact of life on the journey to the New Normal. Recall, a core tenet of “fundamental analysis” is the efficient market hypothesis, which presupposes that rational investors will, given time, always pull nominal – and real – values back toward their “fundamentally justified” levels. Yes, there will be noise in real time, the hypothesis allows, but it also holds that neither irrational gloom nor irrational exuberance will go to extremes: momentum players will, in the end, always be trumped by value players, before momentum players have done any great harm. Market failures, capitalism’s equivalent of estrangement in families, are simply assumed away. They are not supposed to happen; therefore, they won’t.

 

But they do. Such was the case with the Forward Minsky Journey1 that unfolded alongside the Great Moderation for twenty-five years after the recession that ended in 1982. Ever-increasing private sector leverage was applied on the presumption that the Great Moderation was a perpetual motion machine, rather than an epoch that would eventually implode on its own debt-deflationary pathologies, as Minsky envisaged. Nominal asset prices, notably property, became bubbly-unmoored from “fundamental” value, yet both borrowers and lenders were willing to “validate” those unmoored levels with legally binding nominal debt obligations – hedge debt units followed by speculative debt units followed by Ponzi debt units.

 

It all blew up, of course, with not just trillions of net worth destroyed, but also the wisdom of religious belief in the efficient market hypothesis. Thus, as we look forward, a huge amount of humility is warranted in projecting asset returns on the basis of tight bands around what “fundamentals” suggest constitute fair value. Yes, there is no substitute for fundamental analysis; it remains at the core of investment management. But asset values can stray far, very far, away from their putative “fair” levels, much, much further than was the case during the middle-aged years of the Great Moderation. The efficient market hypothesis may not be dead, but it is most assuredly in retreat.

 

Behavioral Economics and Finance in Ascendency

In contrast, the insights of behavioral economics and finance are very much in ascendency. This personally brings me great satisfaction, as both of my macroeconomic heroes, John Maynard Keynes and Hyman Minsky, were quintessentially behavioral economists, starting with the proposition that developing a theory as to how the world does work is much more productive than developing a theory as to how the world should work. That’s not to suggest that there is not room for both types of theorizing. Indeed, one without the other is silliness, and both Keynes and Minsky did both.

 

And the envelope between those two modes of theorizing is the fact that the future is inherently uncertain. That might not sound like a profound assertion, and it isn’t. We all intuitively know that. But the efficient market hypothesis conveniently assumes away that reality, in what is technically called the “ergodic axiom” – that past and current relationships between variables are reliable predictors of future relationships between variables. This assumption holds in astronomy, which is why astronomers can forecast with incredible accuracy when the next lunar eclipse will unfold.

 

This assumption also holds in calculating the risk of any given hand in a defined card game – there are 52 cards in the deck and it is quite possible to calculate with great precision the odds of winning the game, such as Blackjack or Poker. That doesn’t mean that you can know with precision whether you will win, simply that you can forecast the odds of any given player winning, given the cards in their hands and other players’ hands, in the context of what cards are left in the deck. Indeed, I find it amusing when television shows broadcasting such games flash up the odds of any player winning after each card is dealt. There is risk, but not uncertainty – we know there are 52 cards in the game and we know what constitutes a winning hand. The ergodic axiom holds.

 

In investment markets, however, the ergodic axiom doesn’t hold, even though it is implicitly assumed in the efficient market hypothesis (but ironically, not in the legal disclaimers of all investment presentations, which state that past results are not necessarily indicative of future results!). In investment markets, genuine uncertainty exists: We can’t assume that we know how many cards will be in the future deck or what will constitute a winning hand. That’s not risk, but rather uncertainty.

 

And how do we deal with it? As Keynes explained in Chapter 12 of the General Theory, we deal with it by falling back on convention, or rules of thumb. In his words:

 

“Certain classes of investment are governed by the average expectation of those who deal on the Stock Exchange as revealed in the price of shares, rather than by the genuine expectations of the professional entrepreneur. How then are these highly significant daily, even hourly, revaluations of existing investments carried out in practice?

 

In practice, we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention. The essence of this convention – though it does not, of course, work out so simply – lies in assuming that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change. This does not really mean that we really believe that the existing state of affairs will continue indefinitely. We know from extensive experience that this is most unlikely.

 

The actual results of an investment over a long term of years very seldom agree with the initial expectation. Nor can we rationalize our behavior by arguing that to a man in a state of ignorance; errors in either direction are equally probable, so that there remains a mean actuarial expectation based on equi-probabilities. For it can easily be shown that the assumption of arithmetically equal probabilities based on a state of ignorance leads us to absurdities.

 

We are assuming, in effect, that the existing market valuation, however arrived at, is uniquely correct in relation to our existing knowledge of the facts which will influence the yield of the investment, and that it will only change in proportion to changes in this knowledge; though, philosophically speaking, it cannot be uniquely correct, since our existing knowledge does not provide a sufficient basis for a calculated mathematically expectation. In point of fact, all sorts of considerations enter into market valuations which are in no way relevant to the prospective yield.

 

Nevertheless the above conventional method of calculation will be compatible with a considerable measure of continuity and stability in our affairs, so long as we can rely on the maintenance of the convention. For if there exist organized investment markets and if we can rely on maintenance of the convention, an investor can legitimately encourage himself with the idea that the only risk he runs is that of a genuine change in the news over the near future, as to the likelihood of which he can attempt to form his own judgment, and which is unlikely to be large. For, assuming that the convention holds good, it is only these changes which can affect the value of his investment, and he need not lose his sleep merely because he has not any notion what his investment will be worth ten years hence.

 

Thus investment becomes reasonably ’safe’ for the individual investor over short periods, and hence over a succession of short periods however many, if he can fairly rely on there being no breakdown in the convention and on his therefore having an opportunity to revise his judgment and change his investment, before there has been time for much to happen. Investments which are ‘fixed’ for the community are thus made ‘liquid’ for the individual.”

 

Those few paragraphs, my friends, are the foundation of modern behavioral economics and finance. Human beings, including investment managers, face both risk and uncertainty, and deal with uncertainty by resorting to conventions, notably that yesterday is the best predictor of today, and that today is the best predictor of tomorrow. George Soros calls it reflexivity.

 

But when that comforting convention is overwhelmed by a new reality, all hell breaks loose. Uncertainty can no longer be simply assumed away. And when that happens, human beings tend to disengage, eschewing investment in favor of building up cash reserves. And if this proclivity becomes both widespread and profound, we find ourselves in Keynes’ Liquidity Trap – there is plenty of money around, but risk-averse investors, infected with uncertainty, refuse to “put it to work” – on either Wall Street or Main Street. Such was the case a year ago, following the fateful decision to let Lehman Brothers fall into a watery grave.

 

The way out of that lacuna was for (1) the fiscal authority to step into the breech and borrow money from the newly risk-averse, putting it to work to recapitalize the banking system and on Main Street in support of aggregate demand; and for (2) the monetary authority to drive the interest rate on money to zero and promise to hold it there for an extended period, making holding cash very painful while reducing uncertainty, re-exciting investors’ risk appetite.

 

Bottom Line

Fiscal and monetary authorities around the world have done exactly that over the last year, and since April, in the words of the G-20, it has “worked.” Well, at least on Wall Street, where risk appetite is in full bloom. Whether or not that renewed risk appetite finds its way to Main Street is the key question beyond the immediate horizon.

 

We here at PIMCO think it will, but only in a muted way, not a big-V way. We also recognize, however, that markets can stray quite far from “fundamentally justified” values, if there is a strong belief in a friendly convention, one with staying power. And right now, that convention is a strong belief in a very friendly Fed for an extended period. Thus, the strongest case for risk assets holding their ground is, ironically, that the big-V doesn’t unfold, because if it were to unfold, it would break the comforting conventional presumption of an extended friendly Fed.

 

Simply put, big-V’ers should be wary of what they wish for. U’ers, meanwhile, must be mindful of just how bubbly risk asset valuations can get, as long as non-big-V data unfold, keeping the Fed friendly. But that’s no reason, in our view, to chase risk assets from currently lofty valuations. To the contrary, the time has come to begin paring exposure to risk assets, and if their prices continue to rise, paring at an accelerated pace.

‘MONEY ISSUES THAT CAN TEST EVEN A ROCK-SOLID MARRIAGE, ‘ in the New York Times.

When a couple first gets together, they may not have the same approach to managing money. But it’s often easy enough to get past any differences when so much of the future is theoretical anyway.

 

What was the toughest financial challenge that you faced as a couple, and did your relationship survive it?

Then reality sets in. It may take years, even decades, but the gloss wears off. Children arrive, layoffs occur or housing prices collapse just as adult children run out of money.

In my last column, I highlighted a number of topics that the newly engaged should discuss to keep disagreements about money from later threatening the union. This week, I had intended to move on in my series about the financial impact of divorce and write about what happens after the split.

But some readers warned that I was skipping a step.

While it’s good to focus on financial conversations to have before getting married, they said, what about the wrenching financial issues that come up years or decades into the marriage that you never could have anticipated?

“You may find yourselves with an aging relative thousands of miles away who needs your care and support while you’re trying to put one of your own kids through college,” read a comment on nytimes.com from Leslie. “Tough to plan for that one, especially if the aging relative refuses to talk about their own finances ahead of time.”

Any situation like this can strain a marriage to the breaking point. You can either disengage and get divorced or re-engage, said Sandra Wang, a Morgan Stanley Smith Barney financial adviser who is a licensed marriage and family therapist and a certified divorce financial analyst.

What follows are five of the financial issues that are most likely to cause strife and a few ideas about how to work them out.

REDUCED CIRCUMSTANCES If your household income and assets aren’t what they once were, it can be a real problem for spouses who are not living in the style to which they have become accustomed. You may have thought that neither of you could possibly be the kind of person who would feel this way, until you found yourself in the thick of it and were surprised you were contemplating leaving the marriage. “Do they decide to check out?” asked Ms. Wang, who is based in Palo Alto, Calif. “Because if they decide to re-engage, it means readjusting expectations about what married life is going to look like. Can they redefine a relationship that’s not based around the lifestyle?”

Sadly, some people simply cannot.

YOUR MISTAKES When one person in the household is the chief financial officer, there’s just one place to point the finger when things go wrong. So in families where the price of the home has fallen, the adjustable-rate mortgage is resetting to a higher payment and the retirement accounts have fallen 25 percent from their peak, the resident money manager sometimes comes under attack.

“If you go into debt, you may smack your head and say ‘How could this have happened?’ and ‘You never told me we couldn’t afford this big of a house,’” said Lili A. Vasileff, a financial planner in Greenwich, Conn., who has taken to calling her work “marital financial mediation.”

“But blame is not a Ping-Pong game,” she said. “This often happens because they didn’t realize that they weren’t making joint decisions.”

The solution is more transparency and conversations about assets, debts and risk. But after years of letting the other grownup in the house make the decisions, people get out of the habit of keeping up with the details.

YOUR PARENTS Some of the toughest financial problems that come up well into a marriage are those that feel like a choice between your spouse and another loved one.

Take an aging parent who needs specialized care but has run out of money or can’t get the treatment that you and your siblings want to provide without everyone spending a lot of their own money.

“Many couples find themselves in these situations ethically where they feel like they have to do something” to help a family member financially, said Jerry Gale, an associate professor of child and family development at the University of Georgia, where he’s part of an effort to integrate traditional therapy and financial planning. “But if I do that, what is the cost to my own family?”

YOUR CHILDREN While the desire to do right by the children often keeps couples together, the financial challenges that children pose can be formidable.

Ms. Vasileff, who is also the president of the Association of Divorce Financial Planners, said this sometimes comes up with a third child whose parents have bled the college savings dry paying for the first two children. “How do we not deprive our youngest child of what our other children had because we had more money then? Is that just life, that there is not enough left?” she said. “That really strikes hard between the two spouses.”

Even if you manage to get the children educated, they may move home in their 20s expecting their old room back. “It really comes to a boiling point when a couple realizes that they have very different expectations for what will happen when their kids reach the age of majority and how their coming home could affect the couple’s postretirement years,” Ms. Vasileff said.

YOUR UNCERTAINTY Most couples reckon with a sort of low-grade, long-term economic uncertainty that comes when so many people around them are losing their jobs. The stakes only get higher as you and your marriage age and you have children or other large financial responsibilities.

Some people handle this better than others, but the pervasive anxiety that often results can slowly wear down a couple.

It is possible, if you’re diligent early on and live below your means, to plan around many of these issues. A larger-than-average emergency fund can provide a better mental buffer against uncertainty. Starting early with college savings or buying long-term care insurance for your parents will help, too.

But few couples get everything right, which is why it’s a good idea to stop every so often and reassess how you’ve arranged your finances. Sometimes even the most basic practices deserve re-examination. Dan Icolari and his wife, who live in the St. George section of Staten Island, have been married for 46 years. But about 20 years ago, they realized that their different approaches to money were the source of a lot of their arguments.

“Rather than fighting, we decided to separate our bank accounts,” he said. “Once we did it, it instantly affected every other part of our relationship.”

Over the course of a long marriage, you’re bound to run up against financial issues that you didn’t plan for. Or you may simply change your mind about your goals and how money affects them.

“Step back from where you are, often in the heat of the emotions or frustration or anger,” said Mr. Gale, the Georgia professor. “I try to remind people to think about how they overcame stress and challenges in the past. I think couples, when things get stressful, it becomes ‘Here’s what I need to do or for you to do.’ But it’s really about what you can do together.”

‘SMART YEAR-END TAX MOVES TO MAKE NOW. RIGHT NOW!!!,’ from Money Magazine at fidelity.com.

There’s plenty to distract you from financial planning this time of year, from cheering on your favorite football team to daydreaming about Thanksgiving dinner. But you don’t want to let some end-of-year deadlines slip by without taking steps to minimize taxes and maximize savings. Especially in this economic climate, a little extra cash can go a long way.

 

And there’s more cash on the table than usual this year. The government’s stimulus package is loaded with incentives to motivate people to make certain big-ticket purchases — but the deals will run out soon.

 

So if you were thinking of buying a car or appliance, it might make sense to move those purchases up a few months. In terms of the savings, “it’s now or never,” says Bob Meighan, vice president of TurboTax.

 

DVR the game, and take a bit of time to make these moves now. You’ll start 2010 with more to be thankful for.

 

Snag tax breaks

If you’re in the market for — or have already bought — a car or a home, don’t miss these tax incentives courtesy of the stimulus package.

 

New-car sales tax deduction. You can deduct state and local sales tax paid on a new set of wheels purchased this year (between Feb. 17 and Dec. 31), regardless of whether you itemize. The deduction is limited to the first $49,500 of a vehicle’s price, and the break begins to phase out for singles with modified adjusted gross income of $125,000, or couples with $250,000. If you buy and register a 2010 Honda Accord in Chicago for a base price of $21,055, you would reduce your taxable income by $1,948 (based on a 9.25% sales tax).

 

First-time homebuyer credit. Since a credit is directly subtracted from the taxes you owe, the first-time homebuyer credit could put up to $8,000 back into your pocket if you bought a house this year. To qualify, you must not have owned a principal residence in the past three years.

 

Your modified AGI must be $75,000 or less if single, $150,000 or under if married. Plus, closing and title transfer must be completed by Nov. 30. (If you can’t make the deadline, you may have another shot; bills to extend the credit have been introduced into the Senate.)

 

Replace old appliances

Thinking about buying a more energy-efficient furnace this winter? Congress has earmarked nearly $300 million in rebates for new “green” appliances. The rebates will typically range from $50 to $250 and take effect as early as the end of this year (dates, amounts, and method of redemption will vary by state).

 

While there’s no deadline per se, the offer operates like this year’s “cash for clunkers” program. “When the money is gone, the program will be over,” says Meighan of TurboTax. To find out when rebates start and what they’ll cover, go to energystar.gov (click on Tax Credits for Energy Efficiency).

 

Reap your losses

Even with the market’s rally this year, the S&P 500 (.SPX

 

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) is still down 32% from its 2007 peak. So you probably still have losses in your portfolio. Take advantage of them and the chance to get rid of deadbeats.

 

If you sell a stock, bond, or fund in a taxable account for less than you paid, you can use the losses to offset your gains. Have more losses than gains? The IRS lets you deduct up to $3,000 in remaining losses from ordinary income. The rest can be used on future returns.

 

You can’t buy the same investment or one that is “substantially identical” within 30 days before or after the sale. (Otherwise, it’s considered a “wash sale,” and the loss is disqualified.) So you can’t, for example, swap S&P 500-tracking funds. But you can switch to a fund following another index (even a total stock index), and trading one actively managed fund for another is okay. “Presumably, the managers don’t pick the same stocks,” says wealth manager Chuck Roberson of Old Tappan, N.J.

 

Prep for the AMT

For once Congress passed its alternative minimum tax (AMT) “patch” early in the year, raising the income exemption on this parallel tax structure to $46,700 for singles and $70,950 for marrieds. Generally, higher earners must compute their tax bill using both the traditional code and the AMT, which disallows certain deductions and credits — then pay the higher. The patch is necessary because the AMT, which was intended to keep the wealthy from abusing tax breaks, is not tied to inflation.

 

The new exemption levels are similar to those for 2008. So if you were stuck last year, you’ll probably be stuck this year, says New York City CPA and tax attorney Alan Straus. It’s not easy to get out of the AMT trap, but some strategic end-of-year moves may help.

 

Since big deductions can tip you into the AMT zone, limit what you plan to write off. For example, don’t prepay fourth-quarter estimated taxes to your state, which you can deduct on your federal returns, in December. Wait till January.

 

Also, try reducing your income in order to make the most of your exemption: Max out your 401(k)s. Ask your boss to put off any bonus (ha!) until early next year. And if you’re self-employed, hold off on sending invoices.

 

(And if what you do now fails to get you off the hook, there’s still some potential for relief: As part of the stimulus package, Congress is allowing AMT payers this year to take tax breaks normally disallowed, such as child- and dependent-care credits.)

 

Give gifts

As always, send in donations to charitable organizations by the end of December if you want to deduct the gifts on your 2009 tax return. Also, this is the last year you can do a direct rollover from an IRA to a tax-exempt organization.

 

The 2008 Emergency Economic Stabilization Act lets you give up to $100,000 if you’re 70½ or older. You won’t owe federal income tax on the money (though you can’t take a deduction).

 

Speaking of estate-minimizing strategies: Remember that you can give up to $13,000 per recipient tax-free this year (a couple can give $26,000). That should make somebody’s holidays especially happy.

 

‘LESSONS LEARNED IN SINGAPORE,’ in the Financial Times at fidelity.com.

If you talk to financiers in Singapore these days, the topic of property prices keeps cropping up but, unlike in America, it is not the threat of further real estate market falls.

Instead, as Wall Street worries about American house prices – exemplified by a downbeat report from Goldman Sachs this week – in Asia there is mounting concern about property booms-cum-bubbles.

Thus far this year in Hong Kong, for example, residential property prices are estimated to have surged by about 25 per cent. In Singapore the increase is calculated at more than 15 per cent. However, on a visit to that city this week, I was repeatedly told by locals that these figures may be understating the trend: in prime residential and business centres, there is reportedly such a bidding frenzy for good assets, that prices are far higher than official data implies.

The trend is striking for at least two reasons. For one thing, it provides another graphic sign of an issue I discussed in last week’s column – namely the degree to which a flood of money in the global financial system is now potentially creating new mini-bubbles in certain asset classes.

To be fair, this is certainly not the first time that Asian property markets have been on a rollercoaster ride. After the Asian crisis a decade ago, prices swung dramatically too. And this year’s price surge has still not reversed the dramatic tumble seen last year. The Asian property index is still “only” trading back where it was in the spring of 2008, below the dizzy peaks of 2007. Nevertheless, the sheer scale and speed of this year’s rebound has taken even locals by surprise. And while part of the boom reflects optimism about Asian growth prospects, another key factor is that investors around the world are now frantically searching for yields, amid the ultra loose western monetary policy (which, by default, translates into loose policy into much of Asia too, due to fixed exchange rates).

To make matters worse, there is a growing trend among Asian investment groups to hedge themselves against the chance of future dollar falls by investing in “hard”, non-dollar assets instead. Just look at this week’s comments from the China Investment Corporation, the giant sovereign wealth fund, which is now moving into commodities and real estate. Hence that frenzy for Singaporean prime assets, say, even as property prices continue to tumble in New York.

However, the second reason why the Asian property story is fascinating is that it may herald a potentially striking new twist in the global central bank policy debate. In recent weeks, some Asian central banks have started to tighten policy, by using traditional monetary policy levers. The Australian central bank, for example, recently raised rates, and this week the Indian central bank also tightened policy by forcing its banks to raise reserves (presaging a future rate rise).

However, what has grabbed less global attention is that some Asian authorities are also acting in less orthodox ways, by imposing modest credit constraints and prudential controls. In Hong Kong, for example, the authorities have recently tightened the conditions for down-payments on luxury homes. In Singapore, the government has banned some interest-only loans. Meanwhile in South Korea the government is tightening the screws on mortgages, in relation to loan-to-value conditions.

Thus far these measures are modest and it is far from clear whether they will work. However, they are likely to be closely watched by some western central banks. During most of the past two decades, European and US authorities have shied away from the idea of using prudential measures to control the credit cycle, preferring to rely exclusively on interest rate levers.

However, the recent financial crisis has forced central banks to rethink this exclusive dependence on interest rate levers in terms of combating the slump. Just think of all the innovative measures central banks have adopted, as part of their quantitative easing programmes.

That, in turn, begs another question – namely, whether western central banks may also be tempted to reconsider their exclusive reliance on interest rate levers if, or when, the recovery takes hold.

Thus far, few US or European central banks are rushing to debate that in public; after all, to many western central bankers, the concept of credit controls looks unpleasantly “socialist” (or, at least, something only associated with a place such as China).

However, if asset prices start spiralling out of control in the west and, say, unemployment soars too, the problems of relying on interest rate levels alone may become more apparent. What is being quietly tried in Singapore, in other words, may yet spread into the western markets. Just one more reason – if any was needed – to keep a close eye on Asia.

© The Financial Times Limited 2009. All Rights Reserved.

‘WARREN BUFFET AND THE G-20,’ by Simon Johnson at baselinescenario .com.

Warren Buffett And The G20

Posted: 07 Nov 2009 03:53 AM PST

 

The G20 Finance Ministers and Central Bank governors are meeting today in St. Andrews, talking about the data they will need to look at in order to monitor each other’s economic performance and sustain growth (seriously).

 

The underlying idea is that if you talk long enough about the US current account deficit and the Chinese surplus, stuff happens and the imbalances will take care of themselves – or move on to take another form.

 

Warren Buffett seems to agree.

 

Buffett’s big investment in railroads looks like a shrewd way to bet on growth in emerging markets – which is where most incremental demand for US raw materials and grain comes from.  It’s also a polite way to bet against the dollar or, even more politely, on an appreciation of the renminbi.

 

When China finally gives way to market pressure and appreciates 20-30 percent, their commodity purchases will go through the roof.   You can add more land, improve yields, or change the crop mix of choice (as relative prices move), but it all has to run through Mr. Buffett’s railroad.

 

Of course, Buffett is nicely hedged against dollar inflation – this would likely feed into higher inflation around the world, and commodities will also become more appealing.

 

And Mr. Buffett is really betting against the more technology intensive, labor intensive, and industrial based part of our economy.  If that were to do well, the dollar would strengthen and resources would be pulled out of the commodity sector – the more “modern” part of our production is not now commodity-intensive.

 

The G20 will stand pat, waiting for the recovery and hoping for the best; “peer review” will turn out to be meaningless.  But this raises three dangers.

 

China will overheat, with capital inflows fuelling a giant credit boom.  Books with titles like “China as Number One” and “The China That Can Say No” will appear.  The boom-bust cycle will resemble that of Japan in the 1980s – you don’t need a current account deficit in order to experience a costly asset price bubble.  Other emerging markets may follow a similar pattern (think India, Brazil, Russia.)

US and European banks will be drawn into lending to China and other emerging markets, directly or indirectly.  In a sense this would be a re-run of the build-up of debt in Latin America and Eastern Europe in the 1970s, leading to the debt crisis of 1982 (remember Poland, Chile, Mexico).  Banks with implicit government guarantees will lead the way.

We hollow out the middle of the global economy – with a few people doing ever better and most people struggling to raise their living standards.  Increasing commodity prices hit hard at poorer people everywhere (recall the effects of the relatively mild run-up in food and energy prices in the first half of 2008).  Global volatility of this nature helps big business but at the cost of undermining the middle class.

By betting on commodities, Mr. Buffett is essentially taking an “oligarch-proof” stance.  Powerful groups may rise to greater power around the world, fighting for control of raw materials and driving up their prices further.  As long as there is growth somewhere in emerging markets, on some basis, Mr. Buffett will do fine.

 

As for the G20, they are already a long way behind the curve.

 

By Simon Johnson

‘THE GLIDE PATH OPTION, ‘ John Mauldin’s weekly E-mail newsletter at frontline.com. Long read but worth it.

The present contains all possible futures. But not all futures are good ones. Some can be quite cruel. The one we actually get is dictated by the choices we make. For the last few months I have been addressing the choices in front of us, economically speaking. Today I am going to summarize them, and maybe we can look for some signposts that will tell us which path we’re headed down. For those who are new readers and who would like a more in-depth analysis, you can go to the archives at www.2000wave.com and search for terms I am writing about. And I will start out by briefly touching on today’s ugly unemployment numbers, with data you did not get in the mainstream media.

 

But first, let me welcome the readers of EQUITIES Magazine to this letter. The publisher is sending the letter to you directly. This letter is free, and all you have to do to continue receiving it is type in your email address at www.2000wave.com. Likewise, I have arranged for my regular readers to get a free subscription to EQUITIES Magazine, if you would like. You can go to www.equitiesmagazine.com. For those who don’t know, I write a brief monthly column for them.

 

The Ugly Unemployment Numbers

 

The headlines said unemployment, as measured by the “establishment survey,” was down by 190,000; and even though that was slightly worse than forecast, market bulls were cheered by the fact that the number was not as bad as last month’s. It is an improvement that we are not falling as fast.

 

Well, maybe. What I did not see in many of the stories I read was that the number of unemployed actually soared by 558,000, to 15.7 million, as measured by the household survey. The establishment survey polls larger businesses; the household survey actually calls individual households.

 

Let’s look at the real number in the establishment survey. If you don’t seasonally adjust the number, the actual change in unemployment for October was 641,000, or about 450,000 more than the seasonally adjusted number. And the Bureau of Labor Statistics added 86,000 jobs that they simply guess were created through the so-called birth-death ratio. Interestingly, the birth-death ratio number is not seasonally adjusted, so it is just added to the unemployment number. http://www.bls.gov/web/cesbd.htm

 

The total (U-6) employment rate is at a record high of 17.5% (this includes those who are part-time for economic reasons). There are now over 10.5 million people who have lost their jobs since the beginning of the downturn.

 

My favorite slicer and dicer of data, Greg Weldon (www.weldononline.com), offers up an even more horrific number. As I have noted before, if you have not looked for work in the last four weeks, the BLS does not count you as unemployed. Quoting Greg:

 

“Moreover, when we combine the monthly change in the number of Unemployed, with the number Not in the Labor Force, we might consider the result to be a proxy for the actual ‘change’ in the underlying labor market situation … in which case, October’s figure of 817,000 represents the fourth LARGEST yet, behind last month’s (September’s) second largest figure of 1,021,000 … for a two-month combined figure of 1.838 million, in newly Unemployed, or no longer ‘in’ the Labor Force …

 

“… the second LARGEST two-month total EVER posted, barely trailing the December-08/January-09 total 1.955 million.

 

“Bottom line … basis this measure AND the ‘Total Unemployment Rate,’ we could conclude that not only is there NO ‘improvement’ in the labor market, but moreover, that it continues to DETERIORATE, intently.”

 

There are plenty more implications in the data, but let’s turn to the topic of the day.

 

The Present Contains All Possible Futures

 

Like teenagers, we as a US polity have made a number of bad choices over the past decade. We allowed banks to overleverage and, in the case of AIG (and others), sell what were essentially naked call options of credit default swaps, based on their firm balance sheets, far in excess of their net worth; and that put our entire financial system at risk. We gave mortgages to people who could not pay them, and did so in such large amounts that we again brought down the entire world financial system to the point that only with staggering amounts of taxpayer money was it brought back from the brink of Armageddon. We assumed that home prices were not in a bubble but were a permanent fixture of ever-rising value, and we borrowed against our homes to finance what seemed like the perfect lifestyle. We did not regulate the mortgage markets. We ran large and growing government deficits. We did not save enough. We allowed rating agencies to degrade their ratings to a point where they no longer meant anything. The list is much longer, but you get the idea.

 

Now, we are faced with a continuing crisis and the aftermath of multiple bubbles bursting. We are left with a massive government deficit and growing public debt, record unemployment, and consumers who are desperately trying to repair their balance sheets.

 

If present trends are left unchecked, we will need to find $15 trillion in the next ten years, just to pay for US government debt, let alone state, county, and city debt. And perhaps some loans for business will be needed? Where can all this money come from? The answer is that it can’t be found. Long before we get to 2019 there will be an upheaval in the market, forcing what could be unpleasant changes.

 

We are left with no good choices, only bad ones. We have created a situation that is going to cause a lot of pain. It is not a question of pain or no pain, it is just when and how we decide (or are forced) to take it. There are no easy paths, but some bad choices are less bad than others. So, let’s review some of the choices we can make. (Again, I am being very general here. You can go to the archives for more specifics. This is a summary letter.)

 

Argentinian Disease

 

One way to deal with the deficit is to do what Argentina and other countries have done: simply print the money needed to cover the deficits. Of course, that eventually means hyperinflation and the collapse of the currency and all debt. There are writers who think this is an inevitable outcome. How else, they ask, can we deal with the debt? Where is the political willpower?

 

One large hedge-fund manager in Brazil humorously remarked that Argentina is a binomial country. When faced with two choices (hence binomial) they always made the bad choice. Could it happen here?

 

Hyperinflation is not an economic event; it is a political choice. I think last Tuesday’s election is a sign that the voter population is beginning to pay attention to the need for something more than talk of change. There is growing discomfort with the size of the deficits. Further, the Fed would have to cooperate in order for there to be hyperinflation, and I think there is only a very slight (as in almost zero) chance of that happening. Could Congress change the rules and take over the Fed? Anything’s possible, but I seriously doubt there is any appetite in saner Democratic circles for such a thing to happen.

 

I think the chances of hyperinflation in the US are quite low. It would be the worst of all possible bad choices.

 

The Austrian Solution

 

Here I refer to the Austrian school of economic theory, based on the work of Ludwig von Mises and Friedrich Hayek, et al. There are those in the Austrian camp who argue the need to do away with the Fed, return to the gold standard, allow the banks that are now deemed too big to fail to go ahead and fail, along with any businesses that are also mismanaged (such as GM and Chrysler), and leave the high ground to new and more properly run.

 

In their model, government spending is slashed to the bone, as are (in most cases) taxes. The advantage is that, in theory, you get all your pain at once and then can begin to recover from what would be a very bad and deep recession. The bad news is that you risk getting 30% unemployment and another depression that could take a very long time to climb out of.

 

Now, let me say that I have GREATLY simplified their argument. If you want to learn more you can go to www.mises.org. It is an excellent web site for all things Austrian. While I am not Austrian, I have spent a lot of time reading the literature and have certain sympathies for this view.

 

That being said, this also has almost no chance of being implemented. In Congress, only my friend Ron Paul is its advocate. Most Austrian followers are Libertarian by nature, and that is just not a political reality for the coming decade.

 

The Eastern European Solution

 

As it turned out, Niall Ferguson (last week I wrote about his brilliant book, The Ascent of Money) was in Dallas last night, and I was graciously invited to hear him. He gave a great speech and signed books, and then we went to a local bar and proceeded to solve the world’s problems over Scotch (Niall) and tequila (me), and went farther into the night than we originally intended. He’s a very fun and knowledgeable guy.

 

As we were talking about possible paths, he brought one to mind that I hadn’t thought of. He reminded me of the period after the fall of the Berlin Wall, as the nations of Eastern Europe broke from the former Soviet Union. They started with very weak economies and simply overhauled their entire governments and economies in a rather short period of time, though not in lockstep with one another. Privatization, lowered taxes, etc. were the order of the day.

 

We here in the US are always talking about the need for reform. We need to reform health care or education or energy. In Eastern Europe they did not reform in the sense that we use the word. In many cases they simply started from scratch and built new systems. They had the advantage that there was general agreement that things did not work the way they had been, so there was more room for change.

 

Today in the US there are large constituencies that resist change. We only get to tinker around the edges, when real structural change is needed. Sadly, we agreed that here there is not much chance of major change. We can’t even get the obvious changes needed in the financial regulatory world.

 

Sidebar: I am outraged at the paltry proposed financial “reforms.” Rahm Emanuel said that no crisis should be allowed to go to waste. The Obama administration is wasting this one. How can we allow banks to be too big to fail? Where is the reinstatement of Glass-Steagall? If we are going to allow large banks to exist, then their leverage must be reduced to the point where their failure would not risk the system and require taxpayer dollars. I don’t care if that makes them less profitable. They are making those large profits because they have taxpayers implicitly behind them, and I get no dividend payments from them, the last time I checked. Where is Fannie and Freddie reform (and their breakup)? No mention of an exchange for credit default swaps? (And yes, I know that such an exchange would reduce the number of swaps and the profitability of them. That is the point. They are dangerous if allowed to become too big a market.) This bill reads as if bank lobbyists wrote it. Where is the populist outrage? We have let the fox set up the rules for running the hen house. Shame on us all if we allow this to happen.

 

Japanese Disease

 

I have written a lot over the past year about the problems facing Japan. Their population is shrinking, as is their work force. They are running massive fiscal deficits and have done so for almost 20 years. Government debt-to-GDP is now up to 178% and projected to rise to over 200% within a few years. They started their “lost decades” with a savings rate of almost 16%, and are now down to 2% as their aging population spends its savings in retirement. They have had no new job creation for 20 years, and nominal GDP is where it was 17 years ago.

 

As bad as our problems are here in the US, their bubble was far more massive. Values of commercial property fell 87%! Their stock market is still down 70%. They had twice as much bank leverage to GDP as the US. (Think about how bad off we would be if bank lending was twice as large and had even worse defaults and capital shortfalls!)

 

And yet, they Muddle Through. Productivity has kept their standard of living reasonable. Up until recently their exports were strong. The trading floors of the world are littered with the bodies of traders who have shorted Japanese government debt in the belief that it simply must implode. While I believe that it eventually will, if they stay on the path they are on, Japan is a very clear demonstration that things that don’t make sense can go on longer than we think.

 

Richard Koo (chief economist of Nomura Securities, in Tokyo) argues passionately that Japan had a balance-sheet recession, and that the only way for Japan to fight it was to run massive deficits. Banks were not lending and businesses were not borrowing, as both groups were trying to repair their balance sheets, which were savaged by the bursting of the bubble. It is said that at one time the value of the land on which the Emperor’s Palace sits in Tokyo was worth more than all of California. Clearly this was a bubble that puts our housing bubble to shame.

 

So, I understand the point that there are differences between Japan and the US . But there are also similarities. We too have had a balance sheet recession, although here it was mostly individuals and financial institutions that have had to retrench and repair their balance sheets.

 

Japan elected to run large deficits and raise taxes. As I wrote in the October 16th letter (http://www.2000wave.com/article.asp?id=mwo101609), “Savings equal Investments:

 

GDP (Gross Domestic Product) is defined as Consumption (C) plus Investment (I) plus Government Spending (G) plus [Exports (E) minus Imports (I)] or:

 

GDP = C + I + G + (E-I)

 

I don’t want to go on at length again, but basically, the literature I quoted suggests that government stimulus and deficits have no long-run positive effect on GDP. In fact, the work done by Christina Romer, Obama’s chairman of the Council of Economic Advisors, shows that tax cuts have a three-times-greater positive effect on GDP, and tax increases have the same level of negative effect.

 

In the equation above, if you increase government spending it will have a positive effect in the short run on GDP, but not in the long run. In essence, the increase in “G” must be made up by savings from consumers and businesses and foreigners.

 

But “G” does not enhance overall productivity. Government spending may be necessary but it is not especially productive. You increase productivity when private businesses invest and create jobs and products. But if government soaks up the investment capital, there is less for private business.

 

And that is Japanese disease. You run large deficits, sucking the air out of the room, and you raise taxes, taking the money from productive businesses and reducing the ability of consumers to save. Then you go for 20 years with little or no economic or job growth.

 

This is the path we currently seem to be on. The Japanese experience says that it could last a lot longer than people think before we hit the wall; because if savings rise in the US, and if banks, instead of lending, put that money on deposit with the Fed, as they are now doing (in order to repair their balance sheets), the US could run large deficits for longer than most observers currently believe.

 

We will need 15-18 million new jobs in the next five years, just to get back to where we were only a few years ago. Without the creation of whole new industries, that is not going to happen. Nearly 20% of Americans are not paying anywhere close to the amount of taxes they paid a few years ago, and at least ten million are now collecting some kind of unemployment benefits or welfare.

 

Choosing large deficits does not reduce the amount of pain we will experience, it just seemingly reduces it in the short term and creates the potential for a serious economic upheaval when the bond market finally decides to opt for higher rates. This path is a bad choice, but sadly, in reality it is one we could take.

 

The Glide Path Option

 

A glide path is the final path followed by an aircraft as it is landing. We need to establish a glide path to sustainable deficits (could we dream of surpluses?). That is because at some point there will be recognition, either proactively or forced upon us by the bond market, that large deficits are unsustainable in the long term.

 

If Congress and the president decided to lay out a real (and credible) plan to reduce the deficit over time, say 5-6 years, to where it was less than nominal GDP, the bond market would (I think) behave. Reducing deficits by $150 billion a year through a combination of cuts in growth and spending would get us there in five years.

 

The problem is that there is real pain associated with this option. Remember that equation above. Absent a growing private sector, if you reduce “G” (government spending) you also reduce GDP in the short run. You have to take some pain today in order to do that. But you avoid worse pain down the road: a bubble of massive federal debt that has to be serviced will be very painful when it blows up, as all bubbles do.

 

The Glide Path Option means that structural unemployment is going to be higher than we like (which is actually the case with all the options). And the large tax increases that come with this option will by their very nature be a drag on growth (and cause a double-dip recession in 2011). We can debate tax increases all we want, but I sadly think we will soon have a VAT tax. There are no good options. I just hope that we cut corporate taxes enough when we do create a VAT, that it will make our corporations more competitive, which will be a boost for jobs.

 

That’s pretty much it. This is not a problem we can grow ourselves out of in the next few years. We have simply dug ourselves into a huge hole. This is not a normal recession. There is not a “V” ending to this recession. We are going to have deal with the pain. It will be the pain of reduced returns on traditional stock market investments, a lower dollar, low returns on bonds, European-like unemployment, lower corporate profits over the long term, and a very slow-growth environment. But if we choose this path, we will get through it in the fullness of time.

 

And of course, then we will eventually have to deal with the $70 trillion in our off-balance-sheet liabilities in Medicare and Social Security and pensions. Sigh. But that’s for another time.

 

Philadelphia, Orlando, and Phoenix

 

I really am more optimistic than this letter makes me seem. But if you ignore reality, then you have no chance to figure out how to make the best of your situation. It is the efforts of hundreds of millions of individuals trying to make their own lot a little better than will get us back to a robust economy.

 

Monday I fly to Philadelphia and then the next day to Orlando for two speeches, and then the following week a quick trip to Phoenix, then home to start to plan for Thanksgiving. I will be in New York the first weekend of December (the 4th) for Festivus, a great fundraiser for kids sponsored by Todd Harrison and the team at Minyanville (http://www.rpfoundation.org/), Interestingly, they hold it every year at a “Texas” barbecue joint. Look me up if you are there.

 

Tiffani has been out the last two days of this week. She is due in seven weeks or less, and her hips are expanding. The pain is too much right now for her to walk up the stairs to the office, so she is working from home. The doctor says this is the one time that her pain is not a sign of something bad. She is being a trooper and not taking any pain meds.

 

It has been 30 years since I was around a pregnant lady for more than a few hours, and it does bring back some memories. Watching her grow and change has brought back the sense of awe over how our bodies are designed.

 

Ryan and Tiffani have decided on the name Lively for my first granddaughter, to add to the two new grandsons this year. From zero to three grandkids in just six months! Kind of makes me dizzy.

 

I really enjoyed my time in South America. Rio is quite beautiful and I want to go back and spend some time.

 

Have a great week. There will be enough good friends and family that I know I will. And tomorrow night I finally get to go to a Dallas Mavericks game. We may have a real team this year.

 

Your always optimistic at the beginning of the season analyst,

 

John Mauldin

John@FrontLineThoughts.com

 

Copyright 2009 John Mauldin.

‘FIFTEEN FUNDS ON A 30% RUN FOR 2009,’ from Smart Money at fidelity.com.

Investors who got used to seeing a negative sign in front of the returns for their portfolios can certainly take some satisfaction with the performance of the stock market this year. The average S&P 500 fund dropped around 37% last year. Now those same funds are up 20% this year. Of course, there is still some way to go before investors get back to even territory, but the market is moving in the right direction — at least for now.

The market’s ride upward has lifted some funds more than others. While some offerings are struggling, investors can easily find funds that are up 25%, 30% or 35%. There are more than 2,000 funds and share classes listed in our database that have returned double the S&P’s performance this year.

This week we turn the spotlight on those funds. To construct this screen we suspended some of the usual guidelines we follow, like focusing on long-term track records. This screen concentrates on just one detail: year-to-date performance. There are more than 10,200 funds and share classes beating the S&P 500  this year. We knocked out the funds that charge loads and high fees and minimums. That left us with a universe of over 500 offerings. From that group we highlighted 15 funds that are up at least 50% on the S&P 500 this year and are either run by well-known managers or are popular with investors. They are listed on the table below.

We mention this list with some reluctance. After all, by favoring year-to-date performance we are, in effect, putting our stamp of approval on performance chasing. That certainly isn’t our intention. If you jump into one of these funds hoping for another 30% or 40% pop, you’re bound to be disappointed. Many market watchers think the stock market is due for a pullback at some point.

“I think we may have some room to run,” says Tom Karsten, senior managing partner at Karsten Tax and Financial Management in Fort Worth, Texas. But Karsten says he is still being cautious and taking some profits. “Based on the [price/earnings ratios] we are seeing, the market is starting to get on higher price levels that can’t be fundamentally supported.”

That said, by studying these funds investors can pick out trends — and then decide whether they have staying power or not. Over a dozen of the funds on our larger list are classified as emerging-market offerings. T. Rowe Price Emerging Europe and Mediterranean (TREMX | , for instance, is up a whopping 113% this year. This concentrated fund invests over half its assets in Russia, 17% in Turkey and almost 7% in Egypt. Several Matthews funds concentrating on India, China and Korea are up big, too. These funds have benefitted from investors willing to take on more risk as the market shows signs of improvement and from the general rise in commodities prices. If either of those pillars is shaken, though, the returns could easily cool off.

Sectors like technology, natural resources and real estate are turning in good numbers. In terms of mainstream fund categories, midcaps and multicaps have been the sweet spots. For example, Ariel (ARGFX | Get Prospectus) is up 46.4% this year. Aston Optimum Mid Cap (CHTTX |  has gained 49.9% during that same time period.

That said, there’s likely much merit in following Karsten’s advice. Since March he has been adding weekly to his clients’ equity holdings and is now in the midst of taking some profits. In other words, his clients still have exposure to the market and will participate in any further rally — but they’ll also benefit from locking in some gains.

“People want to regain the capital they lost. The tendency from a psychological standpoint is to be more aggressive,” says Karsten. “I am still focusing on low fees, which will become more important if there is another low-return environment.”

The criteria: The equity funds on our list are open to new money, require a minimum investment under $5,000 and charge an annual expense ratio less than 1.5%. We arrived at the final list by favoring funds that were up at least 30% in 2009 (double the return of the S&P 500 index) and are either run by a well-known manager or are popular with investors.

Funds on a run

Fund Name Assets

($ Millions) Year-to-Date

Return

(%) Expense

Ratio

(%)

Appleseed

(APPLX | 55.5 53.01 0.90

Ariel

(ARGFX | 1714.0 46.44 1.07

Aston/Optimum Mid Cap

(CHTTX | 843.0 49.90 1.16

Buffalo Science & Technology

(BUFTX | 165.5 41.44 1.03

Chesapeake Core Growth

(CHCGX | 370.8 31.60 1.42

Columbia Value & Restructuring

(UMBIX | 6085.0 40.2 0.89

Croft Value

(CLVFX | 122.1 31.69 1.46

Dodge & Cox International Stock

(DODFX | 35320.4 44.80 0.64

Fidelity Magellan

(FMAGX | 22722.6 32.60 0.71

Matthews China

(MCHFX | 2030.0 65.60 1.23

Matthews India

(MINDX | 629.5 77.80 1.29

Oakmark International

(OAKIX | 4044.0 49.80 1.10

Royce Opportunity

(RYPNX | 844.0 49.90 1.17

T. Rowe Price Growth Stock

(PRGFX | 16746.0 33.70 0.71

Yacktman Focused

(YAFFX 430.6 54.96 1.25

Source: Lipper

Note: Data as of Oct. 29th, 2009

‘OBAMA IN CHINA. BREAKING THE EXCHANGE RATE DEADLOCK,’ by Simon Johnson at baselinescenario .com.

President Obama leaves next week for a high profile trip that includes meetings with other “Asia-Pacific” countries (in the APEC forum) and a visit to China.  The President has had considerable diplomatic success on the economic front to date, including at the G20 summit in April and – to a lesser degree – at the follow-up September summit in Pittsburgh.

 

But the issues facing him now in Asia are particularly difficult, primarily because of China’s exchange rate policy.  China essentially pegs its currency (known as the yuan or renminbi) against the US dollar, which means that it rises and – most recently – falls in tandem with the greenback.

 

Many countries operate de facto pegs of this nature, but China is problematic for three reasons: it is a large economy (10 percent of world GDP, if we adjust for purchasing power), it runs a big current account surplus (exporting more to the world than it buys from the world, in the range of 6-12 percent of the Chinese economy), and it consistently has a bilateral surplus with the US that is galling to many on both sides of the aisle on Capitol Hill (and their constituents).

 

The political backlash is not without foundation – jobs have moved and continue to move to China in part because Beijing’s exchange rate policy gives Chinese exporters an unfair trade advantage.  This has long been recognized and China committed as long ago as 2003 to address this issue, but the Bush administration was unable to achieve any lasting success on this front – despite repeated head-to-head talks at the Cabinet Secretary level.

 

The Chinese currency remains at least 20 percent undervalued according to the Peterson Institute for International Economics (disclosure: I have a part-time position at the Institute but don’t work on this calculation); quietly, US officials do not disagree with such numbers.  As a result, China continues to accumulate foreign exchange reserves at a dramatic rate – it reached $2 trillion earlier this year and will like have $3 trillion around the middle of 2010 (i.e., equivalent to 20 percent of US GDP; a huge number).

 

The Bush administration, quite reasonably, tried to give the job of handling China’s exchange rate to the International Monetary Fund – beefing up its long-established mandate in this area.  Unfortunately, the IMF has proved unable to make any significant progress, largely because it lacks the legitimacy necessary to wield any kind of stick on the issue.  The Chinese just continue to say “no”, politely, and the IMF has backed down.

 

This is embarrassing for Mr. Obama, particularly as his strategy at the G20 has been to play up the importance of “global imbalances,” which implies that over the next 12 months, the focus will be on reducing both the Chinese current account surplus and the US current account deficit.

 

What should he say both to China and to its neighbors – who also increasingly find China’s exchange rate policy worrying, particularly as the dollar faces pressure to decline?  Mr. Obama needs to find a carrot and at least the shadow of a stick, but he really does not want to go anywhere near a trade war (remember the tit-for-tat protectionism of the Great Depression).

 

A compelling argument is actually hiding in plain sight.  As a result of easy monetary policy in the United States, combined with the rapid rebound of the Chinese economy, China now faces record capital inflows.  These inflows are greatly encouraged by the inevitable prospect (in the minds of investors) that the renminbi will rise in value against the dollar within the foreseeable future.  If you have access to cheap financing and implicit US government guarantees, for example as does Goldman Sachs, borrowing in dollars and investing (e.g., through private equity deals) in renminbi looks like a one-way bet.

 

The longer China resists appreciation and the more it protests that no one should interfere with this aspect of their sovereignty, the more the capital will pour in.  This can have beneficial aspects, in any country that is trying to grow fast, but it can also be profoundly destabilizing – Mr. Obama should talk gently about the experience of Japan in the 1980s, the US this decade, and almost all emerging markets pretty much every decade.

 

Talking in public about big sticks never goes down well in Asia, and the administration should deny any inclination in this direction.  But the mainstream consensus is starting to shift towards the idea that the World Trade Organization (WTO), not the IMF, should have jurisdiction over exchange rates.  The WTO has much more legitimacy – primarily because smaller and poorer countries can bring and win cases against the US and Western Europe in that forum.  It also has agreed upon and proven tools for dealing with violations of acceptable trade practices – tailored trade sanctions are permitted.

 

No one wants to take precipitate action in this direction, but extending the WTO’s mandate in the direction of exchange rates would take time – and presumably warrant discussion at the G20 level.  The US has great influence over the G20 agenda and Mr. Obama’s staff should hint, ever so gently, that this is where they see the process going.

 

By Simon Johnson

‘FREE MARKETS AND H1N1,’ by James Kwak at baselinescenario .com.

Free Markets and H1N1

Posted: 04 Nov 2009 06:25 AM PST

 

In a free market, companies should be allowed to decide whether or not to offer paid sick leave to employees. At the margin, employees who value paid sick leave will flow to companies that offer it and employees that don’t won’t; also at the margin, companies that offer paid sick leave will be able to pay their employees a little less in other forms of compensation. Everything works out for the best.

 

Unfortunately, not offering paid sick leave creates a classic externality: People go to work even when they’re sick, infecting their co-workers (or customers); employers internalize some of that cost (co-workers), but not all of it (co-workers going home and infecting their kids, who then go to school — because their parents can’t stay home to take care of them — and infect their classmates, etc.). I’ve written before that we are far behind the rest of the developed world in requiring paid sick leave.

 

Now is when it will hurt us. The New York Times has an article today titled “Fears That Lack of Paid Sick Days May Worsen Flu Pandemic.” (Economix has related data on who gets paid sick leave — public sector workers, people at big companies, and the highly-paid.) I’m not sure why they decided to throw in the word “may.” We know that at the margin some people with H1N1 are going to work when they shouldn’t. We know that H1N1 is highly contagious (5.7 million Americans affected so far). We may not know how many more people are getting H1N1 because of our non-policy on paid sick leave, but it can’t be zero.

 

Of course, you can count on the business lobby to deny that there is a problem:

 

“‘The vast majority of employers provide paid leave of some sort,’ said Randel K. Johnson, senior vice president for labor at the United States Chamber of Commerce. ‘The problem is not nearly as great as some people say. Lots of employers work these things out on an ad hoc basis with their employees.’

 

“According to the Bureau of Labor Statistics, 39 percent of private-sector workers do not receive paid sick leave.”

 

Vast majority?

 

There’s another dimension to this, too. Economix says this: “In both the private and the public sector, low-wage workers are far less likely to receive paid sick leave than high-income workers, touching off fears that front-line workers at fast-food restaurants or child care centers might be spreading their illnesses.”

 

That’s an interesting interpretation: the problem is that readers of Economix, who presumably do not work in fast food restaurants or day care centers, might catch H1N1 from a fast-food worker or their child’s day care provider. No, it isn’t. The problem is that our non-policy hurts the poor. Rich people can stay home when they are sick or when their children are sick, which means the rate of transmission in rich communities will be lower. Poor people can’t, so the rate of transmission in poor communities will be higher. This is obviously a simplification; there are poor people with paid sick leave, and rich people without it (many small business owners, for example). There are also communities that include rich and poor people. But in the absence of public policy not only do we have a negative externality, we have one that disproportionately affects the poor.

 

By James Kwak

‘ACKERMAN VS. HOENIG: TAKE IT TO THE WTO,’ by Simon Johnson at baselinescenario .com.

 

Ackermann vs. Hoenig: Take It To The WTO

Posted: 03 Nov 2009 05:31 AM PST

 

Josef Ackermann, chief executive of Deutsche Bank and chairman of the Institute of International Finance (an influential group, reflecting the interests of global finance in Washington) is opposed to breaking up big banks.  According to the FT, he said,

 

“The idea that we could run modern, sophisticated, prosperous economies with a population of mid-sized savings banks is totally misguided.”

 

This is clever rhetoric – aiming to portray proponents of reform as populists with no notion of how a modern economy operates.  But the problem is that some leading voices for breaking up banks come from people who are far from being populists, such as the UK authorities (in the news today) and the US’s Thomas Hoenig.

 

Hoenig is an experienced regulator, who has dealt with many bank failures.  He is also currently President of the Kansas City Fed and an articulate voice regarding how banks became so big, why that leads to macroeconomic problems, and how consumers get trampled (answer: credit cards, issued by big banks; p.6).  He supports a resolution authority that would help deal with some situations, but also says (p.9):

 

“To those who say that some firms are too big to fail, I wholeheartedly agree that some are too big.  However, these firms can be unwound in a manner that does not cause irreparable harm to our economy and financial system but actually strengthens it for the long run.”

 

Mr. Hoenig is, if anything, a little too polite.  There is no evidence that huge banks, at their current scale, provide any social benefit.  When these same banks were much smaller, in dollar terms and as a percent of the economy, the global economy functioned no worse than today.

 

Mr. Ackermann and his colleagues are pursuing a purely self-serving line.  Reasonable centrist opinion is turning against them.  Either the big banks need to shrink voluntarily or they will potentially face consequences that they cannot control.

 

Building on ideas from the Kansas City Fed, the Bank of England, the UK Financial Services Authority, and the European Commission, the consensus is moving towards the view that state-supported banking (i.e., operating through implicit guarantees on Too Big To Fail banks) constitutes an unfair form of protectionism.  Financial services in this guise do not currently fall within the remit of the World Trade Organization, but it would be a simple matter to extend its mandate in this direction.

 

In any reasonable judicial-type process, involving relatively transparent weighing of the evidence, Mr. Ackermann would be most unlikely to prevail.

 

By Simon Johnson

‘BETTING ON GROWTH STOCKS,’ from the Wall St. Journal at fidelity.com.

Seemingly cheap “value” stocks and the mutual funds that buy them have led the stock market up from March lows.

 

But many professional investors believe that market leadership is poised to shift to “growth” stocks, those of companies with greater potential to expand earnings and revenue.

 

Distinctions in relative performance seemed pointless during the bear market, when shares of every type of company—small, large, growth, value—got crushed. In the rebound from the March 9 low, clearer patterns have emerged.

 

Small stocks have beaten large stocks, and among companies of all sizes, value stocks have beaten growth. For instance, funds holding small value stocks are up 74% (through Oct. 28), compared with a 58% increase for funds holding small growth stocks, according to Morningstar Inc. Funds holding large growth stocks are up 52%, the smallest advance among nine categories of diversified U.S. stock funds.

 

It is common for value companies, whose shares appear cheap compared with their earnings, revenue or book value, to lead the way out of a trough. During a severe economic downturn, share prices for the smallest, most struggling firms can collapse because investors sell shares of companies they fear will go bankrupt. “Many cheap value companies are cheap because people doubt their sustainability,” says Ron Sloan, a senior portfolio manager at Invesco Ltd.’s (IAIM fund unit. When the economy starts to improve and it becomes clear that those firms won’t go under, they can rebound sharply.

 

But many investors say that effect won’t last. Small, risky value companies are unlikely to keep leading if a U.S. economic recovery remains weak. Without robust domestic demand, such companies may not perform well and will probably cede leadership to growth companies perceived to have the ability to thrive even in a lackluster economy. Technology, the classic growth sector, could benefit as companies try to maximize productivity in a “jobless” recovery.

 

“If we’re in a tough world where revenues are hard to come by, where you need to sell to emerging markets to find growth, bigger companies will benefit more, and old-fashioned growth businesses” will begin to outperform the value companies that have led the bounce, says Mr. Sloan. Tech giants such as Intel Corp. , Cisco Systems Inc. and Motorola Inc. , which earn a large portion of their revenues overseas, along with health-care firms like Medtronic Inc. , could be winners, he says. All are holdings in the AIM Charter fund (CHTRX | for which he is lead manager.

 

Trading leads

Near a recession trough, value stocks usually start outperforming growth stocks, says Dave Hintz, head of U.S. equity research at Russell Investments. “Sometimes it is slightly before the trough, [or] slightly after,” he says.

 

Over longer periods of time, growth and value stocks tend to switch off in terms of stock-market leadership. That’s seen, for example, in the performance of the growth and value components of the Russell 3000 index  of large and small stocks.

 

The Russell 3000 Growth Index  has generally led the Russell 3000 Value Index  since August 2006 on a two-year rolling basis—that is, comparing their performance over multiple overlapping 24-month periods.

 

From March 2000 to August 2006, value beat growth, except for a couple of short periods, according to data from Russell. And during the tech bubble of the late 1990s, growth led, which isn’t surprising, given that the technology sector makes up a big portion of growth indexes.

 

From March 9 to Oct. 28, the Russell 3000 Value Index rose 63%, while the Russell 3000 Growth Index gained 54%. But year-to-date, the growth index was up 26%, beating the value index’s 12% gain.

 

Eventually, there will be “a handoff” from value back to growth, says Chris Guinther, chief investment officer and president of Silvant Capital Management LLC in Atlanta. Silvant sub-advises three growth-focused mutual funds for RidgeWorth Funds. Silvant predicts growth will outperform value in the next two calendar years.

 

Growth also looks cheaper than usual relative to value, says Russell’s Mr. Hintz. The large-stock Russell 1000 Value Index  had a price/sales ratio of 1.00 at the end of September, the most recent figure available, compared with 1.55 for the growth index. A growth premium of 55% is low, he says; at other points, it has been more than 100%.

 

The industry compositions of growth and value indexes are very different, with financials typically dominating the value indexes and technology stocks accounting for a big portion of the growth indexes. Tech and health-care shares each account for about a quarter of the small-stock Russell 2000 Growth Index , for example, while financials make up about a third of the small-stock Russell 2000 Value Index .

 

Interestingly, the financial sector hasn’t driven the performance of the small-cap value index since March, says Jeff Cardon, chief executive officer of fund manager Wasatch Advisors Inc. in Salt Lake City and manager of Wasatch Small Cap Growth (WAAEX | . As of early last week, financials had gained about 55%, while the whole index was up about 75%. The best-performing sectors, according to data from Russell, have been consumer-discretionary and energy stocks.

 

In contrast to larger financial stocks, which have had a huge rebound off March’s “panic levels,” smaller financials, such as community banks and little banks with real-estate exposure, are still struggling, says Charlie Smith, chief investment officer at Fort Pitt Capital Group Inc. and portfolio manager of Fort Pitt Capital Total Return (FPCGX | , which takes a value-based approach.

 

If the financial system continues to show signs that it is healing, he expects the value category to continue to lead growth. But “the small banks would [need to] pick it up,” he says. If their recovery is sluggish, then growth will probably outperform value, he says.

 

Tech’s story

Many fund managers like the technology sector now, including Wasatch’s Mr. Cardon. If business must “do more with less” in a jobless recovery, he says, “one way to do that is with technology.” He likes Riverbed Technology Inc. (RVBD, which makes network-optimization products, and Power Integrations Inc., which makes semiconductor products that lower the energy consumption of certain consumer goods.

 

Charlie Mercer, manager of Aston/Veredus Select Growth (AVISX |, says he has been buying shares of companies such as Micron Technology Inc. , SanDisk Corp. (SNDK

 

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) and Intel since the beginning of this year. Mr. Mercer expects business spending on personal computers and servers to rise in the coming years after a long period of reduced investment.

 

And Allison Thacker, a co-portfolio manager of several funds at RS Investments, likes computer-security company McAfee Inc. “When you survey IT managers about their priorities and what to spend on in this environment, they say you can’t cut security and you can’t cut storage,” she says.

 

Copyright © 2009 Dow Jones & Company, Inc. All Rights Reserved.

 

‘SEEKING FINANCIAL SIMPLICITY,’ from fidelity.com. KEEP IT SIMPLE. READ THIS & GET ON THE PROGRAM. ANY PROGRAM THAT WORKS FOR YOU. JUST DO IT!!

With today’s economic challenges, it’s not surprising that a growing number of people say they are feeling stressed about their personal finances.

 

In fact, four out of five Americans say they feel anxiety due to money, according to a recent survey by the American Psychological Association.1

 

But there is good news: While you can’t control the direction of the economy, taking a few steps can help you simplify your financial life, and that can make it easier to reach your goals and give you peace of mind.

 

Put your savings on autopilot

If you already take part in your workplace savings plan, you know how easy it is to save when the money is taken directly out of your paycheck. Just set up your contribution level, and each time you get paid, some money goes directly into your retirement account.

 

You can use the same types of automatic solutions to move toward other goals. Fidelity believes retirement savings should be a top financial priority. So, to help you increase your retirement savings rate, some plans offer an annual increase program (AIP).

 

An AIP can automatically increase your contribution rate each year, helping you gradually approach the target you select.

 

You can also automate savings for other goals. For instance, set up your direct deposit to send some of your pay directly to a 529 college savings plan to fund your child’s education. Or, use automatic transfers from your bank account to move a set amount of money into a brokerage account to get ready to make a down payment on a new home.

 

Using direct deposit or an automatic transfer is a simple way to move toward your goals.

 

“Setting up automatic savings is very important,” says Kathy Longo, a financial advisor with Accredited Investors in Edina, Minn. “If you move money into savings only when you feel like you have extra money and remember to do so, you’ll probably forget at least some of the time.”

 

Reduce financial clutter: Consolidate accounts

If you’re like a lot of people, over the years you may have built up a whole collection of bank, retirement, brokerage, and credit card accounts. All the paperwork, fees, and statements can add up to unnecessary costs and headaches.

 

You may be able to simplify your financial life by streamlining your accounts.

 

“Having accounts all over the place can create a lot of confusion,” says James Carroll, an advisor with Financial Advisory Consultants, in Naples, Fla. “That’s not good for your finances or your state of mind.”

 

If you have old workplace savings accounts with previous employers, you may be able to bring them together in a rollover IRA. If you consolidate most of your financial accounts with a single institution, you may be able to save on fees and make it easier to know where you stand.

 

Lets the pros sweat the details

Making investment decisions can be one of the most stressful parts of personal finance. If you lack either the interest or the inclination to make the day-to-day decisions about your money, you can turn to professionals to handle the job.

 

Many workplace savings plans offer lifecycle investment options or some version of a managed account.

 

Although they work differently, both are designed to provide simple strategies to the challenges of saving for retirement.

 

A lifecycle option is designed to be a single-fund strategy for retirement saving. You choose a fund with the target date that most closely matches the year in which you want to retire, and the manager gradually changes the investment mix as you approach your retirement date.

 

When you choose a managed account, professional investment managers will select an investment mix for your workplace savings plan account using your plan’s eligible investment options. You may be able to complete an investor profile questionnaire. Then the investment managers will make active decisions about the individual workplace savings account based on financial trends, market conditions, and time horizon.

 

Let the bills pay themselves

You can also simplify your monthly bills. Virtually all companies, from mortgage lenders to utility companies to credit card issuers, offer an automatic bill payment option. When the bill comes due, the payment is automatically deducted from your bank account.

 

Once you set it up, all you have to do is review your statements at the end of the month to make sure everything is in order.

 

Automatic bill payment frees you from the hassle of writing checks each month, but even better, it also greatly reduces the chances of late fees and blemishes on your credit score. A bonus: You also reduce your risk of identity theft because, contrary to popular belief, your personal information is more likely to be lifted from your mailbox than stolen online.2

 

If you aren’t comfortable with the idea of automatic payment, you can keep more control over when you pay by taking advantage of electronic bill payment programs at your bank or at other financial institutions.

 

Electronic bill payments allow you to handle all your bill paying in a single place. You set up your accounts with your bank or another financial institution, and can receive an e-mail alert whenever a payment is due; all you have to do is point, click, and pay.

 

Make technology work for you

While streamlining your accounts may help, you probably can’t consolidate everything. Luckily, there are a number of tools that help you monitor all your accounts in a single view.

 

Fidelity’s Full View, Intuit’s Quicken software, and Yodlee MoneyCenter let you input your bank accounts, credit cards, mortgages, loans, investments, and even frequent-flier accounts to give you a snapshot of where you stand.

 

Having a full picture can make it easier to make decisions about money, or possibly to recognize the need to change.

 

You can also find a variety of Web calculators and worksheets that can help you make important financial and investment decisions. Fidelity’s online service offers a number of tools, including a budget calculator, savings tool, and other resources to help you get started.

 

For your retirement savings, a good place to start is Fidelity’s myPlan Retirement Quick Check tool, which will provide you with a snapshot of where you stand for retirement savings and action steps you can consider taking to help improve your odds of reaching your goals.

 

Make a plan for prosperity

One way to cut down on the stress of worrying about your money is to make a plan. Even the most basic planning can have a profound impact on the amount of money you ultimately save.

 

For example, a study by a professor at Dartmouth College and a professor at the University of Pennsylvania found that, of the oldest baby boomers, those who did a lot of retirement planning had a median net worth of $200,000; that’s more than double the amount saved by boomers who had done hardly any planning.3  While the study shows that planning can pay off, the process doesn’t have to be intimidating.

 

Pat Doland, a financial advisor with Reason Financial, in Chicago, says even basic planning can work. “Most people don’t need an elaborate plan,” he says, “just a structure to help them save toward their goals.”

 

Planning pays off partly because it gives you the facts you need to work with, and partly because it can kick-start your savings. Putting a plan in writing — or even just thinking about it — makes it much more likely that you’ll take action. So take a moment to use online tools to put together a sound retirement savings plan.

 

The payoff goes beyond the immediate goal of helping you save more — it can actually make you happier. That’s because the very act of planning helps you feel more in control, which in turn helps mitigate anxiety. And these days, gaining more control of your money — and being less stressed by it — is a welcome feeling indeed.

 

© 2009 Fidelity Investor’s Publications

‘DO SMART HARD-WORKING PEOPLE DESERVE TO MAKE MORE MONEY? ,’ by James Kwak at baselinescenario .com.

Do Smart, Hard-Working People Deserve to Make More Money?

Posted: 02 Nov 2009 04:00 AM PST

 

Last weekend Yves Smith posted a story of a family that was down on their luck and struggling with high credit card bills, including plenty of fees. Yesterday she posted a follow-up. Apparently the story triggered a wave of vindictive snobbery from commenters. Here’s one example:

 

“Sounds like someone doesn’t know how to manage their money. I would bet they are making car payments and eat fast food at least 3 times a week. Probably have cable T.V. and deluxe cell phone plans. They probably get a new car like every two years. What happened to her reenlistment bonuses?”

 

Here is Yves’s response:

 

“I think quite a few readers owe her an apology. But I am also sure those readers are so locked into their Calvinist mindset that they will find some basis for criticizing this family. Some people seem constitutionally unable to admit that success and prosperity are not the result of hard work alone.”

 

First, I want to agree completely. There is the obvious fact that a person’s income as an adult is highly correlated with his or her parents’ income. (There was a recent debate about why in the blogosphere, but as far as I know no one contesting that this was the case.) But beyond that, we all owe a tremendous amount of whatever fortune we have to luck, pure and simple. Where would Bill Gates be if IBM hadn’t decided to outsource development of the operating system for the first IBM PC? Rich, no doubt, but $50 billion rich? I have worked hard at enough things, and failed at enough things, and succeeded at few enough things, to know how much luck is involved.

 

Second, I want to go beyond that to another point that seems obvious to me, but that some will probably find controversial. Even if differences in outcomes were entirely due to differences in abilities and effort (which they’re not) — would that make it OK? I think most people would say that it’s fine for smart people to make more money than other people. But why? Why are smart people any more deserving than anyone else? It’s true that in many jobs being smart can make you more productive and valuable, and as a result for many high-paying jobs being at least somewhat smart is a prerequisite. But the fact that a capitalist economy functions this way doesn’t make it morally right that the “winners of the genetic lottery” (a phrase I picked up from some basketball announcer talking about Tony Parker) have better outcomes than the losers.

 

Surely at least people who work hard deserve to do well. In the hierarchy of American moral virtues, hard work must be right at the top. But I’m not convinced of that, either. The ability to work hard is something that you either inherit from your parents or that you develop in your early childhood as a function of the environment around you. Either way, whether or not you have it is as much a matter of luck as is your IQ. Again, it’s obvious that working hard increases your productivity and therefore the wages you will be paid, all other things being equal. A small part of that differential seems “deserved,” since you are forgoing leisure for work. But the differential goes far beyond that. For example, doctors don’t just make more money than other people to compensate them for studying hard in school and working 36-hour shifts in residency; studying hard and 36-hour shifts are hurdles to clear in order to become a doctor and make a lot of money (if you’re a specialist, that is — some people do go through all the work and then make comparatively little).

 

Take me, for example. I’m smart and hard-working. I don’t know if it’s because of my genes, or because my parents brought me up right. But whatever the cause, I didn’t do anything to become smart or hard-working. And that’s the reason why I was able to go to good schools, get a good first job, and make more money than the average person, at least for a few years there (before quitting to go to law school). When I was young and frankly immature, being smart gave me a sense of entitlement. Now I just feel sort of lucky (“sort of” because I’ve learned that there are many more important traits than intelligence).

 

I’m willing to acknowledge that morality simply isn’t a factor when it comes to compensation. Seen from a utilitarian perspective, whether hard-working people deserve more than other people is a distraction. The key issue is that to maximize output in a more or less free market system, it has to be that way, since labor is supposed to be paid its marginal product. But there are still two implications of realizing that everything — even your initial endowments — is a matter of chance, not something you deserve.

 

The first is that you shouldn’t look down on other people (1) because their parents weren’t as rich as yours, or (2) because they aren’t as smart as you, or even (3) because they don’t work as hard as you. I think most people agree with (1); I think you should agree with (2) and (3), too.

 

The second is that the moral argument should be on the side of redistribution. I am willing to listen to utilitarian arguments against redistribution (e.g., high marginal tax rates reduce the incentive to work, blah blah blah blah blah); I may not agree with them, but they are a plausible position. However, I have little patience for the idea that rich people deserve what they have because they worked for it. It’s just a question of how far back you are willing to acknowledge that chance enters the equation. If you are willing to acknowledge that chance determines who you are to begin with, then it becomes obvious (to me at least) that public policy cannot simply seek to level the playing field, because that will just endorse a system that produces good outcomes for the lucky (the smart and hard-working) and bad outcomes for the unlucky. Instead, fairness dictates that policy should attempt to improve outcomes for the unlucky, even if that requires hurting outcomes for the lucky. But given that society is controlled by the lucky, I’m not holding my breath.

 

By James Kwak

‘PAPER OF THE YEAR, ‘ by James Kwak at baselinescenario .com.

Paper of the Year

Posted: 01 Nov 2009 04:00 PM PST

 

As bankers’ pay, at least for the fortunate ones at Goldman and JPMorgan, returns to pre-crisis heights, a paper by Thomas Philippon and Ariell Reshef is becoming everyone’s favorite citation. The paper, “Wages and Human Capital

in the U.S. Financial Industry: 1909-2006,” got a first wave of attention from Paul Krugman, Martin Wolf, and Gillian Tett back in April (see Philippon’s web page for links). It’s also the subject of Justin Fox’s column in Time; see Fox’s blog for links to other discussions. (I also cited the paper in my ramblings provoked by Calvin Trillin.) The earlier references were mainly for Philippon and Reshef’s finding that pay in the financial sector correlated strongly and negatively with the degree of regulation — pay was higher in both the 1920 and in the post-1980 period, and lower under the stricter regulatory system created during the Great Depression. More recent references, including Fox’s column, have focused on the idea that people in finance are overpaid.

 

Since most articles have just focused on the headlines, I’m sure Philippon and Reshef are going to be misquoted all over the Internet. For example, at least two articles focus on a figure of “30% to 50% of financial-sector pay” in ways that are not quite correct. So I’ll try to lay out what they actually say.

 

Section 1 (see Figures 1-3) lays out the facts. Jobs in the financial sector were more complicated and more mathematical, required more education, and were more highly paid both before 1930 and after 1980.

 

Section 2 asks why this happened. They regress relative education (the share of highly-educated people in the financial sector relative to the rest of the economy) and relative wage (the ratio of wages in the financial sector to wages in the rest of the economy) against several explanatory variables:

 

the degree of information technology use in the financial sector

the amount of financial innovation (represented by the number of patents)

the amount and complexity of corporate finance activity (represented by the share of IPO activity and the amount of credit risk)

the amount of deregulation (interstate banking, Glass-Steagall, etc.)

Not all regressions use all explanatory variables, but the results (Tables 3 and 4) are consistent: deregulation is the only explanatory variable with a strong significant effect on both relative education and relative wages. In Table 3, for example, “deregulation alone accounts for 90% of changes in education and 83% of changes in wages.” Patents and IT intensity affect relative education but not relative wages; indicators of corporate finance activity affect wages but not education.

 

Now, none of this so far implies that people in finance are not worth their higher salaries. Deregulation could have created an environment in which the productivity differential between higher- and lower-skilled people became higher in finance than in other industries, making them more valuable in finance than elsewhere. Section 3 analyzes this issue. Figure 7 shows that, since the mid-1980s, the earnings of people in finance have shot up relative to the earnings of engineers (outside finance), even with the same level of education.

 

Figures 10 and 11 are based on the concept of a “benchmark” wage for finance. This is the wage that you would expect people in finance to get based solely on their relative education level (which we know went up after 1980), the skill premium (the amount that more highly-skilled people earn throughout the economy, which has also gone up since 1980), and the relative risk of unemployment (if you are more likely to be fired, you should be paid more to compensate). Figure 10 shows that given all this, you would have expected finance salaries to go up about 20% relative to the rest of the economy since 1980, but in fact they have gone up about 65%. The excess wage (Figure 11) — the difference between the amount people in finance make and the amount you would expect them to make — reached about 0.4 this decade; that means that if the average American is making $100, you might expect people in finance to make $125 (based on education, skill premium, and unemployment risk), but instead they are making $165.

 

The last set of regressions attempts to determine whether the excess wage in finance is due to characteristics of individuals in finance that are not observable in the previous regression. They do this by looking at the Census Bureau’s Current Population Survey, which is an individual-level sample. They determine that over the entire sample period (1967-2005), even after controlling for individual characteristics, working in finance is worth a 4.4% wage premium (Table 5; 8.3% for people with post-graduate education). Looking at specific time periods (Table 6), the wage premium only appears in 1986; from 1986 through 2005 it averages 6.0%. Comparing these wage premiums to the excess wage for the industry as a whole, they conclude that 30-50% of the excess wage is not due to differences in ability, but represents pure rents.

 

Note that the wage premiums calculated here cannot be compared to the excess wage in Figure 11, because Figure 11 is estimated using industry-level data, and the estimates in Tables 5-6  use the CPS, which suffers from top-coding (incomes are reported in categories, and there are no categories for the super-rich). My interpretation is that Figure 11 is the best way to see the size of the excess wage, since it doesn’t suffer from top-coding; Tables 5-6 are primarily useful for showing what proportion (30-50%, according to Philippon and Reshef) of that excess wage cannot be explained by differences between individuals.

 

So note in particular that the 30-50% number in the paper does not refer to the wage premium of people in finance; it is the proportion of the wage premium that cannot be otherwise explained. The excess wage itself depends on how you measure it. In Figure 11 (difference between finance wages and what finance wages would be expected to be based on education, skill premium, and unemployment risk) it gets up to 40%, but only in the last few years.

 

In any case, it’s clear that people in finance make more than people not in finance, and that you can’t explain it away just by saying they are more educated or their jobs are more risky. Now in one sense the defenders of high Wall Street pay are correct: people are probably getting roughly what they could make if they walked across the street and went to another bank. But that doesn’t answer the question of whether the whole industry is making a mistake and transferring wealth to employees that should go to shareholders.

 

By James Kwak

Peter Fellowes writes about the joys of reading poetry. First published in ‘Trinite’ by the American Cathedral in Paris.

Getting the News from Poetry

 

Peter Fellowes

 

Originally published in Trinité (Spring 2007)

 

Once a primary vehicle of Western cultural expression, poetry today occupies a small and precarious niche in our image-driven, mass market culture.  Yet it remains true that there are some things that cannot be said otherwise than by poetry.  The American poet William Carlos Williams put it succinctly: “It is difficult/ to get the news from poems/ yet men die miserably every day/for lack/ of what is found there.”

 

What makes poetry special? The figurative powers of poetry give it special status as a verbal form, and paradoxically, it draws these powers from its very weakness as a vehicle of communication. Compared to prose, poetry is thinly and elusively referential. Because of this quality, some have said that poetry amounts to a special way of listening rather than an intrinsically distinctive style of discourse.  In coming to a poem, we know its aim is to evoke rather than to stipulate, to associate rather than to delimit its subject.  The symbolic resonance of a poem creates concentric circles of meaning that extend its meaning in multiple directions. Ambiguity, not clarity, is the prize.

 

But poetry is also exceptional in that it is almost always lyrical in rhythm, even when it is not formally organized in metrical or stanzaic form.  As a song, a poem gains access to the mind through a different portal than prose, as established by more than a few stroke patients.  Encountering meaning as song, we find our emotions more easily touched.  The standards for plausibility are relaxed as felicitous turns of phrase or rhythm or rime promote our sympathetic participation in the meaning of the poem, thus magnifying its credibility.

 

These two qualities –the figurative force and the lyrical appeals of poetry – make it an hospitable vehicle for the expression of religious belief.  Whatever else it may be, the presence of the God in the world is not a self-evident, empirically verifiable proposition.  As a Christian, one can only say that the claims of truth made by the scriptures appear to be validated by one’s own experience.  The suggestive powers of poetry, aided by the consonances of song, make it well-suited to portraying the fragile linkage between personal experience and faith.

 

Unless one is working within an explicitly Christian context such as Donne’s in Holy Sonnets or Herbert’s in The Temple, the challenge for the lyric poet is always one of tact: how to avoid the temptation of forcing experience into facile or unearned proclamations of faith.  In being true to experience, in giving preference to sensory over abstract language, a poem must take on the risk of not being understood.  “Morning Hunt” was drawn from a morning I spent on the terrace of a home in Tuscany a few years ago.  Like many of my poems, it tries to evoke a particular moment with appreciation for its sensory value and then to turn that moment in a way that yields an inference.  For me, the subject of the poem is the companionable presence of God in the world, that sense of the mysterious wholesomeness of life that can break into certain moments and make one thankful.  But I would quickly add that it is not necessarily about that at all.  It depends on how one listens.

 

 

 

Morning Hunt

 

Blue overhead, the valley still

 

in clouds yields rumors only,

 

the muffled percussive echoes

 

of game sighted, faint shouting

 

of hunters, dogs barking, and then

 

nothing but stillness, unless

 

a shovel’s blade catching a stone

 

in the garden be thought of.

With only a daub of ochre

 

recalling a neighbor’s walls,

 

the hillsides of olives beyond,

 

awaiting an old ladder

 

of joined olive wood polished by

 

three generations of toil,

 

shouldered at the hour appointed

 

for the first pressing of oil.

And the blue hilltops brimming with

 

daylight now, scalloped like waves,

 

dispensing such allowances –

 

a curtain parts, voices call –

one incurs and settles a debt

 

of gratitude opening

 

a folding chair in lifting mist,

 

a blinding white paper, pen.

Peter Mayle writes about Halloween in France in the Herald Tribune.

Op-Ed Contributor

Pumpkin Eaters

 

By PETER MAYLE

Published: October 24, 2009

Appeared in the Oct 31, 2009 International Herald Tribune

 

 

Aix-en-Provence, France — There is a tendency among the French to welcome certain aspects of American life with immediate and uncritical enthusiasm: hamburgers, Jerry Lewis, baseball caps, elderly television series (“Starsky & Hutch” is still running on French TV), Westerns, Marlboro Lights, button-down shirts — these and much more besides have crossed the Atlantic to become firmly embedded in le lifestyle français.

 

The Celtic-by-way-of-America celebration of Halloween is one more example that has always stuck in my mind because it arrived in France about the same time that I did, 20 years ago.

 

I remember the moment well. I was passing the window of a shop that specialized in avant-garde underwear when my eye was caught by a small pumpkin, half-concealed behind the lacy thickets of a black brassiere. A hand-lettered sign tucked into the bra read, “N’oubliez pas l’alowine!” — as if one could ever forget Halloween when reminded of it in such an exotic fashion.

 

But there was a problem. In those unenlightened days, hardly anyone in France had the faintest idea of what alowine was. An informal survey among friends produced nothing at first but shrugs and incomprehension. I gave my respondents a clue in the form of a pumpkin. Ah, they said, soup. I tried again, this time with the date, Oct. 31, the eve of All Saints’ Day. Of course, they said, Toussaint, but this is not a day of pumpkins. Toussaint is marked here in France by the chrysanthemum. But how would you know that, being English? I retired hurt.

 

The years passed, and alowine scored one or two minor victories. I noticed a modest selection of cards, a sprinkling of pumpkins and the odd witch’s hat. But there was nothing to indicate that Halloween was having much of an impact locally until I happened to bump into M. Farigoule in the village cafe. (Here I should explain that M. Farigoule is my mentor — self-appointed — on all matters that have to do with correct behavior for a foreigner living in France, from table manners to income tax. He is an unrepentant chauvinist, a fund of misinformation and a prodigious consumer of rosé. I’m rather fond of him.)

 

It was the first morning of November, and M. Farigoule was seething with indignation. The previous evening, just as he was settling down in front of the television to disagree with the evening news, he had been disturbed by a thunderous clattering on his front door. On his doorstep, he found a gang of sooty-faced infants. One of them, holding up a hollowed-out pumpkin with a guttering candle inside, demanded bonbons. Why should I give you bonbons? asked M. Farigoule. Because it is alowine, was the reply.

 

M. Farigoule looked at me and shrugged, his expression a question mark. It was clear that he was not familiar with Halloween and its customs. At last it was my chance to teach him something. He listened while I described the cast of characters — the witches and hobgoblins, the skeletons and spirits of the dead, the Grim Reaper and his attendant vultures — and he seemed to understand the basic principles of trick-or-treating. It was when I was trying to explain the historical significance and traditional use of the pumpkin that I saw, from his elevated eyebrows and pursed lips, that I had touched a nerve.

 

“Do you mean to tell me,” he said, “that pumpkins all over America are massacred, with all that good honest flesh tossed away, simply to provide a primitive decoration?” He took a deep swig of rosé and shook his head. “Do our American friends know what treasures they’re missing? Pumpkin fritters! Pumpkin and apple sauce — so delightful with sausages! Then, bien sûr, there is Toulouse-Lautrec’s sublime gratin of pumpkin.

 

“And it must be said that Mme. Farigoule” — he raised his glass to the ceiling in a silent salute — “makes, during the season, a most exquisite pumpkin risotto.” He shook his head again. “No — to sacrifice a pumpkin for such a frivolous purpose as alowine is a waste, a terrible waste. Whatever next?” He allowed me to refill his glass while he recovered his composure, and our conversation moved on to the less sensitive topic of village politics.

 

Another, more official blow to Halloween’s standing in France was the reaction of a local authority, the school attended by my friend’s young children. One year, for reasons that continue to elude me, it was decreed that the pupils should celebrate Halloween by coming to school dressed in appropriately spine-chilling outfits: witches, of course, but also bloodstained ghouls, vampires, a variety of evil spirits and even a small, very hot human pumpkin swathed from head to toe in layers of orange toweling.

 

The following year saw a change in the school’s management. Alas for Halloween, the new principal was someone with more traditional views, and she was not sympathetic to the idea of fancy dress in the classroom, particularly when inspired by some ridiculous foreign novelty. When asked to explain why she had canceled Halloween, her reply was brief and to the point.

 

“It has nothing to do with us,” she said. “We’re French.”

* * *

 

The Pumpkin Risotto of Mme. Farigoule

The secret is in the preparation of the pumpkin. After removing seeds and fiber, cut the flesh into chunks, leaving the skin still attached. With your hands, mix the chunks in a bowl with 2 or 3 tablespoons of the best olive oil, salt and pepper, a tablespoon of fresh marjoram and a teaspoon of dried oregano. Lay the chunks on a baking tray, skin side down, and put them in the oven, which you have preheated to 425°F. When the chunks of pumpkin are soft and the edges are tinged with brown, remove from the oven and allow to cool, scrape the flesh from the skin and shred with a fork. Prepare your risotto in the usual way and once the rice is ready, stir in the pumpkin, along with freshly grated Parmesan and butter. (Mme. Farigoule’s tip is to be extra-generous with both cheese and butter.) Add a sage leaf for decoration, and a sprinkling of Parmesan, et voilà.

 

Peter Mayle is the author of “A Year in Provence” and the forthcoming novel “The Vintage Caper.”

‘ “MANCESSION” PUTS THE BURDEN ON WOMEN,’ by Linda Stern at Reuters via fidelity.com.

WASHINGTON (Reuters) — The current recession has been called a “mancession” because men have lost more jobs than women have, yet some experts contend women are suffering more: The tight money environment is causing them to give up everything from sleep to children as they worry about finances and scale back their lifestyles and family plans.

“This is a transformative recession for women,” says Lisa Caputo, head of Women & Co., a program from Citi . “They are pausing to take stock of where they are and permanently changing the way they are saving and spending. They are protecting their lair.”

Working women say they are delaying having children and planning for smaller families because of the financial burdens imposed by the current recession, according to a study by Guttmacher Institute, a reproductive-health research organization. Working mothers have been hardest hit, with more than half (53 percent) indicating they work longer hours to make ends meet, compared with just 24 percent of women without children and 33 percent of men, according to a new study from Citi.

While they are holding on to their jobs better than men are — the unemployment rate in September was 9.6 percent for men and 7 percent for women — their jobs still tend to be lower paying, lower-level jobs. Women make up 45.5 percent of the labor force, but collect 38 percent of the wages paid.

And, as has been the case for many years, women spend more time doing housework than men do; and they tend to live longer and end up poorer than men do. They also are more likely to be in charge of the family budget than are their husbands.

All together, it adds up to a lot of financial and emotional stress as women need to figure out how to protect their own finances while caring for their families during very tough times. Here are some pointers:

Put the family first. The recession of 2009 is the first time that many families are finding themselves with the wives outearning husbands, or even being the sole breadwinners. That can be an emotional adjustment, even for generations raised on the concept of equality. It’s easy to argue about disproportionate workloads or earnings, and financial stress can add to the anger or resentment. Partners should work hard to stay on the same team and discuss ways to continue supporting each other emotionally. Creating practical schedules for housework, childcare and errands can help. Reviewing the spending rules, such as the amount either partner can spend without checking with the other, can help too.

Set good priorities. Current research says families appreciate experiences more than things. So, with family budgets tight, think of ways you can best deploy your resources so you can enjoy your time together. That may mean spending money for a cleaning service and having a stay-at-home game night, instead of spending money on movie tickets and stressing about the housework.

Save, save, save. Women need buckets of money to make it to the end of their days. A woman who has recently re-entered the workforce should make sure she’s maxing out her own retirement accounts. If she is not working, and her husband is, she should make sure to contribute to a spousal Individual Retirement Account.

Act like the breadwinner you are. Women should make sure they have enough life insurance to protect their families from losing their salaries and home-based contributions. They should not feel guilty about having to be at work, or apologize (even in their own heads) for earning money. They should take their benefits package seriously and make sure they have properly designated beneficiaries for retirement plans and insurance policies.

Career build. The middle of a recession may not be the best time to ask for a raise, but it is a good time to network, sharpen skills, and prepare for that next better-paying job. It’s also a good time to practice negotiating, so when the job market improves, you can demand a better position and a higher salary.

Invest, don’t just save. Women traditionally handle the family’s everyday budget while men make the mutual fund, stock and bond decisions. That’s not a good division of labor. Both should have some experience with the other piece of their financial life.

Help each other. There are a lot of mothers really struggling in this economy, but they can share resources. Single mothers, who have to do it all (and pay for it all) themselves, can lean on each other, living in shared apartments or houses, and trading off childcare, errands, meals and everything else. All can save with some time-honored traditions that never go out of style, like passing down toys and clothes, and taking the kids to the library instead of the book or video store.

Simon Johnson, Peter Boone & James Kwak at baselinescenario .com.

Yesterday morning I testified to a Joint Economic Committee of Congress hearing .  The session discussed the latest GDP numbers, the impact of the fiscal stimulus earlier this year, and whether we need further fiscal expansion of any kind.

I argued that a global recovery is underway and in the rest of the world will likely be stronger than the current official or private consensus forecast, but growth remains fragile in the United States because of problems in our financial sector.  While our situation today is quite different in key regards from that of Japan in the 1990s, the Japanese experience strongly suggests that fiscal stimulus is not an effective substitute for confronting financial sector problems head on (e.g., lack of capital, distorted incentives, skewed power structure).

We are well into the adjustment process needed to bring us back to living within our means. Although such a process always involves an initial fall in real incomes, growth can resume quickly as the real exchange depreciates.  The idea that we necessarily are in a “new  normal” scenario with lower productivity growth seems far fetched, but continuing failure to deal effectively with the “too big to fail” banking syndrome delays and distorts our adjustment process – it also makes us horribly vulnerable to further collapses.

The fiscal stimulus enacted in early 2009 had a major positive impact, particularly as it was coordinated with other industrial countries – this prevented the global recession from being even deeper (disclosure: I testified to the need for a major fiscal stimulus in October 2008).  But a further broad stimulus at this time is not warranted and the first-time homebuyers tax credit should be phased out.  We should extend unemployment insurance and focus our future efforts on improving the skills of people with less education, e.g., through strengthening community colleges.

Like all industrialized countries, we also need to look ahead to “fiscal consolidation” in order to stabilize our debt-GDP levels (and pay for the rising cost of Medicare).  The large contingent government liabilities implied by the existence – and potential collapse – of big banks are a major risk to medium-term outcomes.

My written testimony (with some small updates indicated) is below (pdf version).  This is now our revised Baseline Scenario.

Main Points

1. The world economy is experiencing a modest recovery after near financial collapse this spring.  The strength of the recovery varies sharply around the world:

a. In Asia, real GDP growth is returning quickly to pre-crisis levels, and while there may be some permanent GDP loss, the real economy appears to be clearly back on track.  For next year consensus forecasts have China growing at 9.1% and India growing at 8.0%; the latest data from China suggest that these forecasts may soon be revised upwards.

b. Latin America is also recovering strongly.  Brazil should grow by 4.5% in 2010, roughly matching its pre-crisis trend.  We can expect other countries in Latin America to recover quickly also.

c. The global laggards are Europe and the United States.  The latest consensus forecasts are for Europe to grow by 1.1% and Japan by 1.0% in 2010, while the United Sates is expected to grow by 2.4% (and the latest revisions to forecasts continue to be in an upward direction).  Unemployment in the US is expected to stay high, around 10%, into 2011.  [Update: the latest quarterly GDP data do not make us want to revise this view]

2. The current IMF global growth forecast of around 3 percent is probably on the low side, with considerably more upside possible in emerging markets (accounting nearly half of world GDP). The consensus forecasts for the US are also probably somewhat on the low side.

3. As the world recovers, asset markets are also turning buoyant.  Recently, residential real estate in elite neighborhoods of Hong Kong has sold at $8,000 US per square foot.  A 2,500 square foot apartment now costs $20 million.  Real estate markets are also showing signs of bubbly behavior in Singapore, China, Brazil, and India.

4. There is increasing discussion of a “carry trade” from cheap funding in the United States towards higher return risky assets in emerging markets.  This financial dynamic is likely to underpin continued US dollar weakness.

5. One wild card is the Chinese exchange rate, which remains effectively pegged to the US dollar.  As the dollar depreciates, China is becoming more competitive on the trade side and it is also attracting further capital inflows.  Despite the fact that the Chinese current account surplus is now down to around 6 percent, China seems likely to accumulate around $3 trillion in foreign exchange reserves by mid-2010.

6. Commodity markets have also done well.  Crude oil prices are now twice their March lows (despite continued spare capacity, according to all estimates), copper is up 129%, and nickel is up 103%.  There is no doubt that the return to global growth, at least outside North America and Europe, is already proving to have a profound impact on commodity markets.

7. Core inflation, as measured by the Federal Reserve, is unlikely to reach (or be near to) 2% in the near future.  However, headline inflation may rise due to the increase in commodity prices and fall in the value of the dollar; this reduces consumers’ purchasing power.

8. This nascent recovery is partly a bounce back from the near total financial collapse which we experienced in the Winter/Spring of 2008-09.  The key components of this success are three policies.

First, global coordinated monetary stimulus, in which the Federal Reserve has shown leadership by keeping interest rates near all time lows.  Of central banks in industrialized countries, only Australia has begun to tighten. [Update: and Norway, obviously affected by rising oil prices]

Second, global coordinated fiscal policy, including a budget deficit in the US that is projected to be 10% of GDP or above both this year and next year.  In this context, the Recovery Act played an important role both in supported spending in the US economy and in encouraging other countries to loosen fiscal policy (as was affirmed at the G20 summit in London, on April 2nd, 2009).

Third, after some U-turns, by early 2009 there was largely unconditional support for major financial institutions, particularly as demonstrated by the implementation and interpretation of the bank “stress tests” earlier this year.

9. However, the same policies that have helped the economy avoid a major depression also create serious risks – in the sense of generating even larger financial crises in the future.

10.  A great deal has been made of the potential comparison with Japan in the early 1990s, with some people arguing that Japan’s experience suggests we should pursue further fiscal stimulus at this time.  This reasoning is flawed.

11.  We should keep in mind that repeated fiscal stimulus and a decade of easy monetary policy did not lead Japan back to its previous growth rates.  Japanese outcomes should caution against unlimited increases in our public debt.

12.  Perhaps the best analysis regarding the impact of fiscal policy on recessions was done by the IMF.  In their retrospective study of financial crises across countries, they found that nations with “aggressive fiscal stimulus” policies tended to get out of recessions 2 quarters earlier than those without aggressive policies.  This is a striking conclusion – should we (or anyone) really increase our deficit further and build up more debt (domestic and foreign) in order to avoid 2 extra quarters of contraction?

13.  A further large fiscal stimulus, with a view to generally boosting the economy, is therefore not currently appropriate.  However, it makes sense to further extend support for unemployment insurance and for healthcare coverage for those who were laid off – people are unemployed not because they don’t want to work, but because there are far more job applicants than vacancies.  Compared with other industrial countries, our social safety net is weak and not well suited to deal with the consequences of a major recession.

14.  The first-time home buyer tax credit should be phased out.

15.  GMAC should not receive a further infusion of government money.  It should be turned down for any kind of additional bailout; as with CIT Group earlier in the summer, this would force a negotiation with creditors and some losses for bondholders (most likely through a pre-packaged bankruptcy process).  This would not cause a general financial panic; probably it would actually strengthen the overall process of economic recovery, as it would move incentives in the right direction.

16.  The lack of skills among people who did not complete high school or who did not attend college is a critical longer term problem in the United States.  The impact of the recession will exacerbate the problems in this regard.  We should respond by further strengthening community colleges, allowing them to offer more vocational skills classes and to provide a viable way for more people to work their way into four-year colleges.

17.  America is well-placed to maintain its global political and economic leadership, despite the rise of Asia.  But this will only be possible if our policy stance towards the financial sector is substantially revised: the largest banks need to be broken up, “excess risk taking” that is large relative to the system should be taxed explicitly, and measures implemented to reduce the degree of nontransparent interconnectedness between financial institutions of all kinds.

The remainder of this testimony reviews current U.S. macroeconomic issues in broad terms, assesses the lessons of Japan’s experience in the 1990s, and make proposals for further essential reform (both fiscal and financial).

Current U.S. Issues

To be a strong global leader in the future, America needs to generate an environment where entrepreneurship, technological innovation, and immigration ensure that the nonfinancial private sector can continue to propel the US economy.

It is premature to argue that the US economy has stumbled into a “new normal” paradigm that involves slower growth.  The factors that drove our growth over the last 150 years, particularly entrepreneurial startups and the commercialization of invention, remain despite the crisis.  Indeed, these drivers of growth may become even stronger in the future, if we can reduce the wasteful financial sector activities that grew since the 1980s (and really flourished over the past decade) and allocate resources to more productive activities in the future.

America needs a new framework to harness that growth.   That framework needs to address the following problems with our current economic structure.

Problem 1:  With the recent financial sector bailouts, we have sent a simple message to Americans: The safest place to put your savings is in a bank, even if that bank is so poorly managed, and has such large balance sheet risks, that just six months ago it almost went bankrupt.

Despite being near to bankruptcy six months ago, Bank of America credit default swaps now cost only 103 basis points per year to protect against default, and the equivalent rate for Goldman Sachs is a mere 89 basis points.  Goldman Sachs is able to borrow for five years at just 170 basis points above treasuries.  This is not a sign of health; rather it indicates the sizable misallocation of capital promoted by current policies.  American’s leading nonfinancial innovators would never be able to build the leverage (debt-asset ratio) on their balance sheet that Goldman Sachs has, and then borrow at less than 2% above US treasuries.  The implicit government guarantee is seriously distorting incentives.

Problem 2:  We have not changed the incentive structures for managers and traders within our largest banks.  Arguably these incentives are more distorted than they were before the crisis. So the problems of excessive risk taking and a new financial collapse will eventually return.  Financial system incentives are a first-order macroeconomic issue, as we have learned over the past 12 months.

Today bank management is strongly incentivized to take large risks in order to raise profits, increase bank capital, and pay large bonuses to “compete for talent”.  Since they have access to a pool of funds effectively guaranteed by the state through being “too big to fail”, there is the potential to make large profits by employing funds in risky trades with high upside.  Such activities do not need to be socially valuable, i.e. it could be that the expected return on the investments is negative, but as the downside has limited liability, the banks can go ahead.

Problem 3:  We have not changed the financial regulatory framework in a substantive way so as to limit excessive risk taking.  The proposals currently proceeding through Congress are unlikely to make a significant difference.

Problem 4:  The policy response to this crisis, with very low interest rates and a large fiscal stimulus, is merely a larger version of the response to previous similar crises.  While this was essential to stop a near financial collapse, it reinforces the message that the system is here to stay.

Problem 5:  The public costs of this bailout are much larger than we are accounting for, and people who did not cause this crisis are ultimately paying for it.   Taxpayers and savers are the big losers each time we have these crises.  We are failing to defend the public purse.

Our financial leaders have emphasized that our banks are well capitalized, and no new public funds are likely to be needed to support them.  This is misleading.  The current monetary stance is designed to ensure that deposit rates are low, and the spread between deposit rates and loan rates is high.   This is a massive transfer of public funds to the private sector, and no one accounts for that properly.

It is striking that the Chairman of the Federal Reserve himself, in a recent speech, stated that no more public funds were needed to bail out banks.  His institution continues to provide massive transfers to the banking system through loose credit and low interest rate policy.  That credit could instead go to others; the Federal Reserve has chosen to transfer those funds to banks.  This policy was used in the past to recapitalize banks (e.g., after 1982), but we have now a very different financial sector – with much more capacity to take high risks and a greater tendency to divert profits into large cash bonuses.

Today, depositors in banks earn little more than the Federal Funds rate and are effectively financing our financial system.  We are giving them very low returns on their savings because the losses in the financial system were so large in the past.  This is essentially public money – it is the pensioners, elderly people with savings, and other people who have no involvement in the financial system, that are being required to suffer low returns to support the banks.

We Are Not Japan

After the bursting of its real estate bubble, at the end of the 1980s, Japan faced a serious problem in its financial sector.  This fact has inspired many people to look for parallels with the current US situation, and – in some cases – to draw the implication that we should pursue further large-scale fiscal stimulus today.

There is a cautionary tale to be learned from the Japanese experience – on the need to promote, rather than to prevent, appropriate macroeconomic adjustment.  But this does not encourage a further expansion in the budget deficit at this time.

The property bubble and general credit bubble in Japan were actually much larger than what we recently experienced in the U.S.  The implied price of the land in the Emperor’s Palace, in central Tokyo, was worth more than all of California (or Canada) at its peak.  Land prices collapses and never recovered.  US house and land prices never got so far out of line with the earning capacity of homeowners.

The Japanese stock market rose to price-earnings ratio of around 80 (depending on the exact measure), also as a direct result of the credit bubble.  The US did not experience anything similar in the last few years.

Japan was – and largely remains – a bank-based finance system.  And their nonfinancial corporate sector was generally much more indebted (often using borrowed money to buy land, but also over-expanding their manufacturing capacity) than was the case in the US.  Total Japanese corporate debt was 200 percent of GDP in 1992 – more than double its value in 1984. The implication was a long period of disinvestment and saving by the corporate sector – in fact, this change from the 1980s to 1990s explains most of Japan’s increased current account surplus after the crisis.  Since Japanese corporates had accumulated too much capital, they exhibited low returns in the post-crisis period.  The US has strong bond and equity markets, and our corporate sector is not heavily indebted – so the cash flow of the nonfinancial sector should bounce back strongly.

In contrast to Japan, the US consumer has much more debt and saves less – in fact, on average over the past decade, the our household sector has saved roughly nothing (partly due to the effects of rising wealth, from higher house prices).  This sector will be weak in the US.  In contrast, in Japan during the 1990s there was no significant increase in household saving (and thus no contribution from this sector to their current account surplus.)

The obvious solution for any country in the situation faced by the US is to let the economy adjust, which implies and requires that the real exchange rate depreciates – so our exports go up, our imports (and consumption) go down.  This is a level adjustment downward in our GDP and standard of living, but then growth will resume on this new basis.

In contrast, Japan did not grow largely due to their over-investment cycle (in real estate, but also plant and equipment).  This created a much more difficult adjustment process, which worked for manufacturing primarily through depreciation of installed capacity and a gradual movement of production off-shore (e.g., to China and other Asian countries).

In addition, another major cause of Japan’s poor performance was its demographics, and the relatively lackluster growth of its trading partners in Asia due to the Asian crisis.  With its working population peaking in 1995, Japan lost a major driver of growth.  The country still has strong enterprises and decent productivity growth in the manufacturing sector, which allows them to grow.  But the pace is naturally slower than when they were “catching up” through the 1980s.  During the last ten years Japan’s has grown around the same pace as some of the continental European nations with better but also poor demographics, such as Italy and Germany (the comparison is from Q1 1998 to Q1 2008).

The Japanese policy reaction was to run budget deficits and maintain very loose monetary policy for over a decade, in an attempt to stimulate the economy and obviate the need for painful adjustment (including job losses, recognizing losses at major banks, and properly recapitalizing those banks).  Today Japanese gross debt to GDP is at 217%, and it is still rising (net debt, even on the most favorable definition, is over 110% of GDP).  The working population of Japan is now declining quickly, and so those people that are required to pay back the debt face ever rising burdens.  There is a real risk that Japan could end up in a major default, or need a large inflation, to erode the burden of this debt since their current path is clearly unsustainable.

Japan’s policy approach from the 1990s – repeated fiscal stimulus and very easy money – is not an appealing model for the U.S. today.  All dynamic economies have a natural adjustment process – this involves allowing failing industries to decline, and letting new businesses develop where there are new opportunities.

In fact, while Japan hesitated for over a decade to let this process work (particularly protecting the insiders at their major banks), it has finally moved in this direction.  Unit labor costs in Japan have declined sharply over the last ten years, helping making the country a more competitive exporter.  The forced recapitalization of some major banks, at the end of the 1990s, was also a move in the right direction.

The process of deflation – spoken of with terror by some leading central banks around the world today – actually makes industry more competitive, and while there are negative aspects to it (particularly if the household sector is heavily indebted, as in the US), the modest price declines seen in Japan are not a disaster.  In fact, real GDP per worker in Japan – annualized over the past 20 years – has increased by 1.3 percent per annum; while the comparable number in the US is 1.6 percent.  Over the past 10 years, real GDP per worker (annualized) increased by 1.3 percent in both Japan and the US – and now it turns out that much of the GDP gains in the US financial sector may have been illusory.

The Japan-US comparison is not generally compelling, particularly as Japan ran a current account surplus even during its destabilizing capital inflows of the 1980s.  The current US experience more closely matches the experience in some emerging markets, which have in the past run current account deficits, financed by capital inflows – with the illusion that this was sustainable indefinitely.

The long and hard experience of the International Monetary Fund (IMF) with such countries that have “lived beyond their means” – or over-expanded in any fashion – is that it is a mistake to try to prevent this process of competitive adjustment, i.e., bringing spending back into line with income, which implies a smaller current account deficit or even a surplus.  The adjustment can be cushioned by fiscal policy – and here the IMF has changed its line over the past few years, now offering sensible support for this approach.  But attempting to postpone adjustment with repeated fiscal stimulus is almost always a mistake.

Japan did not want to force its corporate sector to adjust (i.e., in the sense of going  bankrupt and renegotiate its debts), so it offered repeated stimulus.  As a result, it has become stuck with a “permanent” fiscal deficit program which is now threatening their survival as a global economic power, and will – regardless of the exact outcome – burden future generations for decades.

Some analysts further claim that Japan’s early withdrawal of stimulus is a major factor explaining why they have not returned to robust growth rates.  It is true that Japan introduced a new VAT tax in April 1997 not long before the Asian Financial Crisis began, and the Bank of Japan raised interest rates by 25 basis points in August 2000.  Subsequent to these changes the economy slowed down.

However, each of these measures were relatively small.  The Bank of Japan reversed course on interest rates quickly, and a negative turn in the economy was surely already in the cards – this occurred at the same time as the global economy slowed down, and a great stretch to argue that a 25 basis point move could explain the poor performance of Japan’s economy for years or decades subsequent.

As long as there are not major adverse shocks from the rest of the world, the US will experience higher savings, a fall in consumption, a recovery in investment, and an improvement in the its net exports (so the current account deficit will become smaller, or stay at its current level even as the economy recovers).  Growth will resume, driven by demographics, technical progress, and entrepreneurship.  The high level of unemployment also implies that rapid growth will be fuelled by willing workers, subject to the right skills being available.

Proposals For Change

The main threats to the recovery scenario come from the financial system, which has developed serious and macro-level pathologies over the past two decades.

We have weak bank regulation and supervision.  Politically we can’t let banks fail: they bend or lobby to change the rules in order to grow big, and then we bail them out.

New theories of deflation and zero interest rate floors attempt to explain why we need unprecedented large bailouts – with the experience of Japan and the Great Depression of the 1930s offered as partial justification.  More likely, we are on an unsustainable fiscal path with the potential for new financial bubbles.

The following changes should be priorities.

1. Reduce the impact of financial sector lobbying on bank regulation and supervision.  Today the US Treasury is filled with former finance sector workers in key positions responsible for financial sector reform and bailouts.  This is too large a conflict of interest.  We need to close the revolving door between government and the financial sector.

2. Put far greater regulation and closer supervision on the large remaining banks that are clearly too big to fail.  These should be broken up into much smaller pieces, so we have a more competitive system.

When major financial institutions request additional help from the government, such as GMAC, they should be turned down.  This would force their bondholders to take a loss and lead to better incentives for the future.  It is highly unlikely that it would cause a major financial panic.  The financial system is experiencing a sharp bounce back more broadly and GMAC can likely arrange a pre-packaged bankruptcy that would actually allow its debt to rise in value.

Banks can syndicate if they need to do large transactions. This is actually what they do for most capital raising transactions.

Banks should draw up “living wills” and raise additional capital as they become larger relative to the system.

3. We should also toughen our monetary policy to send a clear message that we will not maintain a pro-cyclical monetary policy which bails out banks at the end of each crisis.  The cross-liabilities on banks’ balance sheets should be reduced as far as possible to lower the risks involved with letting one fail. By doing this, we would free the hands of those running our monetary policy to take tougher actions to stop the next bubble.

4. We need to address the inequality driven by our bailouts as a gesture to show that we will defend the public purse beyond the simple accounting in the budget.

Increasingly, there is discussion of taxing “excess risk taking” (reflected in high profits and bonuses) in the financial sector, particularly if that is large relative to the system.  The terms in this debate have not yet been clearly defined and this initiative could go in the wrong direction.  But we should recognize that mismanagement at major banks has created huge negative externalities both for the financial system and for the economy as a whole.  Taxing activities that generate such externalities is entirely appropriate in other sectors, and the same reasoning is likely to be applied for banking also.

In addition, we should also require that Goldman Sachs, GMAC, and other non-banks (i.e., those operating without deposit insurance) with access to the Federal Reserve’s window pay a substantial long term annual fee to compensate taxpayers for that access.  This is a valuable insurance policy which they have – at this point – been given for free.

5. We should withdraw the fiscal stimulus over 5 years and aim for fiscal consolidation, including Medicare costs, at that time.  We should use extra spending to target specific issues that will help people improve their skills, but wind down the temporary public works programs that build jobs in the public sector.

6. All industrialized countries need to make a substantial fiscal adjustment over the medium-run, in order to stabilize public debt levels.  The size of this adjustment depends on assumptions (and policies) regarding longer-run medical costs as the population ages and medical technology becomes more expensive.  The US and almost all other members of the OECD most likely require a fiscal adjustment in the range of 4-8 percentage points of GDP.  In that context, further unfunded or nontransparent contingent public liabilities vis-à-vis the financial sector are untenable; the Japanese experience should be taken as a warning sign in this regard.

7. For the longer-run, we should focus on measures that improve skills for people with fewer years of formal education.  Supporting the expansion of community colleges and other practical skills training is the best way forward, although this will take some time to scale up.

By Simon Johnson, Peter Boone, and James Kwak

John Maudlin writing at FrontLinethoughts .com. On hyperinflation, the dollar, and much more.

I have been in South America this week, speaking nine times in five days, interspersed with lots of meetings. The conversation kept coming back to the prospects for the dollar, but I was just as interested in talking with money managers and business people who had experienced the hyperinflation of Argentina and Brazil. How could such a thing happen? As it turned out, I was reading a rather remarkable book that addressed that question. There are those who believe that the United States is headed for hyperinflation because of our large and growing government fiscal deficit and massive future liabilities (as much as $56 trillion) for Medicare and Social Security.

This week, we will look at the Argentinian experience and ask ourselves whether “it” – hyperinflation – can happen here.

The Ascent of Money

I will be quoting from Niall Ferguson’s recent book, The Ascent of Money. I cannot recommend this book too highly. In fact, I rank it up with my all-time favorite book on economic history, Against the Gods, by the late (and sorely missed) Peter Bernstein. There are very few books I read twice. There are too many books and not enough time. This book I will have to read at least three times, and soon, and I have a lot of underlines and mark-ups in it already.

If there were one book I could require every member of the Congress to read, it would be this one. As I read it, I am struck again and again by how fragile and yet resilient our economic systems are. Fragile in the sense that governmental policy mistakes, no matter how well-intentioned, can destroy the wealth of a nation, and resilient in that it doesn’t happen more often.

In his introduction Ferguson writes, “The first step towards understanding the complexities of the financial institutions and terminology is to find out where they came from. Only understand the origins of an institution or instrument and you will find its present day roles much easier to grasp.”

As is often said, those who do not understand history are doomed to repeat it. If you want to understand what is happening in the economy, what the consequences of our choices could be, then I strongly suggest you get The Ascent of Money. It is easy to read, engaging, full of moments where you are led to pull together different ideas into an “Aha!” Ferguson is a brilliant writer and historian, and we are lucky to have this book at a time when it is sorely needed. (order it at Amazon.com)

As I have been writing, the United States in particular, and the developed world in general, are faced with a series of very unpleasant, if not downright bad choices. The time for good choices was ten years ago. Now we face the prospect of painful decisions, no matter what we do. It is not a matter of pain or no pain, of somehow avoiding the consequences of our bad decisions, it is simply deciding how much pain we will take and when, or allowing the pain to build up to a climactic event. Today we look at what I think would be the worst choice of all.

Catching Argentinian Disease

At the beginning of the 20th century, Argentina was the seventh richest nation on earth. It’s very name means “silver.” “As rich as an Argentine” was a byword. Even after falling from the heights through a series of bad decisions, the country was still so wealthy that, in 1946 when new president Juan Peron first visited the central bank, he could remark that “There was so much gold you could barely walk through the corridors.”

Argentina had actually defaulted on its debt in the late 19th century, not once but twice! But still they managed to avoid destroying the currency and devastating the country. But in 1989, after years of massive budget deficits that were financed with borrowing from abroad and Argentinian citizens, the country was left with so much debt and no one was willing to lend it any more money, that the leaders felt compelled to resort to the printing press.

My Uruguayan friend and Latin American partner, Enrique Fynn, tells me of his experience of going to Buenos Aires and buying a pack of cigarettes one evening. He went into the store the next morning for another pack, and the price had doubled. He came back that evening and the price had doubled again (thankfully for his health, he has quit!). There were no prices on any items in the grocery stores. There was a man with a microphone who would announce the prices of various items, often increasing the price every few hours by 30% or more.

Workers would get their pay in cash and rush to the store to buy anything, as by the end of the week their pay would be worthless. Of course, shelves were empty. The US dollar was king, and could purchase things at amazing prices. I heard stories that were truly compelling. (It made me wish I had gone shopping in Buenos Aires at the time!)

Interestingly, the dollar is still the real medium of exchange. I was told by several people that if you want to buy a house for half a million dollars, you bring the physical cash to the closing. One person counts the money and the other checks the paperwork and title. Argentina has the second largest hoard of physical dollars in the world, only exceeded by Russia. Is it any wonder they are concerned with the value of the dollar?

Let’s look at some quotes from Ferguson (emphasis mine):

“The economic history of Argentina in the twentieth century is an object lesson that all the resources in the world can be set at nought by financial mismanagement… To understand Argentina’s economic decline, it is once again necessary to see that inflation was a political as much as a monetary phenomenon…

“To put it simply, there was no significant group with an interest in price stability…

“Inflation is a monetary phenomenon, as Milton Friedman said. But hyperinflation is always and everywhere a political phenomenon, in the sense that it cannot occur without a fundamental malfunction of a country’s political economy.”

Look at the chart below. Using realistic assumptions, It suggests that the annual US government fiscal deficit will approach $2 trillion in 2019. How can we come up with what looks to be about $15 trillion over the next ten years? The Argentinian answer was to print the money.

In the US, the short answer is that unless the US consumers become a massive saving machine, to the tune of 8% or more of GDP and rising each year, and willingly put their savings into US government debt, it’s not going to happen. So sometime in the coming years, interest rates are likely to start to rise in order to compensate bond investors for what they perceive as risk. That will bring us to some very difficult and painful choices.

As I wrote a few weeks ago, this scenario could be averted IF the Obama administration produced a credible plan to lower the deficit over time and stuck to it. But today’s thought process is about what happens if they don’t.

Ferguson pointed out in the quotes above that hyperinflation is always and everywhere a political decision. Governments have to choose to print money. In theory and in practice, what would happen if the Fed decided to accommodate a politicized US government that wanted to spend money on favorite projects and support groups, maybe even deserving programs like health care or defense or pensions or Social Security? Money they could not borrow?

Then Peter Schiff and like-minded thinkers would be right. Once you start down that path, it is hard to stop short of the brink. Brazil got to 100% inflation per month and has really lowered that level over time, but it is not easy.

In such a scenario, you want to own hard assets. Gold. Foreign currencies. Stocks. Almost anything other than the currency that is being printed.

I was asked at almost every speech about that scenario. In Latin America, hyperinflation is not a theoretical issue; it has been reality. More than one person commented on that no one in US economics schools studies hyperinflation. It is required material in Latin America. For many Latin Americans, the dollar has been their safe haven. And now they are worried, with good reason.

For the record, I do not think the US will experience hyperinflation as long as the Fed maintains its independence. Read the speeches from various Fed governors and regional presidents. These are strong personalities, and they understand that going down that path ends in massive tears. Bernanke warned just a few weeks ago that the government needs to get serious about the fiscal deficit. Watch the rhetoric from the Fed heat up after his reconfirmation and the confirmation of two new governors in the first quarter.

The Fed has committed to buy a fixed amount of government debt in its quantitative easing program. That commitment will be finished by the end of the first quarter (if I remember correctly). Then comes the tricky part.

I have been writing for a long time that the main force in the economy right now is deflation. The Fed will fight deflation tooth and nail. But they don’t have to buy government debt to fight deflation. They can buy mortgage securities, credit card securities, commercial paper, etc. That will have the effect of easing without encouraging the government to run massive deficits. And such debts are naturally self-liquidating, while government debt is not, at least not in the same way.

I believe the Fed will maintain its independence. Not to do so is to court economic disaster of the first order. These are bright and serious men and women. They get it.

The Independence of the Fed Threatened

The risk is that something changes to compromise their independence. And sadly, there is some risk. Let me quote my fishing buddy friend David Kotok:

“It’s now official. The proposed legislation to reform America’s financial service supervision includes granting the Secretary of the Treasury a veto over Section 13(3) emergency action by the Federal Reserve Board of Governors. If this becomes law, it will be a sad day for the independence of America’s central bank.

“The Secretary of the Treasury, a very senior cabinet position, is appointed by the President and meets with the President in the Oval Office weekly. The governors of the Federal Reserve Board are also appointed by the President. Both cabinet officers and Federal Reserve governors are confirmed by the US Senate. There are supposed to be seven governors; politics has purposefully limited this to five throughout the three-year financial crisis period.

“The Federal Reserve governors are supposed to serve staggered 14-year terms with all seven seats filled. Instead, we have been governed by the present five-member, politically configured board.

“The original seven-governor construction was designed to insulate them from political pressure, for very good reasons. Decades of monetary history throughout the world have disclosed what happens when political influence on a central bank intensifies. The Weimar Republic and Zimbabwe are evidence of the worst inflationary effects of politics. The Great Depression in the US and the nearly two-decade deflationary recession in Japan demonstrate that monetary policy is not only inflation-prone. When central banks are under political influence you can get fire or you can get ice.

“In Japan, the central bank contends with two members of the cabinet sitting in on its deliberations. There is no way to know how much of the last 15 years of deflation and recession is attributable to the inside political pressures placed on the governors of the Bank of Japan. But there is evidence to suggest political influence, especially when you observe how little the Bank of Japan has engaged in asset expansion during this crisis.”

This is the nose of the camel under the tent. Starting down this road is very worrisome indeed. I find it appalling that Tim Geithner and Larry Summers went along with this. This is a very clear attempt by the political class to put political pressure on the Fed. I hope the Fed responds with vigor. I can tell you that the officials of whom I am aware will not take kindly to pressure. And that might be an understatement.

(Yes, I am aware of the problems of the Fed being able to decide whom to bail out and why. It is not a perfect world. But better the Fed than Congress.)

All that being said, if the Fed starts to increase its buying of government debt above its initial commitment, then my “optimistic” scenario of a very rough economic patch, which I have been outlining the past few months, is far too rose-colored. I do not think it will happen, but I can guarantee you, I and a lot of other people will be watching.

A Few Quick Thoughts on the Dollar, GDP, and the Recession

Just a few quick notes. When world trade collapsed, so did the need for US dollars, which is what the world uses to transact business. The data looks like world trade is finding a bottom and maybe even recovering somewhat. That means there will be the need for more dollars. And since everybody and their mother are short the dollar, there could be a vicious snap-back rally. I am still bearish the US dollar (and the yen and the euro and the pound) over the long term, but there is the potential for a real rally here.

And my friend Mish Shedlock commented on the US GDP report, which said the US GDP rose 3.5%:

“Today the market is cheering over what is actually an ugly report. A misguided Cash-for-Clunkers added a one-time contribution of 1.66 percentage points to GDP. Auto sales have since collapsed so all the program did is move some demand forward. Government spending increased at 7.9 percent in the third quarter which is certainly nothing to cheer about. Personal income decreased $15.5 billion (0.5 percent), while real disposable personal income decreased 3.4 percent, in contrast to an increase of 3.8 percent last quarter. Those are horrible numbers. The savings rate is down, which no doubt has misguided economists cheering, but people spending more than they make is one of the things that got us into trouble. The only bright spot I can find is exports. However, even there we must not get too excited as imports rose much more.”

John Williams notes that one-time stimulus or inventory items represented 92% of the reported quarterly growth. The nature of the stimulus-related gains was that they tended to steal business activity from the future. The months ahead are the future. Accordingly, fourth-quarter quarterly GDP change will likely turn negative, again. (The King Report)

And David Rosenberg writes: “Only economists see the recession as being over; the man on the street sees it a little differently, perhaps less enthused by the fact that a lower rate of inventory destocking is arithmetically underpinning GDP growth at this time. Put simply, a Wall Street Journal/NBC News poll just found that 58% of the public believe the economic recession still has a ways to go — and that is up from 52% in September and means that the private investor, unlike the hedge fund manager, is not interested in adding risk to the portfolio even after a 60% surge in the equity market.

“Only 29% of those polled believe the economy has hit bottom — imagine having that psychology with nearly zero interest rates, a bloated Fed balance sheet and unprecedented fiscal deficits (poll was taken from October 23-25). Nearly two in three (64%) said the rally in the stock market (still a bear market rally — not the onset of a new bull market) has not swayed their view (or ours for that matter).”

Uruguay, Philadelphia, Orlando, and then…

I am finishing this letter in Montevideo, Uruguay. I have been in Buenos Aires, Sao Paulo, and Rio de Janeiro this week. I must say that Rio is beautiful, very green and lush with marvelous beaches, which I sadly only got to drive past. I will come again. I fly back Sunday and am home for a week, then speaking trips to Philadelphia and Orlando. Then my schedule only shows a few days in New York in early December for Festivus with the gang from Minyanville, and Europe in January. I am sure other things will come up, but I am looking forward to being home for awhile.

My friends at International Living have been writing about Uruguay, and I was really looking forward to visiting the country. I have spent a few days with partner Enrique Fynn in this delightful place. Turns out it is the Switzerland of South America. Reasonable bank secrecy laws, and trades zones where you are not taxed on any business you do outside of Uruguay. Many international companies set up their headquarters here. Beautiful beaches, friendly people, and the charm of a small country, plus what will be a brand new airport in a few weeks, which can get you several times a day to any part of the region, directly to Europe, and one hop away from any major city in the world. You can learn more about the country, and other countries you may want to live in or have a second home in, by subscribing to International Living.

One of the laugh lines I use in my speeches down here is that if the Fed actually does start to monetize the debt, I will have to move to Uruguay. I could make worse choices.

Have a great week. I think this weekend I will switch it up from the heavy reading I have been doing and find some science fiction. Reality is way too scary.

Your ready to be in his own bed analyst,

John Mauldin

John@FrontLineThoughts.com

Copyright 2009 John Mauldin.

‘TIPS BUY PEACE OF MIND, BUT AT A STEEP PRICE,’ by Brett Arends in the Wall St. Journal at fidelity.com.

TIPS buy peace of mind, but at a steep price

BY BRETT ARENDS,  THE WALL STREET JOURNAL — 10/27/09

Current yields, high prices make short-term bonds less appealing; best bets at 20 years or more.

Inflation-protected US government bonds are generally a great core holding for ordinary investors. That’s especially true in uncertain times like these, when many worry that a spike in prices is just around the corner.

 

But here’s the secret of TIPS: You don’t buy them because you know where inflation is headed. You buy them so you don’t have to care.

 

Shares may boom or slump, inflation may rise or fall, but if you buy a long-term inflation-protected bond that pays 3% a year above inflation, that’s what you get.

 

TIPS have performed well this year — the sector is up around 9% since Jan. 1. But their good performance means that many of these bonds are now distressingly expensive. That’s especially true for the shorter-term bonds, which mature within the next five years or so. Today’s bond buyers may not realize it, but they are locking in poor investment returns. With prices at current levels, longer-term bonds, particularly those maturing in 20 years or more, look like better values.

 

Treasury Inflation-Protected Securities, or TIPS, have been around since the late 1990s. Unlike regular bonds, their price and coupons are adjusted to reflect inflation, which makes them a good safe haven investment. The bonds are safe from default because they are guaranteed by the U.S. government, and they are safe against inflation as well.

 

And inflation is a topic very much on investors’ minds right now. Some fear that the vast amounts of federal stimulus money poured into the economy will eventually lead to devaluation of the dollar and skyrocketing prices. Indeed you can see some of that already in the slump in the value of the dollar and the rise of gold. (However, falling yields on regular bonds, including non-protected Treasurys, suggest we might instead see deflation first.)

 

Inflation fears are one reason many ordinary investors have been loading up on TIPS, pushing up the price of those bonds. According to Financial Research Corp., a Boston-based firm that tracks mutual funds, investors have poured about $20 billion into inflation-protected bond funds so far this year — about the same amount they’ve invested in diversified emerging markets funds.

 

Buying TIPS buys peace of mind, but the price you pay for that peace matters greatly.

 

TIPS are generally quoted in terms of their “real” yield, which means the annual return above inflation. So if a bond has a “real yield” of 3% a year, if inflation comes in at 0% you’ll earn 3%. If inflation comes in at 10% you’ll earn 13%, and so on.

 

As a rough rule of thumb, TIPS deliver good value only when the real yield is over 2%, and preferably higher than that. (Last fall, during the depths of the financial crisis, some real yields shot up to 4% or higher as stricken financial institutions sold everything they could in a desperate bid to raise cash. It was free money, with effectively no risk at all.)

 

Even though TIPS have only been around for a little more than a decade, this rule has a long-term historic basis. Over the past half-century, investors in the benchmark ten-year Treasury bond (the non-inflation-protected kind) have earned compound annual returns of about 6.6%, according to the Federal Reserve.

 

The Consumer Price Index, over the same period, has risen by an average of about 4.4% a year. So standard nominal Treasury bonds have produced “real” yields of about 2.2%.

 

The real yield on five-year TIPS has tumbled and is now below 1%. The seven-year is merely yielding 1.22%, mainly because bond market players are betting on short-term deflation. For regular investors, what matters is that these yields look weak.

 

Today only the 20-year TIPS, with a real yield of nearly 2.2%, looks decent, though not awe-inspiring. But at least you’re guaranteed some return on your money.

 

What’s more, TIPS yields are based on the official inflation rate, which arguably understates true inflation for many people. The higher the “real” yield on your bonds, the greater your cushion.

 

That said, if you do decide to buy, some advice: TIPS can be bought through any broker, and should be kept in a tax-protected account, such as an IRA, because the government taxes both the inflation adjustments and the coupons as income. The main downside risk of buying TIPS is that a sustained period of deflation can cause bond values and coupons to fall reflect falling prices, though you’ll never get less than the real yield. Note, also, that they are bonds, not cash: The price is not fixed at the time of purchase, and can fluctuate considerably.

 

Rather than betting on specific TIPS, many investors choose to hold TIPS in mutual funds. These typically invest in short, medium and long-term TIPS bonds. Vanguard’s Inflation-Protected Securities (VIPSX | fund, and the iShares Barclays Treasury Inflation Protected Securities Bond exchange-traded fund , are both about 70% invested in bonds that mature within ten years or less. With happy timing, bond giant Pimco recently launched an exchange-traded fund that specializes in long-term TIPS, PIMCO 15+ Year U.S. TIPS Index Fund (LTPZ

 

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) , that’s a reasonable choice for investors, with a current yield around 2.2%.

‘DOES BERNANKE HAVE THE FACTS RIGHT ON BANKING? ,’ by Simon Johnson & Peter Boone at baselinescenario .com.

Does Ben Bernanke Have The Facts Right On Banking?

Posted: 29 Oct 2009 01:12 PM PDT

Ben Bernanke, chairman of the Federal Reserve, has stayed carefully on the sidelines while a major argument has broken out among and around senior policymaking circles: Should our biggest banks be broken up, or can they be safely re-regulated into permanently good behavior? (See the recent competing answers from WSJ, FT, and the New Republic).

But the issues are too pressing and the stakes are too high for key economic policymakers to remain silent or not have an opinion.  On Cape Cod last Friday, Mr. Bernanke appeared to lean towards the banking industry status quo, arguing that regulation would allow us to keep the benefits of large complex financial institutions.

Note, however, that Bernanke’s quote making this point in the NPR story (at the 45 second mark) is from his spoken remarks; the prepared speech does not contain any such language.  And Mr. Bernanke is wise to be wary of endorsing the benefits of size in the banking sector – the evidence in this regard is shaky at best.

There are three main types of evidence: findings from academic research on the returns to size in banking; current and likely future policy in other countries; and actual practices in the banking industry.

First, while academic research is not always the primary driver of policy choices, it is relevant when we can readily see the costs of big banks (in the crisis around us) but the supporters of those banks claim they bring important benefits.  In fact, the available research indicates that in the banking sector, economies of scale exist only up to a (relatively low) level of total assets, while economies of scope are elusive. The benefits from diversification across countries or lines of business are also small; moreover over the last few months we learned that correlations among different markets and asset classes increase rapidly during a crisis – thus reducing even more the benefits of diversification.  [See “Consolidation and efficiency in the financial sector: A review of the international evidence,” by Dean Amel, Colleen Barnes, Fabio Panetta, Carmelo Salleo; Journal of Banking & Finance 28 (2004) 2493–2519.  Note that one of the authors works at the Federal Reserve Board, and all four work in a central bank or ministry of finance.]

Second, policy in other countries matters because some fear that breaking up big US banks would somehow put us at a competitive disadvantage vis-à-vis big European or other banks.  But on this issue the European Commission spoke loudly this week – ordering the break-up of ING, and the presumption is that they will also soon put similar pressure on big UK banks.

Interpretations of this action vary – some see it as an implementation of competition policy, while others feel the Commission is (rightly) concerned about the unfair subsidies implicit in government ownership and support for large banks.  The Commission itself is being somewhat enigmatic, but the exact official motivation doesn’t matter – the important point is that the leading pan-European policy setting organization, which does not rush into decisions, has determined that whatever the benefits of size in banking, the public interest requires smaller banks.

Third, in terms of actual business practice, any big investment banking transaction is done with a syndicate or group of banks – there is sometimes a lead bank with a favored relationship, but that role is definitely shopped around.

Take, for example, General Electric’s October 2008 share offering, in which there were seven lead managers.  Or look at the prominent Microsoft bond offering, which had Bank of America, Citi, JPM, Morgan Stanley as lead managers and Credit Suisse, UBS, and Wachovia as “joint lead” (in this context, “joint lead” is the junior partner).  If a nonfinancial corporate entity takes out a large bank loan, this is also shopped around and syndicated – even for medium sized companies – so as to divide up the risk.

Similarly, if a company wants to do a foreign exchange transaction, it searches for offers and take the best deal.  It would be unwise to rely exclusively on one bank – they will naturally hit hard you in terms of higher fees.

One area where banks benefit from size is in terms of being able to put their balance sheet behind a transaction – e.g., to get a merger done they may offer a bridge loan, with the real goal being to get merger fees.  Bigger banks with a large balance sheet have an advantage in this regard. However, this kind of risk taking is also what gets banks in trouble (e.g., in the 1997-98 Asian Financial Crisis).  In the past, both Morgan Stanley and Goldman Sachs did not have large balance sheets but still did well in mergers and acquisition.

Goldman is an interesting case because it had $217 billion in assets in 1998 (that’s $270 billion in today’s dollars); it now has around $1 trillion.  Goldman was considered a strong global bank in the late 1990s.  Can it really be the case that the idea size for banks has risen so dramatically over the past decade?  (Lehman had $154 billion assets in 1998 and above $600bn when it failed).

For derivatives (and other instruments) it’s important to have deep markets, but not necessarily big banks.  If you want to buy and sell stock you want a liquid market, and the same is true for derivatives.

If you are a large oil company, and you want to hedge future risk, your choices are:

1.  Hedge with a “too big to fail” bank, because you know taxpayers will bail you out and these banks are subsidized by their government support, so they can give you a better price.

2.  Or you can hedge with several banks to minimize counter party risk.  They then sell of some of the risk – taking take less risk themselves as they are small enough to fail.

If you were hedging you’d prefer the “too big to fail” system because it comes with a nifty subsidy.  But this is not what the Federal Reserve should be supporting – Mr. Bernanke may still come out in favor of markets-without-subsidies.

By Peter Boone and Simon Johnson

‘FIVE WAYS TO HANDLE A TRICKY MARKET,’ from Fidelity Interactive at fidelity.com.

You sold your stocks in the past year because of Wall Street’s plunge. Your cash is parked in a money-market fund earning practically nothing. Now you’re wondering what to do, watching from the sidelines as Wall Street posts one of its most powerful rallies in 70 years.

 

You’re certainly not alone. There is about $3 trillion in cash sitting on the sidelines – enough to fuel a further rise in stocks. Experts agree it’s a good idea to put at least some of your money back to work to build equity and protect against inflation over the long term. But how?

 

The truth is there is no “one size fits all” model here. Much depends on your comfort level with investing and, perhaps more importantly, when you’ll need to use the money. Is it for retirement, or something more immediate, like buying a new home?

 

“There’s no perfect answer for how an individual should get back into the market, because every individual has their own risk-tolerance level and financial situation,” said Bobby Straus, chief investment officer at ICON Advisers Inc., a mutual fund company in Greenwood Village, Colo.

 

You may even want a financial adviser to help with the difficult task of matching your investments to your personal goals.

 

“Coming out of this market environment, people need to be honest with themselves about their comfort level with the day-to-day volatility that different investments have,” said Chris McDermott, Fidelity’s senior vice president for investor education and financial planning.

 

McDermott said it’s important to stay focused on your long-term goals and stick with a plan. “The key is to get invested and have the discipline to remain invested.”

 

Once you’ve picked a mix of assets appropriate for your age, retirement timeline, risk tolerance and other factors, such as how much income you’ll need in retirement, you’re ready to get back into stocks. Here are five ways to do it:

 

1. Jump back in all at once. “By being fully invested from the start, we can enjoy all the potential gains” stocks can provide, according to Gregory Singer and Ted Mann, analysts at Bernstein Global Wealth Management, a unit of AllianceBernstein LP.

 

“Setting aside the risk tolerance issue, it’s always best to put your money in yesterday – all at once yesterday,” said Clint Edgington, president of Beacon Hill Investment Advisory, a fee-only investment advisory firm in Columbus, Ohio.

 

But that’s not easy for everyone, especially after last year’s financial crisis.

 

In a recent article in the CFA Institute’s online newsletter, Singer and Mann at Bernstein Global Wealth noted that over the last 80 years the stock market has risen more than 70% of the time. “The odds that the market will outperform cash are in our favor,” they wrote.

 

Singer and Mann said the stock market’s average gain in all the rolling 12-month periods from January 1926 through November 2008 was 12%. A strategy known as dollar-cost averaging, or investing a set amount each month, returned 8%. Staying in cash returned 4%.

 

And this is going back to when people parked much of their money in “passbook savings” accounts. Rates today for similar short-term holdings are at historic lows, usually 2% or less.

 

2. Dollar cost average. Even if jumping back into stocks feet first tends to produce the best returns over time, it’s not for everyone. Some investors may lack the stomach to pour tens or hundreds of thousands of dollars into stocks all at once. In that case, dollar cost averaging may be the ticket.

 

“That’s always a sound strategy that gives investors an opportunity to get the average cost over a ‘period of time’ rather that just ‘today’s price,’ and it works especially well during sideways and volatile markets,” said Wes Moss, chief investment strategist at Capital Investment Advisors, a fee-only advisory firm in Atlanta.

 

Many investors are familiar with the strategy, but here’s a brief refresher: Invest the same amount each month, spreading your purchases across the market’s ups and downs over a period of many years.

 

To put this strategy to work now, think about committing your cash to stocks over three to 18 months, depending on how comfortable you are with risk and your overall financial situation.  True, you may miss out on some gains as you “average in,” but you’ll limit your losses if the market retreats.

 

“It reduces the volatility of your returns while getting into the market. But it also reduces the returns you can expect during that time period as well,” said Beacon Hill’s Edgington.

 

3. Take “baby steps.” “A lot of people were shell-shocked by what happened last year. They were too scared to pull the trigger and get back into stocks,” said David McPherson, a fee-only financial planner and principal of Four Ponds Financial Planning in Falmouth, Mass.

 

His advice: “Start with some baby steps. Invest in some conservative bond funds a little bit at a time.”

 

McPherson advocated funds that invest in short-term, investment-grade corporate bonds with a one- to three-year maturity. This should help bolster returns and calm your stomach, so you’ll eventually feel better about buying stocks again. “I look at it as a way to build confidence,” said McPherson.

 

4. Don’t just stash it in cash. This may be prudent if you expect to buy a house soon. But experts don’t advise keeping all your money in cash for the long term, particularly if you don’t need the funds for at least five years.

 

Singer and Mann, in their article, said holding cash “did not come close” to the returns earned over time from investing in stocks, all at once or via dollar cost averaging. “You’ve got to keep pace with inflation over the long term,” added Fidelity’s McDermott.

 

But if you do decide to take a more conservative approach, there are ways to help keep inflation from eroding the value of your cash. One is to buy U.S. Treasury Inflation-Protected Securities, or TIPS, whose value is adjusted based on the Consumer Price Index, the government’s main inflation gauge. Another is bonds and bond funds, which provide yield. But beware:  These investments can fall in value when interest rates rise.

 

5. Don’t try to time the market. Maybe you think the market’s run-up since March is going to evaporate, and you’re waiting to pick the bottom. Good luck.

 

“We have yet to find a person on record who has consistently and perfectly picked the bottom to invest and then gotten out at the top,” said ICON’s Straus.

 

So there is no one-size-fits-all solution.

 

If you can stomach short-term losses, getting back in all at once may be for you. Otherwise, consider a gradual approach, perhaps even baby steps. Over the long haul, though, one thing is clear: Getting back into the game is better than sitting on the sidelines.

 

‘A 90-YEAR OLD SHARES THE 45 LESSONS LIFE HAS TAUGHT HER,’ from the Cleveland Pain Dealer. A half a lesson per year. About right!

Written By Regina Brett, 90 years old, of The Plain Dealer, Cleveland ,

> Ohio

>

> “To celebrate growing older, I once wrote the 45 lessons life taught me. It is the most-requested column I’ve ever written.

>

> My odometer rolled over to 90 in August, so here is the column once more:

>

> 1. Life isn’t fair, but it’s still good.

>

> 2. When in doubt, just take the next small step.

>

> 3. Life is too short to waste time hating anyone…

>

> 4. Your job won’t take care of you when you are sick. Your friends and parents will. Stay in touch.

>

> 5. Pay off your credit cards every month.

>

> 6. You don’t have to win every argument. Agree to disagree.

>

> 7. Cry with someone. It’s more healing than crying alone.

>

> 8. It’s OK to get angry with God. He can take it.

>

> 9. Save for retirement starting with your first pay cheque.

>

> 10. When it comes to chocolate, resistance is futile.

>

> 11. Make peace with your past so it won’t screw up the present.

>

> 12. It’s OK to let your children see you cry.

>

> 13. Don’t compare your life to others. You have no idea what their journey is all about.

> 14. If a relationship has to be a secret, you shouldn’t be in it.

>

> 15. Everything can change in the blink of an eye. But don’t worry; God never blinks.

> 16. Take a deep breath. It calms the mind.

>

> 17. Get rid of anything that isn’t useful, beautiful or joyful.

>

> 18. Whatever doesn’t kill you really does make you stronger.

>

> 19. It’s never too late to have a happy childhood. But the second one is up to you and no one else.

>

> 20. When it comes to going after what you love in life, don’t take no for an answer.

> 21. Burn the candles, use the nice sheets, wear the fancy lingerie. Don’t save it for a special occasion, today is special.

>

> 22. Over prepare, then go with the flow.

>

> 23. Be eccentric now. Don’t wait for old age to wear purple.

>

> 24. The most important sex organ is the brain.

>

> 25. No one is in charge of your happiness but you.

>

> 26. Frame every so-called disaster with these words ‘In five years, will this matter?’

> 27. Always choose life.

>

> 28. Forgive everyone everything.

>

> 29. What other people think of you is none of your business.

>

> 30. Time heals almost everything. Give it time.

>

> 31. However good or bad a situation is, it will change.

>

> 32. Don’t take yourself so seriously. No one else does.

>

> 33. Believe in miracles.

>

> 34. God loves you because of who God is, not because of anything you did or didn’t do.

> 35. Don’t audit life. Show up and make the most of it now.

>

> 36. Growing old beats the alternative — dying young.

>

> 37. Your children get only one childhood.

>

> 38. All that truly matters in the end is that you loved.

>

> 39. Get outside every day. Miracles are waiting everywhere.

>

> 40. If we all threw our problems in a pile and saw everyone else’s, we’d grab ours back.

> 41. Envy is a waste of time. You already have all you need.

>

> 42. The best is yet to come.

>

> 43. No matter how you feel, get up, dress up and show up.

>

> 44. Yield.

>

> 45. Life isn’t tied with a bow, but it’s still a gift.

‘FIND YOUR FINANCIAL STYLE AND AVOID ITS PITFALLS,’ in the Wall St. Journal at fidelity.com.

There are few relationships more complicated than the one we have with money.

 

Some of us are intimate with our finances, endlessly doing research and keeping track of every penny. Others are more distant; they have a general idea of where their money is going, but aren’t sure if it’s the right move or if it’s enough. Then there are the emotional ones, those who cling to money at the wrong times and make impulsive decisions.

 

So, what kind of investor and saver are you?

 

Not sure? Ask yourself these questions: Do I consistently keep track of my spending? And do I do so weekly, monthly or annually? Do I feel that I’m OK financially as long as my checks don’t bounce? Do I plan and save for big purchases or do I buy on a whim?

 

There also are online quizzes, such as J.P. Morgan Chase’s “Financial Styles” found at ChaseFinancialStyle.com, that can help you determine your investing and saving profile.

 

Once you determine your style, you can use certain strategies and tools to reinforce the positive aspects of your approach — and contain the negative ones.

 

Understanding your financial approach can help you figure out where your “strategy is most vulnerable to pitfalls or problems,” says Hersh Shefrin, a professor of behavioral finance at Santa Clara University who helped J.P. Morgan Chase develop its quiz.

 

The analytical investor

You’re a stickler for details and data. And while it’s good to be thorough with your research, if taken to an extreme people can forget to take their personal situation and goals into account when making financial and investment decisions.

 

This type of investor can get hit with what some advisers call “analysis paralysis,” where they have trouble making decisions because they can’t help thinking there is always more research to be done.

 

“They’re what I call ’see mores’ — they always want to see more,” says Bryan Place, founder of Place Financial Advisors, a financial-planning firm in Manlius, N.Y. “Rather than overwhelming themselves and spending too much time digging through content,” they should limit themselves to three or four reliable sources, he says.

 

If you have a tendency to delay acting on your financial goals, Mr. Place says, make a list of the pros and cons and give yourself a deadline to decide — and stick to it.

 

While you may be great at budgeting, you might benefit from online expense-tracking tools offered by Mint.com or financial-planning software from Quicken (quicken.intuit.com) that can help you distance yourself from your day-to-day transactions to recognize spending and saving trends over time.

 

At Mint.com, you can build graphs that show how your spending, income, debt or net worth has changed over a specific period. You also can see changes in spending in certain categories, such as groceries.

 

The big-picture investor

You know your bottom line, but you don’t keep track of every transaction or plan every action or expense. While this approach can be less stressful if you’re able to consistently save and meet your financial goals, it can leave you unsure about exactly where your money is going and where you can cut back.

 

To avoid falling into a set-it-and-forget-it routine and ending up with outdated and unsuccessful strategies for investing and saving, review your strategies at least once a year. For instance, the retirement-savings plan you started five years ago might not be on pace to fund the lifestyle you live today given the recession, so re-evaluate allocations at least once a year, says Carlo Panaccione, a financial planner in Redwood Shores, Calif.

 

Break down your expenses into two categories: “necessities,” which would include mortgage payments, utility bills and food; and “lifestyle,” optional costs such as cable television and gym memberships, says Larry Rosenthal, a financial planner near Washington, D.C. Tools at Mint.com and Quicken’s software allow you keep track of spending in each category.

 

To monitor your spending, use a debit card or credit card instead of cash, says Mr. Place, and look at your accounts online at least once or twice a week. But make sure to pay off the credit-card balance each month.

 

Meanwhile, online calculators such as the one offered by Discover Financial Services

, can help you devise a monthly plan for reaching a long-term savings goal.

 

The emotional investor

Emotional investors are reactionary, often making financial decisions based on what’s happening at the moment and ignoring long-term needs and goals.

 

“They might look at it as ‘Gee, my kid’s education is really coming up soon, I have to focus on that and kind of put their retirement on the back burner,” says Mr. Panaccione.

 

For such investors, he suggests creating two lists: one with short-term goals, such as a vacation or car purchase, and one with long-term goals, such as saving for retirement.

 

Then, set up savings or investing accounts for each goal — one account for, say, the purchase of a house, one for retirement and another for college tuition. To ensure that each portion is funded consistently, set up automatic deposits to each account, says Mr. Rosenthal.

 

Matt Havens, partner at Global Vision Advisors, a financial-services firm in Hingham, Mass., suggests forcing yourself to plan for emergencies by building a cash reserve to cover at least six months of expenses. Having that safety net will help you avoid an impulsive move.

 

And when it comes to investing, don’t make drastic changes to your asset allocation. “A main weakness of this group is that they tend to buy high and sell low because of emotion and fear,” says Bryan Hopkins, a financial planner in Anaheim Hills, Calif. It might help to sit down with a planner to create a long-term investment plan.

 

Copyright © 2009 Dow Jones & Company, Inc. All Rights Reserved.

‘ THE KEY TO A HAPPY MARRIAGE? A YOUNGER, SMARTER WIFE (AND SEX).’ SENT BY YOUNGER/SMARTER FRIEND FROM LEMONDROP.COM. LEAVE COMMENTS IF YOU HAVE A TAKE ON THIS.

The Key to a Happy Marriage? A Younger, Smarter Wife (and Sex)

Dating & Love~~~ FROM WWW.LEMONDROP.COM

The practice of “marrying up” might be looked down upon by some, but when you’re talking age, it might be the key to a happy marriage. A recent study showed that the couples who were happiest and had the lowest divorce rate were those where the woman was at least five years younger than her husband — and when she’s better educated.

But it doesn’t work both ways. The same study claims that when the wife is older by five or more years, the couple is three times more likely to break up than if they’re the same age. (We’re looking at you, Demi.)

Does this mean that men with younger wives are destined to be happy? Perhaps. Another factor might be that we’re getting better at staying together; at least that’s what a different poll conducted by The Times of London stated: 54 percent of those polled hadn’t even considered having an affair.

What’s the key to remaining faithful? Pretty obvious: a decent amount of sex. Of the respondents, 44 percent said they had sex at least once a week and 32 percent are having it two to four times a month. Two percent of the couples, who are obviously a little more limber, are having sex every day.

But that doesn’t mean everyone is remaining faithful. Compare the U.K. research with a 1991 survey from this side of the pond conducted by the National Opinion Research Center at the University of Chicago. The study found 22 percent of married men confessed to being unfaithful, while only 10 percent of married women admitted the same. In 2006, the same survey by the NORC found that 16.7 percent of women admitted to infidelity — a dramatic increase.

What makes a person cheat on their partner? It’s a deeply personal issue, but according to Dr. Lauren Rosewarne, quoted in The Times, “People cheat to feel younger, different or challenged.”

Maybe, for those couples facing an age gap — and possibly an intelligence one, too — those extra years are enough to make the difference.

‘ TAX CREDITS, SCREWDRIVERS, & SUPPLY & DEMAND CURVES,’ by James Kwak at baselinescenario .com.

Tax Credits, Screwdrivers, and Supply and Demand Curves

Posted: 27 Oct 2009 06:32 AM PDT

 

Our Washington Post online column today is another cry in the wilderness against the homebuyer tax credit.

 

There are many arguments against the tax credit. One argument we make is that the tax credit is a benefit for sellers of houses more than for buyers of houses. This is simplest to see if you imagine  a permanent credit available for all buyers: “Imagine the credit were expanded to all home buyers and made permanent. This would simply boost housing prices at the low end of the market by close to $8,000, since all buyers would be willing to pay $8,000 more. (Prices would rise by a little less than $8,000 because at higher prices, more people would be willing to sell.)”

 

It turns out Nemo had made a similar argument already.

 

Small point: Nemo (in a follow-up post) says that the tax credit should boost prices by exactly $8,000 (leaving aside leverage for now), because in the short term the supply curve is vertical. I’m not convinced. The reason we said “close to $8,000″ is that the supply curve is typically upward-sloping, not vertical, as shown on the graph in that follow-up post. The supply of houses can shift quickly, because people can decide to sell their houses (say, retirees planning to move to apartments in the city can move that decision forward). Also, if the credit is not available to everyone, it won’t shift the demand curve by exactly $8,000 at every point, because the demand curve for houses is the sum of every individual’s demand for houses, so only some people’s demand will change. This is why expanding the tax credit to everyone is such a bad idea. When you restrict it to first-time homebuyers, they get at least some of the benefit.

 

Bigger point: Nemo points out that the $8,000 increases the homebuyer’s ability to make a down payment; since mortgages provide leverage, this means the potential impact on prices is much higher. If you are buying a house with 3.5% down, then arguably an extra $8,000 in cash (which some states will advance you) can boost your buying power by $200,000. Now, this is a complicated issue, since unless you can get a no-doc loan, you still need to qualify for the monthly payments. (Nemo discusses this here.) But I think it’s fair to say that at least some buyers are constrained by the down payment more than by the monthly payments, especially with interest rates so low (I saw this in my summer legal services job). So the potential impact on a household’s buying power could be a lot more than $8,000, as Nemo says.

 

The net effect is that the buyer pays an inflated price for a house, which will get deflated when the tax credit prop gets taken away. I believe in some places you can effectively use the tax credit as your down payment; this means you will have close to zero equity when the credit goes away, unless housing prices rise.

 

By James Kwak

‘LONG WINDING ROAD TO RECOVERY,’ at fidelity.com.

Recent data releases continued to indicate that the economy is making slow progress towards recovery. However, we are only just in the beginning stages of reversing the damaging effects of the recession. Many sectors and industries had such deep and broad declines that it may take a long time to return to pre-recession levels. Residential housing continues to be a drag on gross domestic product, capacity utilization in the industrial sector remains at historic lows, and retail inventories have yet to be fully restocked.

 

The experience from past recessions suggests that the bigger the decline, the bigger the eventual recovery. Many companies have weathered this economic crisis by slashing payrolls, scaling back production, and depleting inventories. The silver lining in all of this gloom is that once the economic expansion gets going again, it could continue for awhile because there is so much ground to recover.

 

Housing showing signs of stabilization, but still a drag on growth

The Commerce Department reported that new construction of U.S. housing units was essentially flat in September, as housing starts ticked up to 590,000 from a revised level of 587,000 in August. (A housing start is when the excavation begins for a new residential dwelling.)

 

Why are housing starts an important gauge of the health for the U.S. economy? Most homebuilders don’t start building a house until they are reasonably confident it can be sold at completion. Therefore, trends in the rate of housing starts can be an indication of the level of demand for housing and the outlook for the construction industry. In addition, each time a house is sold it can have a ripple effect through the economy as homeowners buy new furnishings and appliances for their new house.

 

Dating back to the first quarter of 2006 when housing starts peaked at 6.36 million units, residential fixed investment (purchases of private residences and residential equipment that is owned by landlords and rented to tenants) has had a negative contribution to gross domestic product (GDP) for 14 straight quarters. In other words, declining activity in residential construction has been a drag on economic growth for over three years.

 

Prior to December 2008, the rolling 3-month total of housing starts had never fallen below 2 million units since 1959 when the Commerce Department began keeping records of housing activity. Throughout 2009, the rolling 3-month total of housing starts has stayed well under 2 million units. We are still a long way from the historical 3-month rolling average of 4.56 million units, but the housing sector is showing signs of stabilization. The rolling 3-month total of housing starts has been increasing since bottoming in May at its all-time low of 1.55 million units.

 

Another signal of increasing activity in the housing sector came from the National Association of Realtors (NAR), which reported that sales of existing homes increased 9.4% in September to a seasonally adjusted annual rate of 5.57 million units. While last month was the highest rate of monthly sales since July 2007, much of the momentum came from first-time homebuyers as they hurried to take advantage of an expiring tax credit.

 

The NAR also reported that the median sales price fell 1.4% to $174,900. Distressed sales (foreclosures and sales where the proceeds fall short of the balance owed on the property) accounted for 29% of sales in September, continuing to put downward pressure on home prices. Last month’s drop in home prices, however, was the smallest year-over-year decline since July 2008.

 

While the upcoming expiration of the $8,000 first-time home buyer credit may dampen the near-term enthusiasm of homebuyers, many of the underlying fundamentals remain favorable. Even though long-term mortgage rates increased over the past week, they remain low by historical standards. Other measures of housing affordability, such as the Housing Affordability Index from the National Association of Realtors, also remain well above long-term averages.

 

 

 

Industrial production, capacity utilization showing improvement

According to the Federal Reserve, U.S. industrial production rose 0.7% in September and 2.8% in the third quarter. The annualized rate of increase in Q3 was 11.8% — a marked improvement from when industrial production was falling this past January at a 21.1% annualized 3-month rate.

 

Increased production in motor vehicles and parts helped lift industrial production in September. Even better news was that the gains were also widespread outside of autos. Overall production excluding motor vehicles was up 0.4% last month.

 

The increase in industrial production helped push capacity utilization to 70.5% in September for the third monthly gain in a row. While last month’s capacity utilization was above the all-time low of 68.3% reached in June, it’s still below the lows of any prior recession over the past four decades — and well under the historical average of 81.1% since records began in 1967.

 

There is still considerable slack in the U.S. industrial sector, but the upside is that manufacturing activity can increase substantially before the utilization rate gets so high as to raise concerns about inflationary bottlenecks in production.

 

 

 

Inventory restocking could boost economy

Another sign of the lagged effects of the recession is the excess inventories, built-up over the past several years, which continued to rapidly deplete. As consumer demand was weak during the recession, many companies cut production and instead worked off inventories. Why add to inventories if demand is uncertain and the economic outlook bleak?

 

Retail inventories fell 2.3% in August and have had year-over-year declines for 11 straight months. However, much of the decline in August was the result of the Cash for Clunkers program. Excluding autos, retail inventories only fell 0.3% in August.

 

Retail inventories have now fallen so much that the retail inventory/sales ratio is at 1.39, its lowest level since records began in 1967. Businesses have been remarkably adept at quickly slashing payrolls and inventories in reaction to the declining sales wrought by the recession. However, if the economy continues to improve and retail sales show even a small uptick, businesses will need to restock depleted inventories. This, in turn, would give a boost to economic growth and explains why many economists and market commentators think this could be an inventory-led recovery.

 

 

 

Long, winding road to recovery

Clearly, there continues to be substantial slack in the U.S. economy. Housing starts, industrial production, and retail inventories have fallen precipitously over the last two years. While the depth of the declines is unsettling, it also points to the possibility of a strong rebound as the economy gingerly exits from the downturn and takes steps towards growth.

 

Signs continue to emerge that the slack is beginning to be put to use. The Conference Board, a business research group, reported that its Index of Leading Economic Indicators rose 1.0% in September for the sixth consecutive monthly increase. The 5.7% increase over the past six months was the strongest since 1983.

 

Regardless of the shape of the eventual economic recovery, the path back to growth will likely be winding and uneven. But even a halting path back to expansion is a welcome and encouraging new direction.

 

‘AMERICAN PREEMINENCE IS DISAPPEARING FIFTEEN YEARS EARLY,’ by Michael T. Klare at information clearing house.com.

Welcome to 2025

American Preeminence Is Disappearing Fifteen Years Early

By Michael T. Klare

October 26, 2009 “Tomdispatch” — Memo to the CIA: You may not be prepared for time-travel, but welcome to 2025 anyway! Your rooms may be a little small, your ability to demand better accommodations may have gone out the window, and the amenities may not be to your taste, but get used to it. It’s going to be your reality from now on.

Okay, now for the serious version of the above: In November 2008, the National Intelligence Council (NIC), an affiliate of the Central Intelligence Agency, issued the latest in a series of futuristic publications intended to guide the incoming Obama administration. Peering into its analytic crystal ball in a report entitled Global Trends 2025, it predicted that America’s global preeminence would gradually disappear over the next 15 years — in conjunction with the rise of new global powerhouses, especially China and India. The report examined many facets of the future strategic environment, but its most startling, and news-making, finding concerned the projected long-term erosion of American dominance and the emergence of new global competitors. “Although the United States is likely to remain the single most powerful actor [in 2025],” it stated definitively, the country’s “relative strength — even in the military realm — will decline and U.S. leverage will become more constrained.”

That, of course, was then; this — some 11 months into the future — is now and how things have changed. Futuristic predictions will just have to catch up to the fast-shifting realities of the present moment. Although published after the onset of the global economic meltdown was underway, the report was written before the crisis reached its full proportions and so emphasized that the decline of American power would be gradual, extending over the assessment’s 15-year time horizon. But the economic crisis and attendant events have radically upset that timetable. As a result of the mammoth economic losses suffered by the United States over the past year and China’s stunning economic recovery, the global power shift the report predicted has accelerated. For all practical purposes, 2025 is here already.

Many of the broad, down-the-road predictions made in Global Trends 2025 have, in fact, already come to pass. Brazil, Russia, India, and China — collectively known as the BRIC countries — are already playing far more assertive roles in global economic affairs, as the report predicted would happen in perhaps a decade or so. At the same time, the dominant global role once monopolized by the United States with a helping hand from the major Western industrial powers — collectively known as the Group of 7 (G-7) — has already faded away at a remarkable pace. Countries that once looked to the United States for guidance on major international issues are ignoring Washington’s counsel and instead creating their own autonomous policy networks. The United States is becoming less inclined to deploy its military forces abroad as rival powers increase their own capabilities and non-state actors rely on “asymmetrical” means of attack to overcome the U.S. advantage in conventional firepower.

No one seems to be saying this out loud — yet — but let’s put it bluntly: less than a year into the 15-year span of Global Trends 2025, the days of America’s unquestioned global dominance have come to an end. It may take a decade or two (or three) before historians will be able to look back and say with assurance, “That was the moment when the United States ceased to be the planet’s preeminent power and was forced to behave like another major player in a world of many competing great powers.” The indications of this great transition, however, are there for those who care to look.

Six Way Stations on the Road to Ordinary Nationhood

Here is my list of six recent developments that indicate we are entering “2025″ today. All six were in the news in the last few weeks, even if never collected in a single place. They (and other events like them) represent a pattern: the shape, in fact, of a new age in formation.

1. At the global economic summit in Pittsburgh on September 24th and 25th, the leaders of the major industrial powers, the G-7 (G-8 if you include Russia) agreed to turn over responsibility for oversight of the world economy to a larger, more inclusive Group of 20 (G-20), adding in China, India, Brazil, Turkey, and other developing nations. Although doubts have been raised about the ability of this larger group to exercise effective global leadership, there is no doubt that the move itself signaled a shift in the locus of world economic power from the West to the global East and South — and with this shift, a seismic decline in America’s economic preeminence has been registered.

“The G-20’s true significance is not in the passing of a baton from the G-7/G-8 but from the G-1, the U.S.,” Jeffrey Sachs of Columbia University wrote in the Financial Times. “Even during the 33 years of the G-7 economic forum, the U.S. called the important economic shots.” Declining American leadership over these last decades was obscured by the collapse of the Soviet Union and an early American lead in information technology, Sachs also noted, but there is now no mistaking the shifting of economic power from the United States to China and other rising economic dynamos.

2. According to news reports, America’s economic rivals are conducting secret (and not-so-secret) meetings to explore a diminished role for the U.S. dollar — fast losing its value — in international trade. Until now, the use of the dollar as the international medium of exchange has given the United States a significant economic advantage: it can simply print dollars to meet its international obligations while other nations must convert their own currencies into dollars, often incurring significant added costs. Now, however, many major trading countries — among them China, Russia, Japan, Brazil, and the Persian Gulf oil countries — are considering the use of the Euro, or a “basket” of currencies, as a new medium of exchange. If adopted, such a plan would accelerate the dollar’s precipitous fall in value and further erode American clout in international economic affairs.

One such discussion reportedly took place this summer at a summit meeting of the BRIC countries. Just a concept a year ago, when the very idea of BRIC was concocted by the chief economist at Goldman Sachs, the BRIC consortium became a flesh-and-blood reality this June when the leaders of the four countries held an inaugural meeting in Yekaterinburg, Russia.

The very fact that Brazil, Russia, India, and China chose to meet as a group was considered significant, as they jointly possess about 43% of the world’s population and are expected to account for 33% of the world’s gross domestic product by 2030 — about as much as the United States and Western Europe will claim at that time. Although the BRIC leaders decided not to form a permanent body like the G-7 at this stage, they did agree to coordinate efforts to develop alternatives to the dollar and to reform the International Monetary Fund in such a way as to give non-Western countries a greater voice.

3. On the diplomatic front, Washington has been rebuffed by both Russia and China in its drive to line up support for increased international pressure on Iran to cease its nuclear enrichment program. One month after President Obama cancelled plans to deploy an anti-ballistic missile system in Eastern Europe in an apparent bid to secure Russian backing for a tougher stance toward Tehran, top Russian leaders are clearly indicating that they have no intention of endorsing strong new sanctions on Iran. “Threats, sanctions, and threats of pressure in the current situation, we are convinced, would be counterproductive,” declared the Russian foreign minister, Sergey V. Lavrov, following a meeting with Secretary of State Hillary Clinton in Moscow on October 13th. The following day, Russian Prime Minister Vladimir Putin said that the threat of sanctions was “premature.” Given the political risks Obama took in canceling the missile program — a step widely condemned by Republicans in Washington — Moscow’s quick dismissal of U.S. pleas for cooperation on the Iranian enrichment matter can only be interpreted as a further sign of waning American influence.

4. Exactly the same inference can be drawn from a high-level meeting in Beijing on October 15th between Chinese Prime Minister Wen Jiabao and Iran’s first vice president, Mohammed Reza Rahimi. “The Sino-Iran relationship has witnessed rapid development as the two countries’ leaders have had frequent exchanges, and cooperation in trade and energy has widened and deepened,” Wen said at the Great Hall of the People. Coming at a time when the United States is engaged in a vigorous diplomatic drive to persuade China and Russia, among others, to reduce their trade ties with Iran as a prelude to toughened sanctions, the Chinese statement can only be considered a pointed rebuff of Washington.

5. From Washington’s point of view, efforts to secure international support for the allied war effort in Afghanistan have also met with a strikingly disappointing response. In what can only be considered a trivial and begrudging vote of support for the U.S.-led war effort, British Prime Minister Gordon Brown announced on October 14th that Britain would add more troops to the British contingent in that country — but only 500 more, and only if other European nations increase their own military involvement, something he undoubtedly knows is highly unlikely. So far, this tiny, provisional contingent represents the sum total of additional troops the Obama administration has been able to pry out of America’s European allies, despite a sustained diplomatic drive to bolster the combined NATO force in Afghanistan. In other words, even America’s most loyal and obsequious ally in Europe no longer appears willing to carry the burden for what is widely seen as yet another costly and debilitating American military adventure in the Greater Middle East.

6. Finally, in a move of striking symbolic significance, the International Olympic Committee (IOC) passed over Chicago (as well as Madrid and Tokyo) to pick Rio de Janeiro to be the host of the 2016 summer Olympics, the first time a South American nation was selected for the honor. Until the Olympic vote took place, Chicago was considered a strong contender, especially since former Chicago resident Barack Obama personally appeared in Copenhagen to lobby the IOC. Nonetheless, in a development that shocked the world, Chicago not only lost out, but was the city eliminated in the very first round of voting.

“Brazil went from a second-class country to a first-class country, and today we began to receive the respect we deserve,” said Brazilian President Luiz Inácio Lula da Silva at a victory celebration in Copenhagen after the vote. “I could die now and it already would have been worth it.” Few said so, but in the course of the Olympic decision-making process the U.S. was summarily and pointedly demoted from sole superpower to instant also-ran, a symbolic moment on a planet entering a new age.

On Being an Ordinary Country

These are only a few examples of recent developments which indicate, to this author, that the day of America’s global preeminence has already come to an end, years before the American intelligence community expected. It’s increasingly clear that other powers — even our closest allies — are increasingly pursuing independent foreign policies, no matter what pressure Washington tries to bring to bear.

Of course, none of this means that, for some time to come, the U.S. won’t retain the world’s largest economy and, in terms of sheer destructiveness, its most potent military force. Nevertheless, there is no doubt that the strategic environment in which American leaders must make critical decisions, when it comes to the nation’s vital national interests, has changed dramatically since the onset of the global economic crisis.

Even more important, President Obama and his senior advisers are, it seems, reluctantly beginning to reshape U.S. foreign policy with the new global reality in mind. This appears evident, for example, in the administration’s decision to revisit U.S. strategy on Afghanistan.

It was only in March, after all, that the president embraced a new counterinsurgency-oriented strategy in that country, involving a buildup of U.S. boots on the ground and a commitment to protracted efforts to win hearts and minds in Afghan villages where the Taliban was resurgent. It was on this basis that he fired the incumbent Afghan War commander, General David D. McKiernan, replacing him with General Stanley A. McChrystal, considered a more vigorous proponent of counterinsurgency. When, however, McChrystal presented Obama with the price tag for the implementation of this strategy — 40,000 to 80,000 additional troops (over and above the 20,000-odd extra troops only recently committed to the fight) — many in the president’s inner circle evidently blanched.

Not only will such a large deployment cost the U.S. treasury hundreds of billions of dollars it can ill afford, but the strains it is likely to place on the Army and Marine Corps are likely to be little short of unbearable after years of multiple tours and stress in Iraq. This price would be more tolerable, of course, if America’s allies would take up more of the burden, but they are ever less willing to do so.

Undoubtedly, the leaders of Russia and China are not entirely unhappy to see the United States exhaust its financial and military resources in Afghanistan. Under these circumstances, it is hardly surprising that Vice President Joe Biden, among others, is calling for a new turn in U.S. policy, foregoing a counterinsurgency approach and opting instead for a less costly “counter-terrorism” strategy aimed, in part, at crushing Al Qaeda in Pakistan — using drone aircraft and Special Forces, rather than large numbers of U.S. troops (while leaving troop levels in Afghanistan relatively unchanged).

It is too early to predict how the president’s review of U.S. strategy in Afghanistan will play out, but the fact that he did not immediately embrace the McChrystal plan and has allowed Biden such free rein to argue his case suggests that he may be coming to recognize the folly of expanding America’s military commitments abroad at a time when its global preeminence is waning.

One senses Obama’s caution in other recent moves. Although he continues to insist that the acquisition of nuclear weapons by Iran is impermissible and that the use of force to prevent this remains an option, he has clearly moved to minimize the likelihood that this option — which would also be plagued by recalcitrant “allies” — will ever be employed.

On the other side of the coin, he has given fresh life to American diplomacy, seeking improved ties with Moscow and approving renewed diplomatic contact with such previously pariah states as Burma, Sudan, and Syria. This, too, reflects a reality of our changing world: that the holier-than-thou, bullying stance adopted by the Bush administration toward these and other countries for almost eight years rarely achieved anything. Think of it as an implicit acknowledgement that the U.S. is now descending from its status as the globe’s “sole superpower” to that of an ordinary country. This, after all, is what ordinary countries do; they engage other countries in diplomatic discourse, whether they like their current governments or not.

So, welcome to the world of 2025. It doesn’t look like the world of our recent past, when the United States stood head and shoulders above all other nations in stature, and it doesn’t comport well with Washington’s fantasies of global power since the Soviet Union collapsed in 1991. But it is reality.

For many Americans, the loss of that preeminence may be a source of discomfort, or even despair. On the other hand, don’t forget the advantages to being an ordinary country like any other country: Nobody expects Canada, or France, or Italy to send another 40,000 troops to Afghanistan, on top of the 68,000 already there and the 120,000 still in Iraq. Nor does anyone expect those countries to spend $925 billion in taxpayer money to do so — the current estimated cost of both wars, according to the National Priorities Project.

The question remains: How much longer will Washington feel that Americans can afford to subsidize a global role that includes garrisoning much of the planet and fighting distant wars in the name of global security, when the American economy is losing so much ground to its competitors? This is the dilemma President Obama and his advisers must confront in the altered world of 2025.

Michael T. Klare is a professor of peace and world security studies at Hampshire College and author of Rising Powers, Shrinking Planet: The New Geopolitics of Energy (Owl Books). A documentary film version of his previous book, Blood and Oil, is available from the Media Education Foundation at Bloodandoilmovie.com.

Copyright 2009 Michael T. Klare

A MASSIVE READ BUT SOME OF YOU WILL DELIGHT IT THIS. I DID…..FROM JOHN MAUDLIN AT INVESTORINSIGHT .COM. WRITTEN BY DAVID EINHORN.

 

Liquor before Beer – In the Clear

 

Value Investing Congress – David Einhorn, Greenlight Capital

 

One of the nice aspects of trying to solve investment puzzles is recognizing that even though I am not always going to be right, I don’t have to be. Decent portfolio management allows for some bad luck and some bad decisions. When something does go wrong, I like to think about the bad decisions and learn from them so that hopefully I don’t repeat the same mistakes. This leaves me plenty of room to make fresh mistakes going forward. I’d like to start today by reviewing a bad decision I made and share with you what I’ve learned from that error and how I am attempting to apply the lessons to improve our funds’ prospects.

 

At the May 2005 Ira Sohn Investment Research Conference in New York, I recommended MDC Holdings, a homebuilder, at $67 per share. Two months later MDC reached $89 a share, a nice quick return if you timed your sale perfectly. Then the stock collapsed with the rest of the sector. Some of my MDC analysis was correct: it was less risky than its peers and would hold-up better in a down cycle because it had less leverage and held less land. But this just meant that almost half a decade later, anyone who listened to me would have lost about forty percent of his investment, instead of the seventy percent that the homebuilding sector lost.

 

I want to revisit this because the loss was not bad luck; it was bad analysis. I down played the importance of what was then an ongoing housing bubble. On the very same day, at the very same conference, a more experienced and wiser investor, Stanley Druckenmiller, explained in gory detail the big picture problem the country faced from a growing housing bubble fueled by a growing debt bubble. At the time, I wondered whether even if he were correct, would it be possible to convert such big picture macro-thinking into successful portfolio management? I thought this was particularly tricky since getting both the timing of big macro changes as well as the market’s recognition of them correct has proven at best a difficult proposition. Smart investors had been complaining about the housing bubble since at least 2001. I ignored Stan, rationalizing that even if he were right, there was no way to know when he would be right. This was an expensive error.

 

The lesson that I have learned is that it isn’t reasonable to be agnostic about the big picture. For years I had believed that I didn’t need to take a view on the market or the economy because I considered myself to be a “bottom up” investor. Having my eyes open to the big picture doesn’t mean abandoning stock picking, but it does mean managing the long-short exposure ratio more actively, worrying about what may be brewing in certain industries, and when appropriate, buying some just-in-case insurance for foreseeable macro risks even if they are hard to time. In a few minutes, I will tell you what Greenlight has done along these lines.

 

But first, I’d like to explain what I see as the macro risks we face. To do that I need to digress into some political science. Please humor me since my mom and dad spent a lot of money so I could be a government major, the usefulness of which has not been apparent for some time.

 

Winston Churchill said that, “Democracy is the worst form of government except for all the others that have been tried from time to time.”

 

As I see it, there are two basic problems in how we have designed our government. The first is that officials favor policies with short-term impact over those in our long-term interest because they need to be popular while they are in office and they want to be re-elected. In recent times, opinion tracking polls, the immediate reactions of focus groups, the 24/7 news cycle, the constant campaign, and the moment-to-moment obsession with the Dow Jones Industrial Average have magnified the political pressures to favor short-term solutions. Earlier this year, the political topic du jour was to debate whether the stimulus was working, before it had even been spent.

 

Paul Volcker was an unusual public official because he was willing to make unpopular decisions in the early ’80s and was disliked at the time. History, though, judges him kindly for the era of prosperity that followed.

 

Presently, Ben Bernanke and Tim Geithner have become the quintessential short-term decision makers. They explicitly “do whatever it takes” to “solve one problem at a time” and deal with the unintended consequences later. It is too soon for history to evaluate their work, because there hasn’t been time for the unintended consequences of the “do whatever it takes” decision-making to materialize.

 

The second weakness in our government is “concentrated benefit versus diffuse harm” also known as the problem of special interests. Decision makers help small groups who care about narrow issues and whose “special interests” invest substantial resources to be better heard through lobbying, public relations and campaign support. The special interests benefit while the associated costs and consequences are spread broadly through the rest of the population. With individuals bearing a comparatively small extra burden, they are less motivated or able to fight in Washington.

 

In the context of the recent economic crisis, a highly motivated and organized banking lobby has demonstrated enormous influence. Bankers advance ideas like, “without banks, we would have no economy.” Of course, there was a public interest in protecting the guts of the system, but the ATMs could have continued working, even with forced debt-to-equity conversions that would not have required any public funds. Instead, our leaders responded by handing over hundreds of billions of taxpayer dollars to protect the speculative investments of bank shareholders and creditors. This has been particularly remarkable, considering that most agree that these same banks had an enormous role in creating this mess which has thrown millions out of their homes and jobs.

 

Like teenagers with their parents away, financial institutions threw a wild party that eventually tore-up the neighborhood. With their charge arrested and put in jail to detoxify, the supervisors were faced with a decision: Do we let the party goers learn a tough lesson or do we bail them out? Different parents with different philosophies might come to different decisions on this point. As you know our regulators went the bail-out route.

 

But then the question becomes, once you bail them out, what do you do to discipline the misbehavior? Our authorities have taken the response that kids will be kids. “What? You drank beer and then vodka. Are you kidding? Didn’t I teach you, beer before liquor, never sicker, liquor before beer, in the clear! Now, get back out there and have a good time.” And for the last few months we have seen the beginning of another party, which plays nicely toward government preferences for short-term favorable news-flow while satisfying the banking special interest. It has not done much to repair the damage to the neighborhood.

 

And the neighbors are angry, because at some level, Americans understand that the Washington-Wall Street relationship has rewarded the least deserving people and institutions at the expense of the prudent. They don’t know the particulars or how to argue against the “without banks, we have no economy” demagogues. So, they fight healthcare reform, where they have enough personal experience to equip them to argue with Congressmen at town hall meetings. As I see it, the revolt over healthcare isn’t really about healthcare, but represents a broader upset at Washington. The lack of trust over the inability to deal seriously with the party goers feeds the lack of trust over healthcare.

 

On the anniversary of Lehman’s failure, President Obama gave a terrific speech. He said, “Those on Wall Street cannot resume taking risks without regard for the consequences, and expect that next time, American taxpayers will be there to break the fall.” Later he advocated an end of “too big to fail.” Then he added, “For a market to function, those who invest and lend in that market must believe that their money is actually at risk.” These are good points that he should run by his policy team, because Secretary Geithner’s reform proposal does exactly the opposite.

 

The financial reform on the table is analogous to our response to airline terrorism by frisking grandma and taking away everyone’s shampoo, in that it gives the appearance of officially “doing something” and adds to our bureaucracy without really making anything safer.

 

With the ensuing government bailout, we have now institutionalized the idea of too-big-to-fail and insulated investors from risk.

 

The proper way to deal with too-big-to-fail, or too inter-connected to fail, is to make sure that no institution is too big or inter-connected to fail. The test ought to be that no institution should ever be of individual importance such that if we were faced with its demise the government would be forced to intervene. The real solution is to break up anything that fails that test.

 

The lesson of Lehman should not be that the government should have prevented its failure. The lesson of Lehman should be that Lehman should not have existed at a scale that allowed it to jeopardize the financial system. And the same logic applies to AIG, Fannie, Freddie, Bear Stearns, Citigroup and a couple dozen others.

 

Twenty-five years ago the government dismantled AT&T. Its break-up set forth decades of unbelievable progress in that industry. We can do that again here in the financial sector and we would achieve very positive social benefit with no cost that anyone can seem to explain.

 

The proposed reform takes us in the polar opposite direction. The cop-out response from Washington is that it isn’t “practical.” Our leaders are so influenced by the banking special interests that they would rather declare it “impractical” than roll up their sleeves and figure out how to get the job done.

 

The bailouts have installed a great deal of moral hazard, which in the absence of radical change will be reinforced and thereby grant every big institution a permanent “implicit” government backstop. This creates an enormous ongoing subsidy for the too-bigto-fails, as well as making it much harder for the non-too-big-to-fails to compete. In effect, we all continue to subsidize the big banks even though we keep hearing the worst of the crisis is behind us.

 

In addition, the now larger too-big-to-fails are beginning to take advantage of developing oligopolies. Even as the government spends trillions to subsidize mortgage rates, the resulting discount is not being passed to homeowners but is being kept by mortgage originators who are earning record profits per mortgage originated. Recently, Goldman upgraded Wells Fargo partly based on its ability to earn long-term oligopolistic mortgage origination spreads.

 

The proposed reform does not deal with the serious risks that the recent crisis exposed. Credit Default Swaps, which create large, correlated and asymmetric risks, scared the authorities into spending hundreds of billions of taxpayer money to prevent the speculators who made bad bets from having to pay.

 

CDS are also highly anti-social. Bondholders who also hold CDS make a bigger return when the issuing firms fail. As a result, holders of so-called “basis packages” – a bond and a CDS – have an incentive to use their position as bondholders to force bankruptcy triggering payment on their CDS, rather than negotiate traditional out of court restructurings or covenant amendments with troubled creditors. Press accounts have noted that this dynamic has contributed to the recent bankruptcies of Abitibi-Bowater, General Growth Properties, Six Flags and even General Motors. They are a pending problem in CIT’s efforts to avoid bankruptcy.

 

The reform proposal to create a CDS clearing house does nothing more than maintain private profits and socialized risks by moving the counter-party risk from the private sector to a newly created too-big-to-fail entity. I think that trying to make safer CDS is like trying to make safer asbestos. How many real businesses have to fail before policy makers decide to simply ban them?

 

Similarly, the money markets were exposed as creating systemic risk during the crisis. Apparently, investors in these pools of lending assets that carry no reserve for loss expect to be shielded from losing money while earning a higher return than bank deposits or T-bills. Mr. Bernanke decided they needed to be bailed out to save the system. It is hard to imagine why this structure shouldn’t be fixed, either by adding them to the FDIC insurance program and subjecting them to bank regulation, or at least forcing them to stop using $1 net-asset values, which gives their customers the impression that they can’t fall in value.

 

The most constructive aspect of the Geithner reform plan is to separate banking from commerce. This would have the effect of forcing industrial companies to divest big finance subsidiaries, which would have to be regulated as banks. During the bubble, companies like GMAC, AIG Financial Products and GE Capital, with cheap funding supported by inaccurate credit ratings, took enormous unregulated risks. When the crisis hit, GMAC and AIG needed huge federal bailouts. The Federal Reserve set up the Commercial Paper Funding Facility to backstop GE Capital among others, and GE became the largest borrower under the FDIC’s Temporary Liquidity Guarantee Program, even though prior to the crisis it wasn’t even in the FDIC.

 

In response to the Geithner proposal, GE immediately let it be known that it had “talked to a number of people in Congress” and it should not have to separate its finance subsidiary because it disingenuously asserted that it hadn’t contributed to the crisis. We will see whether the GE special interest is able to stave-off this constructive reform proposal.

 

Rather than deal with these simple problems with simple, obvious solutions, the official reform plans are complicated, convoluted and designed to only have the veneer of reform while mostly serving the special interests. The complications serve to reduce transparency, preventing the public at large from really seeing the overwhelming influence of the banks in shaping the new regulation.

 

In dealing with the continued weak economy, our leaders are so determined not to repeat the perceived mistakes of the 1930s that they are risking policies with possibly far worse consequences designed by the same people at the Fed who ran policy with the short-term view that asset bubbles don’t matter because the fallout can be managed after they pop. That view created a disaster that required unprecedented intervention for which our leaders congratulated themselves for doing whatever it took to solve. With a sense of mission accomplished, the G-20 proclaimed “it worked.”

 

We are now being told that the most important thing is to not remove the fiscal and monetary support too soon. Christine Romer, a top advisor to the President, argues that we made a great mistake by withdrawing stimulus in 1937.

 

Just to review, in 1934 GDP grew 17.0%, in 1935 it grew another 11.1%, and in 1936 it grew another 14.3%. Over the period unemployment fell by 30%. That is three years of progress. Apparently, even this would not have been enough to achieve what Larry Summers has called “exit velocity.”

 

Imagine, in our modern market, where we now get economic data on practically a daily basis, living through three years of favorable economic reports and deciding that it would be “premature” to withdraw the stimulus.

 

An alternative lesson from the double dip the economy took in 1938 is that the GDP created by massive fiscal stimulus is artificial. So whenever it is eventually removed, there will be significant economic fall out. Our choice may be either to maintain large annual deficits until our creditors refuse to finance them or tolerate another leg down in our economy by accepting some measure of fiscal discipline.

 

This brings me to our present fiscal situation and the current investment puzzle.

 

Over the next decade the welfare states will come to face severe demographic problems. Baby Boomers have driven the U.S. economy since they were born. It is no coincidence that we experienced an economic boom between 1980 and 2000, as the Boomers reached their peak productive years. The Boomers are now reaching retirement. The Social Security and Medicare commitments to them are astronomical.

 

When the government calculates its debt and deficit it does so on a cash basis. This means that deficit accounting does not take into account the cost of future promises until the money goes out the door. According to shadowstats.com, if the federal government counted the cost of its future promises, the 2008 deficit was over $5 trillion and total obligations are over $60 trillion. And that was before the crisis.

 

Over the last couple of years we have adopted a policy of private profits and socialized risks. We are transferring many private obligations onto the national ledger. Although our leaders ought to make some serious choices, they appear too trapped in short-termism and special interests to make them. Taking no action is an action.

 

In the nearer-term the deficit on a cash basis is about $1.6 trillion or 11% of GDP. President Obama forecasts $1.4 trillion next year, and with an optimistic economic outlook, $9 trillion over the next decade. The American Enterprise Institute for Public Policy Research recently published a study that indicated that “by all relevant debt indicators, the U.S. fiscal scenario will soon approximate the economic scenario for countries on the verge of a sovereign debt default.”

 

As we sit here today, the Federal Reserve is propping up the bond market, buying long-dated assets with printed money. It cannot turn around and sell what it has just bought.

 

There is a basic rule of liquidity. It isn’t the same for everyone. If you own 10,000 shares of Greenlight Re, you have a liquid investment. However, if I own 5 million shares it is not liquid to me, because of both the size of the position and the signal my selling would send to the market. For this reason, the Fed cannot sell its Treasuries or Agencies without destroying the market. This means that it will be challenged to shrink the monetary base if inflation actually turns up.

 

Further, the Federal Open Market Committee members may not recognize inflation when they see it, as looking at inflation solely through the prices of goods and services, while ignoring asset inflation, can lead to a repeat of the last policy error of holding rates too low for too long.

 

At the same time, the Treasury has dramatically shortened the duration of the government debt. As a result, higher rates become a fiscal issue, not just a monetary one. The Fed could reach the point where it perceives doing whatever it takes requires it to become the buyer of Treasuries of first and last resort.

 

Japan appears even more vulnerable, because it is even more indebted and its poor demographics are a decade ahead of ours. Japan may already be past the point of no return. When a country cannot reduce its ratio of debt to GDP over any time horizon, it means it can only refinance, but can never repay its debts. Japan has about 190% debt-to-GDP financed at an average cost of less than 2%. Even with the benefit of cheap financing the Japanese deficit is expected to be 10% of GDP this year. At some point, as American homeowners with teaser interest rates have learned, when the market refuses to refinance at cheap rates, problems quickly emerge. Imagine the fiscal impact of the market resetting Japanese borrowing costs to 5%.

 

Over the last few years, Japanese savers have been willing to finance their government deficit. However, with Japan’s population aging, it’s likely that the domestic savers will begin using those savings to fund their retirements. The newly elected DPJ party that favors domestic consumption might speed up this development. Should the market re-price Japanese credit risk, it is hard to see how Japan could avoid a government default or hyperinflationary currency death spiral.

 

The failure of Lehman meant that barring extraordinary measures, Merrill Lynch, Morgan Stanley and Goldman Sachs would have failed as the credit market realized that if the government were willing to permit failures, then the cost of financing such institutions needed to be re-priced so as to invalidate their business models.

 

I believe there is a real possibility that the collapse of any of the major currencies could have a similar domino effect on re-assessing the credit risk of the other fiat currencies run by countries with structural deficits and large, unfunded commitments to aging populations.

 

I believe that the conventional view that government bonds should be “risk free” and tied to nominal GDP is at risk of changing. Periodically, high quality corporate bonds have traded at lower yields than sovereign debt. That could happen again.

 

And, of course, these structural risks are exacerbated by the continued presence of credit rating agencies that inspire false confidence with potentially catastrophic results by over-rating the sovereign debt of the largest countries. There is no reason to believe that the rating agencies will do a better job on sovereign risk than they have done on corporate or structured finance risks.

 

My firm recently met with a Moody’s sovereign risk team covering twenty countries in Asia and the Middle East. They have only four professionals covering the entire region. Moody’s does not have a long-term quantitative model that incorporates changes in the population, incomes, expected tax rates, and so forth. They use a short-term outlook – only 12-18 months – to analyze data to assess countries’ abilities to finance themselves. Moody’s makes five-year medium-term qualitative assessments for each country, but does not appear to do any long-term quantitative or critical work.

 

Their main role, again, appears to be to tell everyone that things are fine, until a real crisis emerges at which point they will pile-on credit downgrades at the least opportune moment, making a difficult situation even more difficult for the authorities to manage.

 

I can just envision a future Congressional Hearing so elected officials can blame the rating agencies for blowing it, as the rating agencies respond by blaming Congress.

 

Now, the question for us as investors is how to manage some of these possible risks. Four years ago I spoke at this conference and said that I favored my Grandma Cookie’s investment style of investing in stocks like Nike, IBM, McDonalds and Walgreens over my Grandpa Ben’s style of buying gold bullion and gold stocks. He feared the economic ruin of our country through a paper money and deficit driven hyper inflation. I explained how Grandma Cookie had been right for the last thirty years and would probably be right for the next thirty as well. I subscribed to Warren Buffett’s old criticism that gold just sits there with no yield and viewed gold’s long-term value as difficult to assess.

 

However, the recent crisis has changed my view. The question can be flipped: how does one know what the dollar is worth given that dollars can be created out of thin air or dropped from helicopters? Just because something hasn’t happened, doesn’t mean it won’t. Yes, we should continue to buy stocks in great companies, but there is room for Grandpa Ben’s view as well.

 

I have seen many people debate whether gold is a bet on inflation or deflation. As I see it, it is neither. Gold does well when monetary and fiscal policies are poor and does poorly when they appear sensible. Gold did very well during the Great Depression when FDR debased the currency. It did well again in the money printing 1970s, but collapsed in response to Paul Volcker’s austerity. It ultimately made a bottom around 2001 when the excitement about our future budget surpluses peaked.

 

Prospectively, gold should do fine unless our leaders implement much greater fiscal and monetary restraint than appears likely. Of course, gold should do very well if there is a sovereign debt default or currency crisis.

 

A few weeks ago, the Office of Inspector General called out the Treasury Department for misrepresenting the position of the banks last fall. The Treasury’s response was an unapologetic expression that amounted to saying that at that point “doing whatever it takes” meant pulling a Colonel Jessup: “YOU CAN’T HANDLE THE TRUTH!” At least we know what we are dealing with.

 

When I watch Chairman Bernanke, Secretary Geithner and Mr. Summers on TV, read speeches written by the Fed Governors, observe the “stimulus” black hole, and think about our short-termism and lack of fiscal discipline and political will, my instinct is to want to short the dollar. But then I look at the other major currencies. The Euro, the Yen, and the British Pound might be worse. So, I conclude that picking one these currencies is like choosing my favorite dental procedure. And I decide holding gold is better than holding cash, especially now, where both earn no yield.

 

Along these same lines, we have bought long-dated options on much higher U.S. and Japanese interest rates. The options in Japan are particularly cheap because the historical volatility is so low. I prefer options to simply shorting government bonds, because there remains a possibility of a further government bond rally in response to the economy rolling over again. With options, I can clearly limit how much I am willing to lose, while creating a lot of leverage to a possible rate spiral.

 

For years, the discussion has been that our deficit spending will pass the costs onto “our grandchildren.” I believe that this is no longer the case and that the consequences will be seen during the lifetime of the leaders who have pursued short-term popularity over our solvency. The recent economic crisis and our response has brought forward the eventual reconciliation into a window that is near enough that it makes sense for investors to buy some insurance to protect themselves from a possible systemic event. To slightly modify Alexis de Tocqueville: Events can move from the impossible to the inevitable without ever stopping at the probable.

 

As investors, we can’t change the course of events, but we can attempt to protect capital in the face of foreseeable risks.

 

Of course, just like MDC, there remains the possibility that I am completely wrong. And, personally, I hope I am. I wonder what Stan Druckenmiller thinks.

‘MONEY TALKS TO HAVE BEFORE MARRIAGE,’ by Ron Lieber in the N. Y. Times.

Divorce tends to be emotionally gut-wrenching for the people who go through it (not to mention those around them). But most couples don’t realize that divorce can also be among the most ruinous financial moves anyone can make.

Sure, you could bet big and lose on a single stock or money manager. Or your small business could go bankrupt, taking your life savings with it. But divorce and the costs that often come with it — from legal bills to the sudden need for an additional residence — affect far more people.

The risk that any marriage will end in divorce is about 45 percent, according to David Popenoe, a professor of sociology emeritus at Rutgers University. The chances fall to about 40 percent for first marriages and decline further for college-educated couples, people from intact families and couples who share the same religion.

Given the various financial complications, I’ve long wanted to devote a series of columns to divorce and money. This week, I’ll start with a topic that could save some marriages if more people made it a priority. It’s crucial to air and resolve financial disagreements beforehand.

“It’s almost impossible to be hooked up to somebody who has the same balance of spender and saver as you, or expansiveness versus conservativeness or financial circumstances,” says Gregory A. Kuhlman, a New York City psychologist who runs marriage success training programs with his wife, Patricia Schell Kuhlman.

He adds that the mix gets even more volatile with second marriages, when couples may have children, ingrained financial habits and savings or other assets that necessitate the discussion of a prenuptial agreement. “Success in marriage is only partly attributable to compatibility. It’s about how you manage those differences and whether you have a style for doing so that is successful.”

What follows is a list of four financial issues that ought to be near the top of the discussion list before getting married. Please add to the list in the comments of the online version of this article.

ANCESTRY When Lisa J. B. Peterson started her Boston-based financial planning firm, Lantern Financial, she knew she wanted to focus her practice on young professionals. She quickly realized that many of them could use premarital financial counseling and built a program called Harmoney around their needs.

One of the first things she asks clients about is what she refers to as their financial ancestry. “It’s looking back at your own personal past,” she says. “How did your parents deal with money, how does that impact how you deal with it, and how might that impact the couple’s relationship?”

Because so many of our money behaviors are learned, she asks couples to share their earliest money memories — whether their father hid money from their mother or how either parent fretted over the funds available. This can be a particularly intense discussion for people whose parents were divorced, and the stories are sometimes accompanied by tears. “Money is so emotional, and people forget that,” Ms. Peterson says. “You think that it’s just numbers.”

CREDIT While it’s about the least romantic subject imaginable, your credit history holds a chunk of your permanent financial record. It follows naturally from the ancestry conversation, and Lantern Financial pulls credit reports and scores for its clients.

Molly Milinazzo and Scott Donovan, an engaged couple who live in the Dorchester section of Boston and are both 24 years old, were relieved to discover that their scores were within about 15 points of one another when they went through the Harmoney program in May. “A lot of people end up surprised, and it’s best to keep those kinds of surprises at bay,” Ms. Milinazzo says.

Full disclosure on the credit front is useful for two reasons. First, a credit report is, in part, a catalog of past mistakes and overall habits — loan payments you missed or department store credit cards you didn’t really need. That in itself is a good starting point for a discussion about what you’ve learned (or still need to learn) about handling money.

There’s an immediate practical side to this, too. If there are errors or low credit scores that a couple can improve, there may still be time to make the fixes so that the couple can get the best rates on a loan for their first home a year or two later.

CONTROL Figuring out who will pay the bills each month may not seem to be an important conversation or assignment. But it gets tricky when both people want to take it on. “People understand that in a relationship, money is control,” says Jeff Kostis, a financial planner in Vernon Hills, Ill., who walks engaged couples and newlyweds through a checklist of questions. “If you’re not paying the bills, you don’t know where the money is going, and you feel like ‘He doesn’t want me to go out with my friends’ or ‘She doesn’t want me to play in the fantasy football pool.’ ”

For two people who have both been on their own for a while and don’t want to give up doing the monthly financial chores their own way, Mr. Kostis suggests, at a minimum, regular household meetings complete with Quicken or other spreadsheets so that the person writing the checks can keep the other one up to speed. With more stubborn couples, he might suggest handing the controls back and forth at the beginning of each year.

Mr. Kuhlman, who explains the counseling approach he and his wife take with clients at stayhitched.com, says it shouldn’t be surprising that control issues come up constantly when talking about money. “It’s concrete, you can see it,” he says. “It’s not ephemeral or less measurable, like affection.”

A few things that he suggests couples discuss early on: If one person is making most or all of the money, does that person get to make most or all of the financial decisions? If you’re the car aficionado or have researched all of the local school options for the children, do you get to make the decisions about those things? “These are the kinds of things that don’t come out when you’re dating,” he says.

AFFLUENCE Here’s another question that tends not to come up during courtship: Just how rich do we want to be one day? Mr. Kuhlman refers to this more politely as the “desired level of affluence.” “Are our career paths going to be something that pulls us together? Or, more often, are they things that will tend to pull us apart, where we’ll really have to be proactive to make sure it’s under control?” he says.

Mr. Kostis might put it a bit more bluntly, say to a spouse of an aspiring investment banker or corporate lawyer: Are you O.K. with acting essentially as a single parent, with your partner working 80 hours a week until the age of 80? “Not that there is a right or wrong answer,” he says. “It’s just about understanding, going into the marriage, what that would really mean.”

He adds that people in the financial advice business often joke that they spend half their time talking about money and the other half acting as marriage counselor. “But it’s the same communication style,” he says. “You’re giving people permission to be honest without having someone jump down their throat for giving the answer that they really want to give.”

What did your divorce cost you? Write to rlieber@nytimes.com.

‘APPLE AND GOOGLE. THE IDEAL BUY-AND-HOLDS?,’ by James B. Stewart at smartmoney. com.

Apple and Google: The ideal buy-and-holds?

BY  JAMES B. STEWART,  SMARTMONEY — 10/20/09

I’ve often made the point that it doesn’t take a lot of great investment ideas to outperform market averages. Sometimes it only takes one, or, in the present case, two.

This week I’ve been pinching myself at the good fortune to have Google (GOOG)  and Apple (AAPL) as two of my core holdings. I hope legions of Common Sense readers are experiencing the same sensation, since I’ve been vigorously recommending these innovative companies for years, most recently championing them (and adding to my holdings) during the recent slump.

After plunging to below $260 a share in November, Google has more than doubled, to about $550 a share. Apple shares have performed even better, hitting $200 intraday this week after sinking to about $78 in January. With holdings like this, it isn’t hard to surpass the S&P 500’s (.SPX)  impressive 60% trough-to-peak rise from March until now.

Even better, from my perspective, is that the gains in both stocks have been powered by solid earnings results, including the much-better-than-expected profits reported in recent days. The results indicate that Google and Apple can not only survive the worst of times, but should positively thrive during the recovery. The results reflect my conviction that both are the beneficiaries of unique competitive advantages that should propel gains for years to come — my original investment thesis for these stocks.

Google is, in my view, the rare natural monopoly. The quality of Internet search is strengthened by volume, and no one can or will match Google’s head start and share of total searches. Microsoft’s (MSFT)  hapless efforts only reinforce my conviction. Although Google remains under close antitrust scrutiny, it’s important to bear in mind that natural monopolies aren’t illegal (as opposed to anticompetitive behavior or conspiracies.)

The case for Apple is less straightforward, and I was slower to embrace it than Google, a stock I’ve owned since its public offering. Apple has seized a technological advantage with the iPhone, no small feat considering the entrenched competitors it faced. But that advantage could erode. What impresses me is how Apple is creating a seamless world of interconnected devices that will someday link all aspects of communication, entertainment and computing. I can hardly wait to see the much-rumored new tablet device that’s expected to take on Amazon’s (AMZN) Kindle.

Like all stocks, Google and Apple go down as well as up, and you could argue that now might be an ideal time to take profits, given all the recent good news and the market’s strong overall rise. I wouldn’t object if some readers told me they wanted to take some money off the table. But I won’t be among them. I consider Google and Apple to be the ultimate buy-and-hold stocks as long as my investment thesis remains sound. I have used pullbacks, such as those during the past year, to add to my positions, in some cases by buying calls. (In addition to owning shares of Google and Apple, I also currently own call options in both that expire in 2011.)

My continuing belief in these stocks also reflects my belief that when it comes to individual stocks, most investors are best served by owning a relatively small number of positions in which they have a strong conviction. There simply aren’t that many great investment ideas at any given time, which is one reason that I don’t recommend specific stocks every week. This strategy also keeps transaction costs to a minimum.

Nor do most investors have the time and expertise to follow a large number of companies. I’ve seen too many portfolios that pretty much mirror the S&P 500. Such investors would be better off owning a low-cost index fund, supplemented by the few individual stocks they strongly believe in.

This is the opposite approach from that embraced by the Galleon Group hedge fund, whose billionaire head, Raj Rajaratnam, was charged with insider trading last week. Whatever the merits of this fascinating case (Rajaratnam has insisted he’s innocent), some accounts describe a culture where Galleon employees were under intense pressure to generate constant trading ideas and gain an “edge.” Ironically, two of Galleon’s biggest holdings were Google and Apple, according to Securities and Exchange Commission filings. How much better it would have been for all concerned, including Galleon’s investors and certainly for Rajaratnam, had the funds simply bought and held those two stocks.

© 2009 SmartMoney. SmartMoney is a joint publishing venture of Dow Jones & Company, Inc. and HearstSM Partnership. SmartMoney is a registered trademark. All Rights Reserved.

‘U.S. JOINS THE RANKS OF FAILED STATES, by Paul Craig Roberts at creators.com. ‘LET EM EAT CAKE,’ is one of the nicer things the Masters say about the working stiff/tax-paying/ peasant class.

U.S. Joins Ranks of Failed States

The U.S. has every characteristic of a failed state.

The U.S. government’s current operating budget is dependent on foreign financing and money creation.

Too politically weak to be able to advance its interests through diplomacy, the U.S. relies on terrorism and military aggression.

Costs are out of control, and priorities are skewed in the interest of rich organized interest groups at the expense of the vast majority of citizens. For example, war at all cost — which enriches the armaments industry, the officer corps and the financial firms that handle the war’s financing — takes precedence over the needs of American citizens. There is no money to provide the uninsured with health care, but Pentagon officials have told the Defense Appropriations Subcommittee in the House that every gallon of gasoline delivered to U.S. troops in Afghanistan costs American taxpayers $400.

“It is a number that we were not aware of, and it is worrisome,” said Rep. John Murtha, chairman of the subcommittee.

According to reports, the U.S. Marines in Afghanistan use 800,000 gallons of gasoline per day. At $400 per gallon, that comes to a $320,000,000 daily fuel bill for the Marines alone. Only a country totally out of control would squander resources in this way.

While the U.S. government squanders $400 per gallon of gasoline in order to kill women and children in Afghanistan, many millions of Americans have lost their jobs and their homes and are experiencing the kind of misery that is the daily life of poor Third World peoples. Americans are living in their cars and in public parks. America’s cities, towns and states are suffering from the costs of economic dislocations and the reduction in tax revenues from the economy’s decline. Yet, Obama has sent more troops to Afghanistan, a country halfway around the world that is not a threat to America.

It costs $750,000 per year for each soldier we have in Afghanistan. The soldiers, who are at risk of life and limb, are paid a pittance, but all of the privatized services to the military are rolling in excess profits. One of the great frauds perpetuated on the American people was the privatization of services that the U.S. military traditionally performed for itself. “Our” elected leaders could not resist any opportunity to create at taxpayers’ expense private wealth that could be recycled to politicians in campaign contributions.

Republicans and Democrats on the take from the private insurance companies maintain that the U.S. cannot afford to provide Americans with health care and that cuts must be made even in Social Security and Medicare.

So how can the U.S. afford bankrupting wars, much less totally pointless wars that serve no American interest?

The enormous scale of foreign borrowing and money creation necessary to finance Washington’s wars are sending the dollar to historic lows. The dollar has even experienced large declines relative to currencies of Third World countries such as Botswana and Brazil. The decline in the dollar’s value reduces the purchasing power of Americans’ already declining incomes.

Despite the lowest level of housing starts in 64 years, the U.S. housing market is flooded with unsold homes, and financial institutions have a huge and rising inventory of foreclosed homes not yet on the market.

Industrial production has collapsed to the level of 1999, wiping out a decade of growth in industrial output.

The enormous bank reserves created by the Federal Reserve are not finding their way into the economy. Instead, the banks are hoarding the reserves as insurance against the fraudulent derivatives that they purchased from the gangster Wall Street investment banks.

The regulatory agencies have been corrupted by private interests. “Frontline” reports that Alan Greenspan, Robert Rubin and Larry Summers blocked Brooksley Born, the head of the Commodity Futures Trading Commission, from regulating derivatives. President Obama rewarded Larry Summers for his idiocy by appointing him director of the National Economic Council. What this means is that profits for Wall Street will continue to be leeched from the diminishing blood supply of the American economy.

An unmistakable sign of Third World despotism is a police force that sees the pubic as the enemy. Thanks to the federal government, our local police forces are now militarized and imbued with hostile attitudes toward the public. SWAT teams have proliferated, and even small towns now have police forces with the firepower of U.S. Special Forces.

Summons are increasingly delivered by SWAT teams that tyrannize citizens with broken down doors, a $400 or $500 repair born by the tyrannized resident. Recently, a mayor and his family were the recipients of incompetence by the town’s local SWAT team, which mistakenly wrecked the mayor’s home, terrorized his family and killed the family’s two friendly Labrador dogs.

If a town’s mayor can be treated in this way, what do you think is the fate of the poor white or black? Or the idealistic student who protests his government’s inhumanity?

In any failed state, the greatest threat to the population comes from the government and the police. That is certainly the situation today in the U.S.A. Americans have no greater enemy than their own government. Washington is controlled by interest groups that enrich themselves at the expense of the American people.

The 1 percent that comprise the superrich are laughing as they say, “Let them eat cake.”

To find out more about Paul Craig Roberts, and read features by other Creators Syndicate writers and cartoonists, visit the Creators Syndicate web page at www.creators.com.

COPYRIGHT 2009 CREATORS.COM

‘IN THIS 10-YEAR RACE, BONDS WIN BY A MILE,’ by Jeff Sommer in the N.Y. Times today. MERCI PAUL HORNE.

http://www.nytimes.com  /2009/10/25/business /economy /25mark.html ?_r=1&ref =business& pagewanted=print

October 25, 2009

In This 10-Year Race, Bonds Win by a Mile

By JEFF SOMMER

WHEN the Dow Jones industrial average climbed back to 10,000 this month, the achievement was widely noted but barely celebrated, and for good reason.

“Haven’t we done this several times before?” asked Edward Yardeni, the economist and investment strategist.

In fact, we had. The Dow had crossed 10,000 on more than 20 occasions, starting in late March 1999, when the market was so hot that stock-picking seemed to have become the national pastime. In that year, the book “Dow 36,000” confidently declared that stocks were “actually less risky than bonds” and that the Dow would more than triple in value within a few short years.

As investors know all too well, the financial history of the last decade turned out a bit differently. Stocks proved to be extremely risky. Despite the recent rally, in the 10 years through September, most stock investors lost money.

What may be less widely understood is that over that same 10 years, while the stock market’s overall returns were disappointing, the bond market produced handsome gains. Bond rallies have not generated the hoopla that the stock market customarily receives, but over the last 10 years, investors have had more reason to celebrate if they held bonds, not stocks, in their portfolios.

Calculations performed for Sunday Business by Morningstar, using data from its Ibbotson Associates subsidiary, show that the stock market underperformed important bond categories over the 10 years through September — with an annualized loss of 0.2 percent for the Standard & Poor’s 500-stock index, versus annualized gains of 8.1 percent for long-term government bonds and of 7.8 percent for long-term corporate bonds.

What’s more, the S.& P. 500 underperformed long-term government and long-term corporate bonds over the last 20 years as well. Over longer periods — 30 years, 40 years, and in an 83-year stretch from 1926 to 2009 — the Ibbotson numbers indicate that stocks did outperform bonds, sometimes by more than three percentage points, annualized. But bonds were far less volatile throughout. And the further back in history you go, the less directly comparable is the data.

Writing in the May-June issue of the “Journal of Indexes,” Robert Arnott, chief executive of the investment firm Research Affiliates in Newport Beach, Calif., declared that bonds had been neglected by the financial press and by many investors. He reviewed market returns going back 207 years, and found that stocks outperformed bonds by only 2.5 percentage points, annualized. This “2.5 percentage point advantage over two centuries compounds mightily over time,” he said. But for very long stretches, bonds have done better than stocks.

The wild ride of the last decade or so does not mean that stocks will underperform bonds in the months or years ahead. If only it were that simple.

For one thing, past returns never provide a clear guide for the future — especially when technology, innovation and government policies are changing the structure of financial markets and transforming the global economy as rapidly as they are right now.

For another, it can be argued that the recent stretch of relative stock market weakness and bond market strength is precisely why stocks are likely to do better than bonds. Jeremy J. Siegel, a finance professor at the Wharton School of the University of Pennsylvania and the author of “Stocks for the Long Run,” advocates stock holdings for people with long horizons but acknowledges that some periods have been painful for equities.

He says that the environment is auspicious again. “Historically, whenever you’ve had long periods when bonds outperform stocks, that sets up an excellent time to invest in stocks,” he said. “So looking forward, things look very favorable for stocks and not favorable for bonds, certainly not Treasury bonds.”

In part because of market intervention by the Federal Reserve, yields on long-term Treasury bonds remain extremely low, and prices, which move in the opposite direction, are high. When and if the economy recovers, bond yields are likely to rise and prices are likely to fall. Low yields, meanwhile, make it cheaper for many companies to finance their operations, which could help generate outsize profits.

Laszlo Birinyi, president of Birinyi Associates, a stock market research firm in Westport, Conn., who says he believes that we are in the middle of a vigorous bull market for stocks, has studied the long-term returns of many asset classes. He has found that from 1970 to 2008, emerging-market stocks outperformed the S.& P. 500, the bond market and alternative assets like oil, gold, real estate and diamonds.

But Mr. Birinyi recommends sticking mainly with domestic stocks and bonds, perhaps adding a sprinkling of foreign stocks that “don’t replicate your domestic stock holdings.”

“My issue with diversification beyond that,” Mr. Birinyi said, “is that an incremental or arithmetic increase in the number of decisions you make leads to a geometric increase in the degree of difficulty.”

The logic for treating domestic stocks and bonds as the two central asset classes was outlined in the 1930s by Benjamin Graham and David Dodd, the fathers of value investing. In their classic work, “Security Analysis,” they emphasized safety — favoring bonds, and only those of the highest quality, as far more suitable for small investors than stocks, which attracted “speculators.”

Because shares of common stock are much riskier than bonds, they need to have the potential for a much higher return to induce investors to hold them, Mr. Graham and Mr. Dodd said. But they wouldn’t have been surprised by long stretches of bond market outperformance

‘WHO IS SMARTER: VANGUARD OR FIDELITY INVESTORS?,’ at Morningstar Information.

I find Morningstar Investor Returns data fascinating. Recently, I looked at the gap between total returns and investor returns across the Morningstar Style Box and found that it had widened significantly. While looking at those figures, I wondered how they worked out on a fund company level. By asset weighting investor returns on a fund company level, I could find out whose shareholders fared better. Or, put another way, whose shareholders are smarter?

About the AuthorRussel Kinnel is Morningstar’s director of mutual fund research. He is also the editor of Morningstar FundInvestor, a monthly newsletter dedicated to helping investors pick great mutual funds, build winning portfolios, and monitor their funds for greater gains. Kinnel would like to hear from readers, but no financial-planning questions, please. Contact Author | Meet other investing specialists

As you may recall, investor returns are calculated by adjusting returns for flows in and out of funds in order to arrive at an estimate of the average investor’s return in the fund. As I pointed out in my comparison of  CGM Focus’ (CGMFX

)  investor returns with  T. Rowe Price Equity Income’s (PRFDX

), steady returns at T. Rowe Price Equity Income led to steady flows and typically solid investor returns. However, CGM Focus’ investor returns were much worse than its total returns because a huge portion of its shareholder base came into the fund in 2007 and the first half of 2008 when performance was great only to get whipsawed when performance slowed. While the gap between the two return figures is interesting, investor returns are really the bottom line. I’d feel better about CGM Focus if it had a big gap but its investor returns were still strong.

For my first fund company smack down, I went straight to the fund industry’s Montagues and Capulets (substitute Hatfields and McCoys or Wolverines and Buckeyes if you prefer): Vanguard and Fidelity. To be fair, many investors have accounts with both companies, and I’m one of those–so please take this in the spirit of fun that it is intended.

To gauge whose investors are smarter or better off, I looked at 10-year returns through September 2009. I limited the study to funds that were in existence for the whole 10 years. While that could introduce serious survivorship bias for shops like Columbia and BlackRock, which have eliminated a lot of funds, Vanguard and Fidelity don’t kill off many funds. We looked at investments by asset class and overall.

The Winner Is …

Vanguard. Collectively, Vanguard investors earned a 2.63% annualized 10-year return compared with an annualized 1.52% for Fidelity investors. The asset-weighted total returns for the two firms were closer than the investor returns. Vanguard’s overall figure was 3.42% compared with 3.06%. Vanguard shareholders outperformed Fidelity shareholders in U.S. stock funds, taxable bonds, and balanced funds–the first two are the biggest asset classes at both shops. Fidelity shareholders did better in international and alternative assets. The firm’s municipal-bond shareholders finished within a basis point, so I’m calling that a draw.

The story on domestic stocks reflects the challenges that both firms have faced this decade. Large-cap stocks haven’t done much, but that’s naturally where most big equity operations will have most of their money. Performance of the most important cap-weighted indexes that Vanguard tracks has been tepid. For example,  Vanguard Total Stock Market Index’s (VTSMX

)  10-year return through the third quarter is 0.84% annualized–that’s a little better than the average large-blend fund but in absolute terms not great. However, performance has at least been steady: The fund finishes most calendar years in the second quartile.

On the flip side, Fidelity has had a few wonderfully consistent managers like Will Danoff and Joel Tillinghast, but many other funds like  Independence (FDFFX

),  Magellan (FMAGX

),  Export & Multinational (FEXPX

), and  Dividend Growth (FDGFX

) have been roller-coaster rides with big shifts in performance, some of which led to a manager change. Thus, a 1.92% total return for the funds withered to an investor return of 0.66%.

The story on munis is also interesting. There, Fidelity beat Vanguard by 43 basis points annualized on total returns but its shareholders had the same returns as Vanguard’s. The reason is that Fidelity investors redeemed about twice the percentage of assets as Vanguard investors did in the fourth quarter of 2008. Both came back when munis rallied in the first quarter of 2009, but the Fidelity investors missed enough to bring their returns back down to Vanguard investors’ level.

Fidelity produced superior international total returns and investor returns through steadier performance and a sizable dose of emerging markets.  Fidelity Diversified International (FDIVX

)  is by far the biggest of Fidelity’s foreign group. In the first half of the decade, it had great returns, and, while returns have been middling in the second half, that wasn’t enough to throw investors. Other funds like  Fidelity International Discovery (FIGRX

) and  Fidelity Emerging Markets (FEMKX

) have strong returns in the past five years, and that means those who did get in have largely been rewarded.

Asset-Weighted 10-Year Investor and Total Returns by Broad Asset Group for Two Fund Families

FamilyCategory Group10-Year Investor Return10-Year Total ReturnFidelity InvestmentsAlternative13.3915.48Fidelity InvestmentsBalanced2.463.71Fidelity InvestmentsInternational Stock2.945.92Fidelity InvestmentsMunicipal Bond3.705.40Fidelity InvestmentsTaxable Bond3.655.87Fidelity InvestmentsU.S. Stock0.661.92Fidelity InvestmentsOverall1.523.06VanguardAlternative12.7216.13VanguardBalanced4.144.78VanguardInternational Stock2.354.55VanguardMunicipal Bond3.714.97VanguardTaxable Bond4.345.95VanguardU.S. Stock1.802.16VanguardOverall2.633.42

10-year returns as of 9/30/09.

What It Means

Vanguard has produced steadier performance and that makes for better investor results. Both its passive and active strategies have been more dependable on the equity side. Fidelity’s challenge in domestic equities is not just to produce better performance but to be able to maintain that performance edge and tone down manager changes.

It’s possible that the performance gap also has something to do with each firm’s message to investors. Vanguard preaches long-term investing and goes so far as to warn investors away from hot-performing funds. Just this month, it closed  Vanguard Capital Value (VCVLX

)  because too much hot money was coming in. Fidelity also preaches long-term investing, but it sometimes nudges people to invest based on short-term results. Shortly before Fidelity Independence tanked, for example, Fidelity was advertising the fund heavily even though it had just changed managers on the fund. When you draw a big line under one-year or three-year performance, investors will naturally sell your fund when its one-year or three-year performance is weak. Unfortunately, that’s often the time that the fund is about to rebound.

Where I Placed My Bets

Vanguard and Fidelity offer quite a lot, so I have accounts with both. I go to Fidelity for its index funds, muni funds, and money markets. I go to Vanguard for its actively managed stock funds and one index fund. And I’m a patient investor so that I can be there when the rally starts or at least close enough. My Vanguard holdings include the closed  Capital Opportunity (VHCOX

) and  Vanguard Primecap Core (VPCCX

) as well as the still-open  Vanguard International Growth (VWILX

) and  Vanguard FTSE Social Index (VFTSX

). I’ve owned Cap Opp and International Growth since the mid-1990s. At Fidelity, I own  Fidelity Tax-Free Bond (FTABX

),  Fidelity Spartan Total Market Index (FSTVX

), and  Fidelity Spartan International Index (FSIVX.

)

~~A MUST READ/STUDY/ADOPT-ASAP!!! ~~ ‘A WELLNESS PROGRAM FOR A HOLISTIC ECONOMY,’ by Anand Giridhardas in the Herald Tribune. ASTOUNDING BIT OF WRITING & WISDOM.

Employment won’t throb. The circulation of capital remains weak. Industry is breathing, but barely. And if we can agree on anything one year into this mess, it is that there is little we can do when the patient arrives already this bad.

That is why the talk now is so often of prevention. Prevent the next crisis through health insurance and a green-energy sector, the American president says. Prevent it by cutting spending and nurturing personal responsibility, American conservatives retort.

But the truth is that politicians, and not just in the United States, are rarely willing to invest in a problem that hasn’t occurred. Consensus and action are easier to come by after a 9/11 or a Lehman Brothers than before. Problems in the embryonic, soluble phase don’t interest us; and those that do interest us are often too big to solve.

Which is where acupuncture comes in.

Western medical practices have attracted similar criticisms in recent years, for an emphasis on intervening in disease rather than preventing it beforehand and promoting quotidian well-being. But in health, unlike politics, an alternative approach called wellness has emerged, focused on investing in health before it breaks down.

What can wellness tell us about our present economic malady? As it moves from fringe to mainstream — with wellness programs in the health care reform proposals now in Congress, wellness manifestos on the best-seller lists and a U.S. Army wellness program that asks soldiers to introspect and meditate — I asked experts about the approach’s core tenets and how they might be applied to the body politic.

Nip it in the bud. Wellness argues for cultivating health a little every day, not just restoring it during calamities. We increasingly accept that it is better to monitor a diabetic’s blood sugar with regular clinic visits than to amputate her limbs. We accept that businesses can avoid costly cancer treatments by encouraging workers to stop smoking. But in our political life, we prefer to wait until things reach the emergency room.

We barely regulate financial markets for years, thinking regulation oppressive, until we are compelled to nationalize private firms. We avoid expensive investments and controversial new methods in public education, then pay the price in lower social mobility and vast prison populations. We neglect building roads and bridges and Internet highways, fearing the cost, and then reap the much greater costs of whole regions falling off the economic grid.

“With a lot of social problems, we’re not sure how to prevent it, and therefore we don’t spend money on it, because we always have a lot of other priorities,” said David Cutler, a Harvard economist who has advised both the Clinton and Obama White Houses on health care.

Go to the roots. Western medicine tends to fight symptoms, whether suppressing coughs or flooding the brains of the depressed with serotonin. Wellness is interested in underlying causes. It is inclined to see an infertile woman, for example, as a stressed woman rather than a woman with defunct ovaries, and may suggest that she eat and work differently rather than take ovary-manipulating pills.

In public policy, a symptom bias rules. A housing crisis? Enact a tax credit! Bank failures? Bail them out!

There is nothing wrong with such steps — except for what they leave out, as most economists will tell you.

Even amid all this action, we have virtually ignored the complex weave of issues beneath the issues: meager savings, a debt addiction, a congenitally spendthrift political system, an almost pathological craving for stuff. And, with our topical cures, we should not be surprised to see new symptoms of the old maladies appearing: insurance again being packaged into derivatives, bonuses again soaring on Wall Street.

“We treat symptoms, and we do not look at the causes of the symptoms,” Deepak Chopra, the famed alternative-medicine and wellness guru, said when asked to extend the wellness metaphor to the economy. “We are totally at this moment looking at it in a reductionist manner. The reductionist manner is a bailout. And somehow that’s supposed to solve the problem, whereas the problem occurred because we were thinking reductively.”

Look within. Wellness sees the causes of and remedies for ailments as lying within us. Avoid infection by building immunity. Defeat disease by eating foods that help the body heal itself.

With the economy, we look everywhere but within. It’s the fault of greedy Wall Street bankers. It’s Washington’s fault. Bush’s fault. Obama’s fault. Greenspan’s fault. Somebody fix it!

But what about us? Why can’t we acknowledge that it was us who bought all those unaffordable houses, us who listened to that zero-gravity financial “advice,” us who bought and bought and never kept a rainy-day fund? And why, in solving the problem, do we expect the state to create substitute dynamism instead of renewing the culture of decentralized dynamism that made the U.S. economy so vital to begin with?

“Conventional medicine is very unbalanced in placing all its emphasis on external interventions rather than looking to advance that internal capacity to maintain healing,” said Andrew Weil, founder of the Arizona Center for Integrative Medicine and the author of several books on wellness. Likewise with the economy, he said: “Instead of simply identifying external threats and developing weapons and strategies against them, we should instead identify and strengthen immunity and resistance.”

A politics of wellness would transcend party. It would emphasize the up-front investments that Democrats like in order to achieve the long-run fiscal solvency on which Republicans insist. It would fulfill the liberal belief in a positive role for government in maintaining well-being but would honor the conservative conviction that government’s chief role is to help the social organism heal itself. It would acknowledge, with the left, the complex lattice of cultural and institutional influences that govern a society’s well-being, while emphasizing, with the right, the limits of what any external healer can do.

Think wellness in these hard times. The most urgent problems, after all, may be the ones we haven’t had yet.

‘HEED THE HOPEFUL SCIENCE, ‘ by Prof. Paul A. Samuelson. WARNING OF THE COMING RUN ON THE DOLLAR. ‘REMEMBER WHERE YOU READ THIS FIRST,’ he yells out. After seven decades of teaching & author on the text ‘ECONOMICS’. My first buy at Cornell in 1961!!!! YOU IGNORE THIS AT YOUR OWN PERIL.

President Barack Obama’s 2008 electoral landslide victory averted a global financial meltdown. Had John McCain won that election, the present G.D.P. in the United States would have been even lower than it is now by more than 15 percent. Similar losses in global productivity would also have taken place.

Hail then the flexibility of Chairman Ben Bernanke’s U.S. Federal Reserve and of the European Central Bank for embracing activist fiscal policy for the first time since the Franklin D. Roosevelt New Deal.

Former Federal Reserve Chairman Alan Greenspan and the governors of the European central banks avoided the preventive policies that could have averted most of the present meltdown. They had falsely believed that unregulated capitalism could dodge the bullet of depression. That’s proved to be a wrong belief everywhere.

The 2008 election brought an end to Bush administration blunders, and to other post-Reagan “make the poor and middle classes subsidize the ultra rich” enactments. These are bad morals and not justified by higher growth efficiency.

We begin now a new era in which China will increasingly make obsolete America’s 1950-2009 world leadership. Your children and my grandchildren will live in this new and challenging era.

We’ll see China catch up and pass Japan as the economy second in total G.D.P. to the United States. Then, unless China’s one-party leadership explodes, the day will come when China’s total real G.D.P. will exceed America’s. Boohoo. But that’s the realistic expectation.

However, don’t expect smooth and quiet rotation of the globe pace-setters. More likely, within the coming decade, there will be a massive run against the U.S. dollar. Why? Because ever since the year 1000 A.D., export-led growth has been the rule whenever an educatable low-wage population has begun to imitate the technology of a more advanced nation, and thus out-compete the industries of the affluent regions.

So it was and so it will always be. Whenever a low-wage, educatable population can imitate the technology of a more advanced nation, it will do so. That’s why protectionism is like a persistent herpes virus, and must be guarded against.

Recently I’ve come to fear that the inevitable disorderly run against the dollar looms earlier than I used to think. I hope I turn out to be wrong. Many times during seven decades of economics teaching and textbook creation I have been wrong. Still, remember where you read all this first.

I do have a positive recommendation that might reduce the risks outlined above and even delay them into the further future. I counsel those many who invest in dollar assets at near-zero interest yield to switch soon into a diversified portfolio that earns the higher average worldwide yields. That will help better stabilize those volatile foreign holdings of low-yield bonds.

Thanks to the advance of science and engineering, today’s centrist mixed economies can all look forward to longer good-quality-of-life longevity. Before 1700 A.D., that was never the case. The new reality is that white Caucasians are a minority in the world. People of color are the majority, and will continue to become ever more dominant.

Readjust to these new permanent truths. Don’t expect to reverse basic trends. Adjust to reality sooner rather than later. Gone forever, one hopes, are the idiocies of Friedman-Hayek libertarian selfishness.

When I started my economic studies at 16, Carlyle was right to call economics the Dismal Science. Thanks to modern science and better economic knowledge, this Malthusian curse has been vanquished. Good modern economics make economics the Hopeful Science. At last!

Paul A. Samuelson is an Institute Professor at the Massachusetts Institute of Technology and recipient of the 1970 Nobel Prize in economics.

‘THE ELEMENTS OF DEFLATION,’ by John Maudlin at frontlinethoughts .com.

The Elements of Deflation

One of the advantages of travel is that it gives you time away from the tyranny of the computer to think. (Am I the only one who feels like I am drinking information through a fire hose?) But getting the information is important too, as it gives you something to think about. And I have been thinking a lot lately about deflation.

I get asked at almost every venue where I stop, whether I think we will see inflation, or deflation. And I answer, “Yes.” And I am not trying to be funny. I think the primary forces in the developed world now are deflationary. When asked if I don’t think that the Fed monetizing debt of all kinds won’t eventually be inflationary, I answer, “We better hope so!”

Let’s quickly summarize some of the ideas from the last few months of this letter. Just as water is made up of two parts hydrogen to one part oxygen, so deflation has its own elemental structure.

The first element is Rising Unemployment. There has never been a sustained inflationary period without wage inflation. Wages are basically flat and falling. With 9.8% unemployment, 7% underemployed (temporary), and another 3-4% off the radar screen because they are so discouraged they are not even looking for jobs, and thus are not counted as unemployed (who made up these rules?), it is hard to see how wage inflation is in our near future.

Think about this. Only a few years ago, less than 1 in 16 Americans was unemployed or underemployed. Today it is 1 in 5. That is a staggering, overwhelming statistic. Mind-numbing.

Keynes said that you should stimulate the economy in recessions in order to bring back consumer spending. That is not going to happen this time. As my friends at GaveKal point out, this time we will have to have an Austrian (economic) recovery, or a business-spending recovery. My argument will be, when I am with them in Dallas in December at their conference, “Where are we going to get business-investment spending when banks aren’t lending and capacity utilization is at an all-time low?” This, of course, leads the Keynesians to jump in and say, “The government has to step up and jump-start consumption!” Which means more debt. Wash. Rinse. Repeat.

The next element of deflation is massive Wealth Destruction. Two bear markets and a housing market collapse have put the American consumer on the ropes. And the next bear market will bring him to the canvas.

Then we have Reduced Borrowing and Lending, as consumers are paying down debt and banks are reducing their lending. Both are necessary in a credit crisis-caused recession. Bank lending is basically back to where it was two years ago, and shows no sign off rebounding. Banks, as I have written, are buying US government debt in an effort to shore up their balance sheets. Lending to small business, the real engine of job creation, is sadly decreasing each month. (See graph below.)

Next up in our elemental list we have Decreased Final Demand and its counterpart Increased Savings. Although the savings rate has come back down to 3% from 6% a few months ago, almost every expectation is that it will rise over the next 3-5 years back up to the 9% level where it was only 20 years ago. The psyche of the American consumer has been permanently seared. Consumption and savings habits are being changed as I write.

And of course we must address the element of Low Capacity Utilization. While capacity utilization is rebounding, it is still lower than at any time since the data has been collected, other than the last few months. It is hard to see where businesses are going to get pricing power, when not only US but world capacity utilization is still extremely low. The chart below is not the stuff that inflation is made of.

And let’s just quickly throw in Massive Deleveraging and $2 trillion in Bank Losses and a Very Weak Housing Market. Which brings us to a Slowing Velocity of Money.

As I have written on several occasions, prices are a function of the amount of money times the velocity of money. If the velocity of money is slowing, the amount of money can rise without bringing about inflation. It is a delicate balance, but nonetheless the hyperventilation in some circles about the coming hyperinflation is, well, overinflated. Simplistic. Economically naive.

The Fed is going to do what it takes to bring about inflation (in my opinion). But they will not monetize US government debt beyond what they have already agreed to. If they need to “print money” to fight deflation, they can buy mortgage or credit-card or other forms of private debt, which have the convenience of being self-liquidating. Read the speeches of the Fed presidents and governors. I can’t imagine these people will recklessly monetize US debt. You don’t get to their level without having a stiff backbone. (Yes, I know the gold bugs will call me terminally naive. We will have to wait to see who is right. Peter Schiff, care to make a bet on this one?)

Bernanke warned Congress again last week about rising deficits. Watch the deficit rhetoric coming from the Fed after the next two governors are appointed next year, side by side with Bernanke’s reappointment. There will be a line drawn in the sand. Some in Congress will not be happy, but my bet is that the Fed will maintain its independence. If they do not, then my recent letters will prove far too optimistic (and many of you protest my rather less-than-positive suggestion of a double-dip recession). But I must admit I cannot imagine that happening. And there are not enough votes in Congress to change that independent status. There is a day of reckoning coming with the US debt. And thank God for that.

Bottom line: The Fed will do what it takes to keep us from deflation. They will deal with the problems of the ensuing inflation. I wrote six years ago that the best outcome from all the easy monetary policy and budget deficits would be stagflation. I see no need to change that assessment. I am not happy with stagflation, but as I came into my young adult life in the ’70s (see below), I know that we can deal with that. The far more worrisome prospect is continued trillion-dollar deficits.

‘THE LOIN IN WINTER. HUGH HEFNER REFLECTS ON HIS LONG LIFE, ‘ in the Herald Tribune online at IHT.com. AND I PAID 3 EUROS FOR THE TRIB TODAY HERE IN PARIS ($4.50 for 20 pages). NEVER AGAIN!!!!

LOS ANGELES — Hugh Hefner leaned back on a red loveseat, the saggy one in the study of his infamous mansion here, and interlocked his fingers behind his head. A visitor had asked — more like shouted, since he has trouble hearing — a question about mortality.

He says that “pop culture is a thinner soup today,” adding, “It used to be a thick porridge.”

At 83, does he think about it?

In a word, no. Mr. Hefner, the legendarily libidinous founder of Playboy, the prophet of hedonism, does not believe that his denouement is at hand.

He doesn’t act like it, either. He still works full days on his magazine, flies to Europe and Las Vegas, pops Viagra, visits nightclubs with his three live-in girlfriends — each young enough to be his great-granddaughter — and is working with the producer Brian Grazer on a film.

“This is one of the very best times of my life,” he said, grinning, dressed in pajamas and slippers. “It’s even better, richer than people know.”

You want to believe him, but it is hard to ignore the realities of his business. Playboy Enterprises, hobbled by a shifting media landscape, is in need of heart paddles. On Tuesday, the magazine said it would cut the circulation numbers it guarantees to advertisers to 1.5 million, from 2.6 million. The company has lost money for seven quarters in a row.

And perhaps most shockingly, the company said earlier this year that it would consider acquisition offers, something that was believed to be unthinkable while Mr. Hefner was still alive.

Mr. Hefner knows every good party must end, having long ago bought a crypt next to Marilyn Monroe at a Los Angeles cemetery. In interviews over the years, he has talked about how life wouldn’t be worth living without Playboy. “If I sold it, my life would be over,” he has said. But he may be coming around: “I’m taking more seriously the fact that I’m not 30 years old anymore. I need to think about the continuity of the magazine.”

Love him or loathe him, no one doubts Mr. Hefner’s influence in American cultural history. As a magazine publisher, he essentially did for sex what Ray Kroc did for roadside food: clean it up for a rising middle class.

As a cultural force, however, Mr. Hefner still divides the country — 56 years after Playboy’s first issue. To his supporters, he is the great sexual liberator who helped free Americans from Puritanism and neurosis. To his detractors, including many feminists and social conservatives, he helped set in motion a revolution in sexual attitudes that have objectified and victimized countless women and promoted an immoral, whatever-feels-good approach to life.

Mr. Hefner will concede that there are dark consequences of what he helped set into motion, but said “it’s a small price to pay for personal freedom.”

“People don’t always make good decisions. The real obscenities on this planet have very little to do with sex,” he said, adding that “it’s not as romantic a time.”

Less romantic and — with instantly available pornography online and graphic sex talk, including on Mr. Hefner’s own show, “The Girls Next Door,” on TV — it’s a time that makes Playboy’s ideals seem quaint. Mr. Hefner — who uses the word “cat” to describe himself, as in, “I’m the luckiest cat on the planet” — doesn’t think much of today’s cultural landscape.

“I feel strongly that the pop culture is a thinner soup today,” he said. “It used to be a thick porridge.”

At the same time, he tries to be an active participant. While the magazine is still edited largely in Chicago, Mr. Hefner approves “every Playmate, every cover, the cartoons and the letters.” Working from a home office or his bed, where the 1970s-era Tasmanian opossum fur bedspread has been traded for a silk and velvet one, Mr. Hefner helped drive the recent decision to buy a 5,000-word excerpt of Vladimir Nabokov’s unfinished novella, “The Original of Laura,” for a forthcoming issue.

His girlfriends recently educated him about Twitter. (“I’ll be playing gin rummy tonight” was a recent tweet.) He’s hooked on the HBO drama “True Blood.” He recently filmed a Guitar Hero commercial, holding the pipe he gave up after a suffering a small stroke in 1985. He has also suffered personal humiliations. Former live-in girlfriends, including those who have appeared on “The Girls Next Door,” have portrayed him in interviews and a book as a control freak who enforces a curfew of 9 p.m. The mansion itself has seen better days. During a July visit, the game house (the one with a room that has a mattress as flooring) smelled musty, while the bird aviary needed scrubbing. That famous grotto, with its Jacuzzis of varied depth, seemed more like a fetid zoo exhibit than a pleasure palace (although nearby shelves were stocked with enormous bottles of Johnson’s Baby Oil).

In March, with the housing market in a nosedive, he put his wife’s home, located next door to the Playboy Mansion, up for sale for $28 million. It sold in August for $18 million. Mr. Hefner, who separated from Kimberly Conrad Hefner in 1998, filed for divorce in early September; she is suing him, claiming he owes her $4 million under a prenuptial agreement and proceeds from the home’s sale.

MORE ON THE ARTICLE AT IHT.COM IN TODAY’S PAPER……ONLINE FREE!!!!!!

‘THE DOLLAR IS WEAKER, BUT IT IS NOT DOOMED,’ from CNN Money at fidelity.com. Could be. NOT THE WAY I WOULD BET WHERE THE DOLLAR IS HEADED.

It sounds like the plot of a bad spy novel.

A group of international villains are holding a secret meeting in their headquarters — which are naturally buried deep in the side of a mountain. They are thinking of grand schemes to destroy the American dollar and replace it as the global standard with a basket of other currencies and gold.

All we need is to have the group’s leader stroking the pet cat sitting on his lap to make the scene complete. Mwa ha ha ha ha!

Now they say that the truth is stranger than fiction. But the notion that a group of oil-rich Middle Eastern nations, Russia, Brazil, France, Japan, India and China are actively looking to replace the dollar as the currency of choice for pricing oil in the not-so-distant future seems a bit silly at this point.

Yes, the dollar has weakened significantly in the past few months. And that has to be a cause for concern for oil exporters as well as nations that hold big chunks of other dollar-denominated assets such as U.S. Treasury debt.

But it doesn’t appear as if the dollar is on death’s doorstep just yet, despite what was reported in a very sensationalistic article in the British publication The Independent earlier this week.

Bond market not worried about inflation

The fact that U.S. Treasurys have rallied sharply in recent weeks is one sign that some of the concerns about the dollar are overblown. If people were so spooked about the possibility of skyrocketing 1970s style inflation, it’s hard to fathom why anyone would be buying long-term bonds right now.

Yet, the yield on the benchmark 10-year Treasury is currently hovering around a relatively low 3.3%, down from nearly 3.9% two months ago. Bond prices and yields move in opposite directions and lower yields are usually a sign that bond investors aren’t too worried about inflation.

With that in mind, Michael Strauss, chief economist with Commonfund, a money management firm based in Wilton, Conn., said he thinks that the recent surge in other inflation hedges such as gold and oil are more about speculation than anything else.

“There is a disconnect here. You look at gold and oil. Gold has no industrial purpose so it’s not about supply and demand. Oil’s runup doesn’t fit with what the price of gas and other byproducts are doing,” he said. “So if people are really worried about inflation, why is the yield on the 10-year this low?”

Keith Hembre, chief economist with First American Funds in Minneapolis, added that the recent surge in stocks also wouldn’t be justified if the dollar was really headed towards obsolescence.

Sure, there is some element of people trading out of the dollar and into other riskier assets like stocks because there is a growing belief that the global economy is recovering. But Hembre argued that if people really feared that the dollar was expected to weaken much further, then there would be little reason to make bets on any U.S. companies or government debt.

“If there was a true dollar crisis, you’d also have a flight from dollar denominated assets,” he said. That means Treasury yields would be higher and U.S. stocks would be a lot lower.”

And for all the talk of how weak the dollar is right now, it’s not as if it’s at all-time lows just yet. As the narrator on the canceled way too soon ABC  show “Pushing Daises” would say, the facts are these.

The dollar is trading at about $1.47 against the euro. That’s a 17% slide since the stock market rally began in March, but the dollar was 8% weaker at last year, at about $1.60 to the euro — an all-time low. The dollar is also still about 7% above the low it hit in March 2008 against a basket of six other global currencies.

Of course, the trend lately is for the dollar to go down and that trend bears watching. Nobody wants to see the greenback come close to last year’s levels, especially since that round of dollar selling also coincided with record high oil and gas prices.

Some benefits to a weaker dollar

But there are also some benefits to a weaker dollar. It helps make U.S.-made goods cheaper, which could provide a boost to demand for American exports.

“Looking forward, if consumer spending is not leading the U.S. economy, one way to finance growth is through a weaker dollar. In the context of an expanding global economy, the weaker dollar is positive for U.S. exports,” Hembre said.

Big U.S. corporations also could get a lift to their profits because international sales will be higher when translated from stronger currencies like the euro back into dollars.

A cynic could rightfully point out however that it’s not certain that the global economy is recovering but not yet recovered. So it may be a mistake to expect that consumers in Europe and emerging markets like China, India and Brazil are going to lead the United States out of its funk by buying tons of cheap American cars.

What’s more, the currency translation bump to earnings is more of an accounting trick than anything else. It is going to be more critical for companies to report sales and earnings growth because of real demand, not favorable foreign exchange rates.

Still, there may be a floor to how low the dollar falls. Economists said the talk about replacing the dollar is probably due more from a desire to pump the dollar back up than a real wish to get rid of it as the reserve currency.

“The reason the dollar isn’t dead yet is that you haven’t seen a major fundamental change in many of the economies of the countries that are worried about a weak dollar and favor a strong dollar. They want their own exports to be cheap,” said David Merkel, chief economist with Finacorp Securities, a broker-dealer based in Irvine, Calif.

“We could get back toward record lows on the dollar, but it would only be after a failure to intervene by central banks that are interested in keeping the dollar strong,” he added.

There’s also the issue of what a much weaker dollar would do to the investments that many countries have in U.S. dollar-denominated assets. China, for example, is the world’s largest owner of Treasurys, with more than $800 billion worth of bonds.

“The dollar weakness may be putting pressure on China,” Commonfund’s Strauss said.

But other than trying to act tough, Merkel thinks there is not much China or other nations can do if they are unsatisfied with the dollar’s decline.

Merkel said that selling bonds to minimize damage from further hits to the dollar is not an option just yet because selling Treasurys would just lead to a further erosion in value of existing holdings.

“If you are taking on too much dollar debt and you don’t like it, then you have to take the pain. There may come a day when countries are willing to do so but they are not ready this go around,” he said.

Hembre agrees. And he doesn’t believe that there’s much that will be done other than to let the currency markets run their course.

The Federal Reserve could try and prop up the dollar in order to quell long-term inflation fears sparked by concerns about the glut of money pumped into the economy in the form of stimulus and bailout packages.

But it appears that the Fed is going to keep rates near zero for some time in order to make sure the recession (which some believe is over) doesn’t get worse.

Hembre thinks that is the right move because the risks associated with a weak dollar are far outweighed by broader concerns about rising unemployment and what appears to be a still fragile recovery in the housing market.

“The dollar is simply not an issue. Dollar weakness would only become problematic if it caused disruption in funding markets which led businesses or governments to be unable to finance their spending needs. We see no evidence of that,” he said.

So it looks like all those nefarious plots to take down the dollar may not be coming to pass after all.

™ and © 2009 Cable News Network and Time Inc. and/or their affiliated companies. All Rights Reserved.

~~~ A MUST / MUST READ!!!! ~~~”LAYING ON BETS AT AMERICA’S LARGEST PENSION FUND,” from Reuters at fidelity.com. CALPERS is the 800 pound gorilla in the investment world. This is one fascinating story from a three reporter team at Reuters. SHARE THIS WITH ALL YOU WHO HAVE THE NEED TO KNOW IN THE FINANCE GAME. Press on!! SPHIX which I told you about Feb. 10th at a post was $6 NAV. Yesterday $8.25!!

SAN FRANCISCO/NEW YORK (Reuters) – Russell Read, the former chief investment officer of Calpers, the largest pension fund in the United States, knows his trees.

Read owned a 500-acre Maine forest landscaped with the same mix of maples and oaks the colonists would have seen when they first arrived on the shores of America.

Bob Carlson, who was a board member at the California Public Employees’ Retirement System for nearly half its history, recalls asking about commodities like timber during Read’s interview for the position at Calpers.

“His eyes lit up,” said Carlson. “That’s what I wanted.”

Read got the job in June 2006 at the age of 42 and quickly set out to turn Calpers into a modern, aggressive investor.

At the time, esoteric new markets were racking up huge, almost unimaginable gains. He and the board were in agreement — Calpers should be part of it.

“I think the push for commodities and infrastructure and forestry and some of those other things was kind of a movement afoot,” said Tony Oliveira, Supervisor of California’sKings County and one of the Calpers board members who helped choose the new investment chief.

A former senior executive at Deutsche Bank, who had once taught risk management, Read seemed to be the right person for the times.

Despite Read’s background and the ever riskier bets he was making, Calpers still struggled with risk management. Carlson, who describes Read’s risk management plans as “brilliant,” said that Read left the fund before he could put them in place.

Red flags about the growing riskiness of Calpers’ portfolio also went unheeded. A consultant warned Read in December 2007 about the size of the fund’s commitment to private equity, but the push went on.

For a while, Calpers looked smart under Read, hitting a peak value of $260 billion in October 2007 as it borrowed money to boost returns and moved into sophisticated collateralized debt obligations, land for residential real estate, as well as commodities.

But as the financial crisis unfolded last year, Calpers lost $100 billion, more than a third of its value, tumbling to $160 billion a year and a half after the high. The other thing it lost was its gold plated reputation, founded on steady returns, pioneering new investments and policing public companies as an activist shareholder. Smaller rivals who were more conservative lost much less.

Calpers has not retreated, though — just the opposite, in fact. As the entire pension industry questions what level of risk it should be taking in the aftermath of last year’s financial meltdown, Calpers in June increased its target for venture capital and private equity — what the fund’s advisor itself called the highest risk, highest reward bet — to 14 percent of overall investments, up from 10 percent.

Chief Investment Officer Joseph Dear, who declined to comment for this story, in a published internal interview called the changes “relatively minor”. “We looked at the long term return assumption and basically said we don’t see a significant reason to change,” he said.

“Calpers has the reputation of being the gold standard of pension investing, largely by the virtue of its size. But the reality is very different,” said Edward Siedle of Benchmark Financial Services, a pension fund investigator and investment consultant.

The new strategy by the board was nothing more than a high-stakes attempt to dig itself out of a hole, he said, reflecting the view of many critics. “Since their liabilities have grown and their assets have shrunk, they have concluded that they need to take more risk to close the gap,” he added.

Voters in California are beginning to understand that they will have to make up any shortfalls. Rating agencies are reviewing municipal debt with an eye to what billions of unexpected liabilities could do to fragile budgets.

And in the past weeks, a scandal about how former Calpers officials lobbied to place investments has drawn renewed attention to the obscure world of managing pensions.

“In all likelihood this risky gamble will not end well,” Siedle said.

CALPERS MODEL

Big as Calpers is, its influence is even bigger. It takes on countries, refusing to invest where labor practices don’t meet its standards, for instance.

Olivia Mitchell, Chair of Wharton business school’s Insurance and Risk Management Department, remembers traveling to Thailand, where the primary question from officials was what were Calpers’ plans for investment there.

Every year the fund, which serves about 1.6 million members including former state and city workers, from janitors to judges, challenges what it feels are corporate governance laggards with a Focus List that commands considerable attention. Targets have ranged from drug company Eli Lilly & Co to chairmaker La-Z-Boy. Calpers argues that singling out corporate inadequacies leads to better stock performance — and higher returns for the fund.

Over the past quarter century, Calpers also has transformed how the entire pension industry is run.

Former director Carlson chaired a 1984 voter initiative to lift a cap on stock investments for the fund, whose solvency is guaranteed by the state.

The goal was to break free from political dictates of state capital Sacramento, whose investment ideas gave Calpers directors pause. “They wanted us to invest in government buildings, that’s what they wanted. We did away with it,” Carlson said.

The measure squeaked by, stock investments rose, and the fund got more aggressive. Shortly after 2000 it made its first investment in hedge funds — a shot heard around the pension fund world.

“It was their investment more than anything else that basically allowed every other pension fund to invest in the hedge fund space,” said NYU Stern School of Business Professor Stephen Brown. “Nobody could be fired for doing what Calpers did.”

SIZE MATTERS

One reason Calpers invests so much is that it has to: $200 billion, roughly twice the state of California’s annual budget, is a lot to invest, and Read had his hands full getting such a big ship to turn.

Failures that would cripple other ventures merely put a dent in Calpers. Read closed a $2.5 billion venture known as LandSource in the summer of 2007, the beginning of the end of the American housing boom. LandSource filed for bankruptcy protection in early 2008, though Read still got a $208,000 bonus for the fiscal year.

In 2001, before Read joined Calpers, board members said they wanted to get into agriculture. “The board members didn’t care what the product was,” recalled Michael McCook, the former head of the real estate division. The only caveat was that the money could not go into an area with price supports, he said.

Word of the interest spread through the grapevine. Richard Wollack, a real estate tycoon, soon pitched McCook a plan to buy prime vineyard land in Northern California, Oregon and Washington.

By April 2002, Calpers struck a $100 million deal with the politically-connected Wollack to run Premier Pacific Vineyards, to buy and plant land with grapes, then sell to established vineyards within seven years.

The vineyards are losing money, and the investment is up to $200 million, but in a fund roughly a thousand times bigger, it is a rounding error.

“It doesn’t take Calpers a long time to make up a bad decision, because it is diversified and so large,” McCook said.

But bad decisions can pile up.

THE YALE MODEL

While Calpers led public pension funds into alternative investments, arguably they were far behind Yale University Chief Investment Officer David Swensen, father of the “Yale Model” of investing, which produced double-digit returns for years from diversification into poorly understood and illiquid markets, where sophisticated investors saw an edge.

With Yale showing the way, Calpers and other endowments began private equity, real estate and foreign companies.

Mark Anson, Read’s predecessor and now president of Nuveen Investments, made many of the early alternative investments and also started the risk management system in 2001. Calpers bought a computer program for equities and fixed income, then added on real estate and other parts of the portfolio.

The result of the computer model is “a starting point to talk about risk,” Anson said, arguing that the risk management system, which was upgraded in 2007 under Read, didn’t fail in 2008. “When you say, ‘My gosh what should be the risk management policy?’ or ‘Why didn’t Yale or Calpers or anyone else see this coming?’, well, not even the Fed saw this coming,” he said.

But at least one board consultant saw something amiss. Michael Schlachter, managing director and principal at Wilshire Associates, by email said he warned Read in a December 4, 2007 memo that Calpers’ then-proposed increased allocation to private equities seemed “large.” The fund had already outspent its target of 6 percent, he pointed out in the memo.

Critics say the board lacked more than fancy computer models. It lacked common sense.

Boards of funds like Calpers could have and should have seen the big picture — starting in the 1990s when fat stock market returns could have been reaped and rolled into bonds.

“Where would they be if they had captured the returns? They would be fully funded,” said Thomas Flanigan, founding chief investment officer of the California State Teachers’ Retirement System, the smaller sister fund to Calpers.

“It was too obvious … Even my sister called up and said, ‘The market is at 30 times earnings and I’m going to sell.’ I said, ‘That’s a good idea.’”

Had public pension funds locked in profits then, pension fund boards years later would have thought twice about buying into opaque investments and Wall Street may not have been so inventive, Flanigan added.

“It would not have been necessary to create these overly risky products with the intent to recover from what they missed,” he said.

Flanigan sees history repeating itself as Wall Street accommodates the appetite at public pension funds for more risk in the search of home-run profits to make up for losses over the last two years.

Calpers is looking at its own relations with consultants, probing more than $50 million in fees paid by private equity firm Apollo Management and others to a firm headed by a former Calpers board member.

State Attorney General Jerry Brown has also launched a Calpers probe into the so-called placement agents who lobby for pension fund business.

At the same time, board member Oliveira is leading the Calpers push to reassess risk management, and he looks at it from a very broad perspective, from studying the political risk of laws governing Calpers to understanding how health costs could affect its massive programs for beneficiaries.

There is a lot to do: an assessment report to kick off the drive concluded “there is no comprehensive risk policy within the organization” and “management of risk appears to be more reactive than proactive,” among 18 observations.

Like other funds, Calpers is keeping more cash on hand. It also is changing rules for private equity funds that want to work with it, requiring more disclosures and overhauling how they are paid. And it is turning to lawyers for help.

Faced with huge losses on subprime loans, Calpers is suing the rating agencies which it said misled them by giving top ratings to mortgage bond funds which later turned out to be a house of cards. Calpers also was overcharged for foreign exchange transactions, says state Attorney General Brown, who is suing bank State Street.

The market rally this year also has helped. “The recovery now is showing our asset strategy is doing pretty well,” Oliveira said. Calpers’ losses have been cut by about half from the market low, taking the fund to around $200 billion.

The recovery, however, remains wobbly, and California, the nation’s largest economy, is in dire straits. The state resorted to IOUs when it nearly ran out of cash, a third year of drought has left farms fallow, and layoffs have even reached into Silicon Valley and Hollywood.

CHANGE IS UNPOPULAR

If Calpers falls short on its pension commitments, taxpayers will pay. But there is growing pressure from Governor Arnold Schwarzenegger and others to cut future pensions or do away with them altogether in favor of 401(k)-style programs where individuals manage their own money and both reap the rewards and suffer when risks don’t pay off.

Most Californians support pension changes for new hires including an upper limit on benefits, replacing pensions with 401(k) plans and changing pension calculations to cut benefits, according to a Field Poll in October.

Meanwhile Calpers is aiming for an annual investment return target of 7.75 percent, in line with returns in recent go-go decades. Lawrence Fink, chief of gargantuan asset manager BlackRock told the Calpers board in July he didn’t think the fund would hit its target. “I think it’s going to be subpar for many years,” he said, suggesting that cuts in benefits be considered.

Shortfalls add up fast. Taxpayers are on the hook for about $2 billion for each percentage point investments are behind target, said Rick Roeder, an actuary who has consulted for public pension funds. And the targets are high, he added.

“Calpers has relatively optimistic assumptions about investment returns compared to other public funds in the state,” Roeder added.

Politics only adds to the risk at Calpers.

The state guarantees state pensions and elected officials hold many board seats, a potentially dangerous mix. Wall Street banks waited to find out if they were “too big to fail” but California has a legal obligation to rescue Calpers if it founders.

“In any instance where you know you have a (safety) net, your behavior is likely to be riskier. The net here is taxpayer dollars,” said Jessica Levinson, director of political reform at the Center for Governmental Studies in Los Angeles.

“There’s no downside to losing money,” said Orange County Supervisor John Moorlach, who was a board member of the county employees’ fund from 1995 to 2006. Calpers could have put aside money in the late 1990s, when they were fully funded against liabilities, but instead it backed raising benefits.

Stacking the board with political representatives of beneficiaries only makes things worse, argued Keith Richman, a former Republican state lawmaker and critic of the state’s public pension funds. Politicians are encouraged to make promises and are gone by the time promises come due.

“In Calpers the conflict of interest is built into the state Constitution. It says the majority of board members need to be recipients,” he said.

Wharton’s Mitchell said studies showed that political boards tended to be more aggressive investors.

WHO’S THE BOSS

Calpers’ mission statement is to do well by pensioners, but if the payer of last resort is the state, perhaps the mission should be to avoid catastrophe for taxpayers, would-be reformers say.

“Calpers’ responsibility, broadly speaking, is to the taxpayers,” said Steven Frates, senior fellow at the Rose Institute of State and Local Government. “When the check comes due, those are the people who pay it.”

Common wisdom holds that if pension funds act more like trustees than aggressive investors, returns will be lower.

“We can’t have it both ways,” said pioneering shareholder advocate Robert Monks.

But a March presentation to the Calpers board by Wilshire Consulting showed a different picture. The most conservative investments, such as treasury bills, had had the best returns over the previous 10 years, in complete opposition to the presentation’s theory of efficient markets, which says riskier rewards like private equity have higher payouts.

Even holding funds in cash proved more lucrative than most investments, including stocks and private equity.

“Calpers is fine,” board President Rob Feckner, a union representative and glazier, said in a recent defense of the fund in a Sacramento Bee opinion piece. The fund is “fine-tuning” its investment strategy, negotiating for reduced fees from outside managers and aimed to keep contribution increases to a minimum. Meanwhile the board is ’smoothing’ recent returns, an accounting device which lets the fund take the 2008 hit over many years rather than at once.

The alternative is to cut city and state salaries, jobs or both.

“Everyone has learned there was too much optimism and too much leveraging and so on,” State Treasurer Bill Lockyer, an ex-officio Calpers board member, told Reuters.

But now is a good time to buy, he said. “It’s an opportunity for those of us who have more money to go and make more,” he said.

Read did not respond to interview requests.

He and his wife have a non-profit forest foundation in Maine, where Pensions & Investments described his property in a 2006 interview. Calpers says it has made a more than 9 percent return in its Forestland portfolio since 2007, and is considering distressed Australian timberland.

Perhaps Read’s legacy will live on.

(Additional reporting by Paritosh Bansal in San Francisco, additional research by Courtney Hoffman in San Francisco, editing by Jim Impoco and Claudia Parsons)

‘BIG BANKS FAIL,’ by Simon Johnson at baselinescenario .com.

Big Banks Fail

Posted: 22 Oct 2009 04:35 AM PDT

In the Wall Street Journal on Tuesday morning, Charles Calomiris, a leading banking expert, published an op ed entitled “In the World of Banks, Bigger can be Better.”  It begins,

“Legitimate concern about the risks to taxpayers and the economy posed by banks that are “too-big-to-fail” has prompted some observers, among them Simon Johnson, former chief economist of the International Monetary Fund, to favor draconian limits on financial institution size. This is misguided. There are sizable gains from retaining large, complex, global financial institutions—and other ways to credibly protect taxpayers from the cost of government bailouts.”

And the article goes on to make the detailed case for keeping intact our largest banks – in contrast to the recently expressed views of two former Federal Reserve chairs (Paul Volcker, Alan Greenspan) and – late Tuesday – the current governor of the Bank of England (Mervyn King), who are calling for these banks to be broken up in some fashion.

Professor Calomiris, to his credit, emphasizes (in his second paragraph) that we cannot currently deal with the failure of large cross-border financial institutions and this huge hole in our regulatory structures has helped and will help large banks to press for bailouts. But he also insists “the challenge of coordinating the efforts [when a bank fails] among different countries’ regulators can be met through prearranged, loss-sharing arrangements that assign assets to particular subsidiaries based on clear rules. This would make it possible to transfer control over the assets and operations of a large international financial institution in an orderly fashion, in case of its failure.”

Theoretically, he may be right.  But how far are we from being able to implement such a process?

The G20 should have taken this on as an essential priority at Pittsburgh, but it did not.  The IMF has for years pushed the European Union or at least the eurozone to adopt the kind of framework that Calomiris advocates, but to little avail.

Perhaps this is due to bureaucratic inertia.  More likely it is, once again, the blocking power of big banks.

In any case, once this hurdle is overcome, we can talk in more detail about the Calomiris arguments that big firms need big banks (odd, because big firms can go directly to securities markets), that the latest banking mergers created great value (possible, just not generally what most research finds), and that the rise of banking-as-derivatives-trading over the past 30 years has had big positive effects on the rest of the economy (strange, as there is no supporting evidence in the literature).

Competition between banks is good – on this Calomiris and I agree.  We differ with regard to whether allowing large quasi-monopoly banks to dominate the landscape (e.g., Goldman Sachs and JP Morgan Chase today) is helpful to competition in any sense.

We should also throw into the mix three additional considerations.

First, the expected costs of allowing “too big to fail” banks to continue to operate are huge.  The Calomiris benefits might be positive, you need to weigh these against what we have just seen: a huge recession (and the risk of worse), a big increase in government debt (perhaps 40% of GDP, when all is said and done), and almost 6 million jobs lost.  Calomiris wants to assume these away, with an “immaculate regulation”, but this is simply implausible.

Second, the big banks definitely create some private benefits – mostly for the insiders, in the form of upside (e.g., bonuses) when times are good.  The costs are born by society and not just by people who lose their homes – it’s businesses all across America that have lost income, fired people, and are now struggling to stay afloat.  This is not only unfair, it is inefficient.  Excessive risk taking by big banks generates massive negative externalities.  You can either price this appropriately (and good luck with imposing that tax) or break up the banks – down to a size where we know the FDIC can handle bank failures (see the latest failed bank list).

Third, our big banks have demonstrated an unmatched ability to take over regulators and to convince politicians that a dangerous financial structure is good for America. These same people will almost certainly render ineffective whatever new regulations you put in place.  More broadly, how can you run a well-functioning political system when a few large banks are so powerful?

The key insight at the heart of breaking up Standard Oil in 1911 was that it was too big to regulate.  That breakup may have been good for competition; it was certainly good for democracy.

As Nicolas Trist – secretary to President Andrew Jackson – said about the incredibly powerful privately owned Second Bank of the United States, “Independently of its misdeeds, the mere power, — the bare existence of such a power, — is a thing irreconcilable with the nature and spirit of our institutions.” (Schlesinger, The Age of Jackson, p.102)

By Simon Johnson

A slightly edited version previously appeared on the NYT’s Economix; it is used here with permission. Please ask the New York Times if you would like to republish the entire post.

~~PERSONAL NOTE~~ I SPOKE AT UNIVERSITY OF PARIS II/PANTHEON CLASS TODAY FOR TWO HOURS TO GRADUATE STUDENTS. They work first three days of the week & attend classes all day Thurs./Friday. Here are the questions they submitted to me days before and hoped that I would address.

THESE ARE 22/23 YEAR OLDS WHO CANNOT GET ‘REAL JOBS’ BECAUSE THERE ARE NONE IN FRANCE  FOR THEM. SO THEY GO TO GRAD SCHOOL, WHERE THERE IS NO TUITION TO SPEAK OF, AND GAIN SOME WORK EXPERIENCE, ANOTHER ACADEMIC DEGREE AND GET PAID AS WELL.

HERE ARE THE QUESTIONS:

How do you manage risk and what are the limits?

Are there risk-free investments?

What about the pursuit of happiness?

Real Estate markets?

According to Humanist principles, what do you think about financial speculation?

How did the crisis affect you personally?

How do you advise us to invest, as we are beginners?

How can we start from ZERO?

Is it necessary to have high risk to have high return?

How do you see the position of France in 10 years?

What about the relation between the US and China?  Between the US and Europe?

What about “Green” technology?

DO you ever think about the consequences of your investments?  (Investing in arms suppliers for example)

What do you do with your free time?

How much time, per day, per week, do you spend looking after your investments?

What advice would you give to young people today?

When will this crisis ever end ?

What do you think of Obama getting the Nobel prize?

Which products are best to invest in  terms of risk/return ratio?

Are bankers gangsters?

What is the future for Capitalism?

Would you buy physical Gold now (not paper)?  What about oil?

Do you play poker?  What is the future of on-line poker and gambling in general?

Do you give some of your money back to charity?  How do you work with associations?

Is it possible to love money and be a good human being?

Should we “moralize” the economy?

What rules are there for financial planning?  What rules do we need for the future?

‘TOP TEN FREE SITES TO FIND RELIABLE, AUTHENTIC CUSTOMER PRODUCT REVIEWS ,’ from Accelerated Online Degrees. CHECK IT OUT!

The Top 10 Free Sites to Find Reliable, Authentic Customer Product Reviews

Consumer reviews make purchasing products or services much easier. Unfortunately, you can’t always find an honest review for everything you need, but you can check these 10 websites to see if the product or service does have a consumer review listed somewhere online. Check these free consumer review websites before making big purchases like appliances, automobiles or electronics. Also try our number two pick, Angie’s List, to find reviews on service providers in your area.

Better Business Bureau for Consumers: The Better Business Bureau is the best place to find consumer reviews on businesses and their products. It’s free and easy to use. The Resource Library section provides consumers with tips on how to avoid scams, find a reliable business or service and alerts on scammers, bad business practices and other consumer-related news. You can even ask the BBB a question if you can’t find the answer on its extensive site.

Angie’s List: Angie’s List is a newcomer in consumer reviews and protections online, but it’s a great place to look for reviews on services anywhere from dentists to bricklayers. On Angie’s List, you’ll find more than 40,000 member reviews on services to help you find the best person or company for the job you need completed. This online consumer review community has received media attention from Good Morning America, U.S. News and World Report and Fox News. Don’t hire a contractor without checking it first.

Amazon: While technically Amazon is a consumer marketplace, reviews are abundant. You can find a review on practically everything sold on Amazon. Search the Amazon departments for the product, and review the search results to see if the product is listed on Amazon. If you find it (you probably will), you only need to click the link and scroll down the product page to see if any reviews are posted. It’s simple and you’ll usually find lots of good information from other consumers just like you.

BizRate: BizRate is a product of Shopzilla.com and posts user and consumer reviews on millions of stores and products. You can browse by departments like electronics or appliances to find exactly what you’re looking for. BizRate also allows users to compare prices online on the same or similar products from different retailers. The search bar is beyond easy to use because all you have to do is enter the product you’re shopping for and a list of pretty accurate results will appear in a matter of seconds.

Consumer Search: On Consumer Search, users can search for reviews and get the best information through the Consumer Search process. The website will find the most reliable reviews, analyze the reviewers opinions of products and even recommend what to buy based on the reviews. Consumer Search, a product of About.com, doesn’t include press releases or advertisements in the review selection process so you get honest results.

ConsumerREVIEW.com: At ConsumerREVIEW.com, users can browse through a list of categories to find reviews and price comparisons on products listed online. All of the reviews are generated by members of the community. The website lists many different categories, but specializes in outdoor sporting goods and consumer electronics reviews.

Viewpoints: Viewpoints is an online review community that allows users to post advice on products, ask questions of other users about products before you buy and post reviews on products you love or hate. You’ll probably make a few friends too. Users can browse reviews by category, brand name or by product type. You can easily find consumer reviews on Viewpoints for free which is why it makes our list.

Rate It All: At Rate It All, you can find an opinion or review on just about anything from beauty products to pets. On the main page, you’ll find some of the most current reviews and posting topics listed along with a star rating system that describes the type of review – one star being the worst and five stars being the best possible scenario. Registration is free, but you don’t have to register to read the reviews. You must register to write a review however. The only drawback is that Rate It All can be a little random in its clickable results. The best way to find what you’re looking for is to use the search tool.

Ratings.net: Ratings.net is a free service for members that helps them find reviews on all types of products by category. Click on a category and you’ll find a mixed bundle of products with price comparisons and some consumer reviews. Not all products listed will have a rating unfortunately making this consumer review site semi-helpful, but still a good source of information for electronics reviews.

Epinions: At Epinions, consumers can find loads of reviews on products and services by category. The home page lists a bunch of the most helpful reviews found on Epinions, but the list is random at best. By joining for free you can also post reviews for other members and potentially earn money for being a top reviewer. The drawback? The money incentive may not provide the most honest and best reviews possible.

Best Paid Site for Consumer Reviews

Consumer Reports: Consumer Reports.org is the most trusted paid resource for consumer reviews and independent analysis of products, services and businesses. Subscribe to the service for unlimited access for $26 a year or $6 a month automatically. You can find a review on just about anything from Consumer Reports.

Now that you are armed with these 10 websites to find the best products and services, hopefully you’ll never end up with a dud of a toaster again.

‘WHY IS THE CHAMBER OF COMMERCE DEFENDING BIG BANKS?,’ by Simon Johnson at baselinescenario .com.

On Warren Olney’s radio show To The Point yesterday, I had a chance to talk with US Chamber of Commerce management directly regarding the issue posed here last week: Why would an organization representing 3 million small businesses come out in support of our largest banks?  My question was picked up and focused by the host.

Warren Olney (at the 36:35 mark): “Mr. Hirschmann, back to you.  Are you serving the interests of your own members, if you resist the idea of breaking up the big banks?”

David Hirschmann (leading the Chamber’s financial lobbying efforts): “I just don’t think the question is whether we need to break up the big banks.  The question is how do we ensure that the kinds of practices that they engaged in — and others outside the banking system — don’t happen any more.  Which is why we pointed to transparency in areas like derivatives and leverage.” [my transcription]

Mr. Hirschmann then goes on to talk about the consumer protection agency (he’s opposed).

The conflict between the Chamber’s principles and its actions becomes increasingly clear.

Hirschmann made some good statements, along the lines of: no one should have permanent access to the taxpayer’s pocket, and any firm – no matter how large – should go out of business if its managers make the wrong decisions.  This is exactly  what the representative of small business should say.

But, despite being given repeated opportunity to say something at least generally along the lines of Alan Greenspan last week (e.g., “too big to fail is too big to exist”), Hirschmann retreated into platitudes about the need to modernize our entire regulatory system.

At the same time, he emphasized that the Chamber is adamantly opposed to the main piece of this modernization – as proposed by the administration – which is a new agency to protect consumers vis-à-vis financial products.

He didn’t dispute that the actions of our largest financial players have seriously hurt small business people – through bringing about a massive financial crisis and deep rececession – but the Chamber apparently favors just reshuffling regulatory responsibilities and more “transparency” on all sides.

There is a long tradition in the United States of big business trampling on independent entrepreneurs, and of those entrepreneurs fighting back through the ballot box.  This time around, big banks captured their regulators, badly damaged small firms, and look set to do it again.

Why is the Chamber of Commerce refusing to stand up for small business?

By Simon Johnson

‘WALL STREET’S NAKED SWINDLE,’ by Matt Taibbi in Rolling Stone. Unbelievable but true!!!!!!

On Tuesday, March 11th, 2008, somebody — nobody knows who — made one of the craziest bets Wall Street has ever seen. The mystery figure spent $1.7 million on a series of options, gambling that shares in the venerable investment bank Bear Stearns would lose more than half their value in nine days or less. It was madness — “like buying 1.7 million lottery tickets,” according to one financial analyst.

But what’s even crazier is that the bet paid.

At the close of business that afternoon, Bear Stearns was trading at $62.97. At that point, whoever made the gamble owned the right to sell huge bundles of Bear stock, at $30 and $25, on or before March 20th. In order for the bet to pay, Bear would have to fall harder and faster than any Wall Street brokerage in history.

The very next day, March 12th, Bear went into free fall. By the end of the week, the firm had lost virtually all of its cash and was clinging to promises of state aid; by the weekend, it was being knocked to its knees by the Fed and the Treasury, and forced at the barrel of a shotgun to sell itself to JPMorgan Chase (which had been given $29 billion in public money to marry its hunchbacked new bride) at the humiliating price of … $2 a share. Whoever bought those options on March 11th woke up on the morning of March 17th having made 159 times his money, or roughly $270 million. This trader was either the luckiest guy in the world, the smartest son of a bitch ever or…

Or what? That this was a brazen case of insider manipulation was so obvious that even Sen. Chris Dodd, chairman of the pillow-soft-touch Senate Banking Committee, couldn’t help but remark on it a few weeks later, when questioning Christopher Cox, the then-chief of the Securities and Exchange Commission. “I would hope that you’re looking at this,” Dodd said. “This kind of spike must have triggered some sort of bells and whistles at the SEC. This goes beyond rumors.”

Cox nodded sternly and promised, yes, he would look into it. What actually happened is another matter. Although the SEC issued more than 50 subpoenas to Wall Street firms, it has yet to identify the mysterious trader who somehow seemed to know in advance that one of the five largest investment banks in America was going to completely tank in a matter of days. “I’ve seen the SEC send agents overseas in a simple insider-trading case to investigate profits of maybe $2,000,” says Brent Baker, a former senior counsel for the commission. “But they did nothing to stop this.”

The SEC’s halfhearted oversight didn’t go unnoticed by the market. Six months after Bear was eaten by predators, virtually the same scenario repeated itself in the case of Lehman Brothers — another top-five investment bank that in September 2008 was vaporized in an obvious case of market manipulation. From there, the financial crisis was on, and the global economy went into full-blown crater mode.

Like all the great merchants of the bubble economy, Bear and Lehman were leveraged to the hilt and vulnerable to collapse. Many of the methods that outsiders used to knock them over were mostly legal: Credit markers were pulled, rumors were spread through the media, and legitimate short-sellers pressured the stock price down. But when Bear and Lehman made their final leap off the cliff of history, both undeniably got a push — especially in the form of a flat-out counterfeiting scheme called naked short-selling.

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FOR FULL ARTICLE IN ROLLING STONE GO TO:

http://www.rollingstone.com /politics/story/30481512/wall _streets_naked_swindle

‘NEW FORMULA PUTS ONE IN SIX AMERICANS IN POVERTY,’by Hope Yen A.P. writer, found at Information Clearing House (“News you wont find on Fox News”). Go to website for free subscription.

Revised Formula Puts 1 in 6 Americans in Poverty

By HOPE YEN

Associated Press Writer

October 20, 2009 “AP” — WASHINGTON – The level of poverty in America is even worse than first believed.

A revised formula for calculating medical costs and geographic variations show that approximately 47.4 million Americans last year lived in poverty, 7 million more than the government’s official figure.

The disparity occurs because of differing formulas the Census Bureau and the National Academy of Science use for calculating the poverty rate. The NAS formula shows the poverty rate to be at 15.8 percent, or nearly 1 in 6 Americans, according to calculations released this week. That’s higher than the 13.2 percent, or 39.8 million, figure made available recently under the original government formula.

That measure, created in 1955, does not factor in rising medical care, transportation, child care or geographical variations in living costs. Nor does it consider non-cash government aid when calculating income. As a result, official figures released last month by Census may have overlooked millions of poor people, many of them 65 and older.

According to the revised NAS formula:

_About 18.7 percent of Americans 65 and older, or nearly 7.1 million, are in poverty compared to 9.7 percent, or 3.7 million, under the traditional measure. That’s due to out-of-pocket expenses from rising Medicare premiums, deductibles and a coverage gap in the prescription drug benefit.

_About 14.3 percent of people 18 to 64, or 27 million, are in poverty, compared to 11.7 percent under the traditional measure. Many of the additional poor are low-income, working people with transportation and child-care costs.

_Child poverty is lower, at about 17.9 percent, or roughly 13.3 million, compared to 19 percent under the traditional measure. That’s because single mothers and their children disproportionately receive non-cash aid such as food stamps.

_Poverty rates were higher for non-Hispanic whites (11 percent), Asians (17 percent) and Hispanics (29 percent) when compared to the traditional measure. For blacks, poverty remained flat at 24.7 percent, due to the cushioning effect of non-cash aid.

_The Northeast and West saw bigger jumps in poverty, due largely to cities with higher costs of living such as New York, Boston, Los Angeles and San Francisco.

The Census Bureau said it expedited release of the alternative numbers for this month because of the interest expressed by lawmakers and the Obama administration in seeing a fuller range of numbers. Legislation pending in Congress would mandate a switch to the revised formula, although the White House could choose to act on its own.

Arloc Sherman, a senior researcher at the nonprofit Center on Budget and Policy Priorities, said that because the revised formula factors in non-cash government aid, the amount of increase in poverty from 2007 to 2008 was generally smaller compared to the current measure.

“Food stamp participation rose during the first year of recession and appears to have softened what could have been an even greater increase in financial hardship,” he said.

Sherman said the revised formula could take on greater importance in measuring poverty for 2009 as more Americans take advantage of tax credits and food stamps under the federal stimulus program. Food stamp assistance currently is at an all-time high of about 36 million.

‘KNOWING WHEN TO CUT YOUR LOSSES AND SELL, from Money Magazine at fidelity.com. YOU MUST KNOW THE PSYCHOLOGY OF INVESTING & WHERE YOU FIT INTO THAT PICTURE OR ELSE YOU ARE DOOMED TO FAIL. It takes about two minutes for me to pull the trigger once I make a decision. Sometimes three!!!

After the market dealt you one bad hand after another over the past decade, you may feel relieved that your luck is finally starting to change. Stocks have shot up more than 50% since early March.

But now comes the hard part: deciding if it’s time to cut your losses in some shares now that you’ve at least made up a little ground. There’s a strong case for doing at least a little selling. Though you’re probably feeling better about your portfolio than you did a year ago, stocks aren’t cheap anymore — not after enjoying their best six-month run since 1938.

And though the economy is improving, the recovery is still shaky. Then there’s the fact, rally or not, that your shares likely are worth less than what you paid for them. And with year-end tax-selling season nearing, strategic selling could make sense.

Here are some simple guidelines to help you decide whether to stay at the table or cash in.

Remove the psychological barriers

Maybe you really want to sell, but you’ve decided not to pull the trigger until you recoup all your losses. This sentiment is so common there’s a term for it: loss aversion.

Investors don’t like to sell stocks that are down because that would be admitting that their original buy decision was wrong, says Hersh Shefrin, a behavioral finance expert at Santa Clara University. “It’s their egos that get in the way.”

But the market doesn’t care whether you made or lost money in a stock. So forget what you paid — it has no bearing on the future price.

Take a fresh look

Rather than fixating on your purchase price, consider what the stock is trading for now. Then ask yourself, Would those shares be worth buying anew at today’s price?

To answer that, it’s useful to compare a stock’s current valuation against that of its peers, says Tom Forester, manager of the Forester Value Fund (FVALX |. If a stock’s price/earnings ratio — or an equivalent measure — climbs above its sector average, Forester will typically sell. “At that point,” he says, “we can find better opportunities elsewhere.”

Say you own Starbucks . After a huge rally since March, its shares trade at a steep premium to their peers. Yet lattes aren’t nearly the growth story they were a few years ago, when consumers didn’t think twice about spending $4 for a cup. And the stock is still down more than 30% from late 2004.

At the very least, make sure the reasons for liking a stock are still there. You may have purchased Citigroup (C

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) shares years ago, for example, because of its global dominance and earnings potential. But it’s a much smaller bank now, and Uncle Sam owns a third of it. Plus the stock has quadrupled since March, yet it’s still off more than 90% from its high.

Execute the trade

Once you’ve decided to pull the plug, you have another decision: dump all at once or sell gradually?

If you’ve concluded that your portfolio is better off without a stock, the logical response is to sell it all. If you need help getting past the psychological hump of letting go, try the incremental approach.

Unloading, say, a fourth of your position every quarter removes the fear of missing out on a rebound. That fear can be pronounced in a market like this, says John Nofsinger, author of “Investment Madness: How Psychology Affects Your Investing.” When stocks are rising, investors fear missing gains, not the risk of suffering losses. “The irony,” he says, “is investing becomes riskier after prices have shot higher.”

‘ZEN LESSONS IN MARKET ANALYSIS,’ by John P. Hussman at Outside the box (merci John Mauldin). SUMMARY & PRECIOUS MESSAGE AT VERY END.

“Everything, including the market, is ultimately empty of a separate self. One market can only be understood and analyzed in the context of other markets and conditions. Supply and demand, in particular, should not be considered in isolation.”

Long time Outside the Box readers are quite familiar with Dr. John Hussman, as he is a frequent choice for this column. But this week I think he has written one of his bests essays ever. He cleverly weaves in quotes from a Zen master who is his friend and gives us a very fresh look at market analysis. This is a thought piece and you should set aside some time to absorb the lessons. You will be well rewarded.

Dr. John Hussman is president of Hussman Investment Trust. You can find out more about the mutual funds he is involved with at http://www.hussmanfunds.com/.

And I recorded three sessions for Yahoo Tech Ticker in New York this morning. You can go to Yahoo and see them.

John Mauldin for Outside the Box

Zen Lessons in Market Analysis By John P. Hussman, Ph.D.

“The best way of preparing for the future is to take good care of the present, because we know that if the present is made up of the past, then the future will be made up of the present. All we need to be responsible for is the present moment. Only the present is within our reach. To care for the present is to care for the future.”

This week’s comment is dedicated to my dear friend Thich Nhat Hanh, a Vietnamese Buddhist monk who was born on October 11, 1926, having been born previously in January of that same year, and twice again about 25 years earlier, not to mention countless other times through his ancestors, teachers, and other non-Thich Nhat Hanh elements. Thay (the Vietnamese word for “teacher”) would simplify this by saying that today is his eighty-third “continuation day,” because to say it is his birthday is not very accurate.

If the quote at the top of this page looks somewhat familiar to our long-term shareholders, it may be because the practice of tending to the present moment – responding to prevailing conditions rather than relying on forecasts – is central to our investment discipline.

Focusing on the present moment doesn’t imply ignoring the past or failing to consider the future. It’s clear, for example, that we put a great deal of attention on estimating future cash flows and discounting them appropriately in order to evaluate whether various investments are priced to deliver satisfactory long-term returns. We certainly devote our attention to macroeconomic pressures and latent risks that threaten to become full-blown crises later. Still, we rarely make near term forecasts. Nor do we answer surveys like “where do you think the S&P 500 will be at year-end?” – a question that falls entirely outside of our way of thinking – like asking Columbus what sort of trees he thinks are planted along the edge of the Earth. The reason we avoid forecasts, very simply, is that they are not required, and that they can be a hindrance.

Expectations

One of the major debates among investors is between buy-and-hold investing and market timing. Think of the market as a big hat that has both red and green marbles in it, red corresponding to declines, and green corresponding to advances. The buy-and-hold investor essentially believes that it is impossible to predict which color marble will be drawn next, but that on average the marbles will be green. So the buy-and-hold approach simply holds on, regardless of prevailing conditions. The market return expected by a buy-and-hold investor is the “unconditional expected return” – something that has historically been about 10% annually. Let’s call this E[R]

In contrast, a forecaster does believe that the next draw can be predicted given some information “X”. As that information varies, forecasters will decide to buy or sell. But forecasters typically do something extra. Generally speaking, forecasters are not content with dealing with the present moment, and instead are prone to making bold forecasts about the next month, quarter, year, or even an entire stream of future returns (bull markets and bear markets).

The problem with this, in our view, is that it implicitly assumes that the information set “X” will remain constant. Worse, the size of the forecasts is generally far too large to be rational. A good forecast is most often a humble one.

Robert Hall of Stanford University (also the chair of the NBER Business Cycle Dating Committee that officially dates the beginning and end of recessions) calls this the Iron Law of Econometrics – the variance of a proper forecasting approach will always be smaller than the variance of the actual data. The reason is that if actual returns are equal to expected returns plus a random error,

R = E[R] + e

then a proper forecast is one where the errors are independent of (not correlated with) the expected returns. That means that the variance of actual returns – call it V(R) – must be equal to the variance of your expected returns V(ER) plus the variance of the error terms V(e). As long as there is any forecast error at all, an efficient forecast will always be one where your expected returns are less variable than what actually takes place. Forecasters hate this, because they like to make big, flamboyant predictions about a whole string of events, rather than focusing on the present moment.

Consider that hat full of marbles again. Suppose you are told that 80% of the marbles are green, and that 10 marbles will be drawn (with replacement). If someone asks your forecast, it’s very likely that you’ll be comfortable predicting that 8 of the marbles will probably be green.

Now suppose the first marble is drawn, and suddenly, someone switches the hat, right in front of you. What happens to your confidence in your forecast? Well, it should collapse, because suddenly you’re facing a new X. If the information set X can change, then it is not reasonable to make forecasts that assume that it will be constant over the forecast horizon.

So if we don’t want to assume that market returns are simply constant at 10% regardless of valuations or other conditions, and we also don’t want to make inefficient forecasts, what is the alternative?

For us, it is to focus on the present moment. We focus on “conditional expected returns” – the return we can expect, given the particular information set X that we have in hand. This is generally written E[R | X]. But unlike forecasters, we recognize that the predictable component of market behavior for any given period is so small, relative to random noise, that making specific forecasts is futile. We take our information set one X at a time, and we rely on discipline and the law of large numbers to mute the impact of that random noise over the long-term.

Specifically, we can go back over history and use observable conditions such as valuations, market action, overbought/oversold status, macroeconomic factors, and so on to separate history into various “bins.” Each bin represents a combination of observable conditions occurring together (what I’ve called “X”). Then we can ask, for every observation in the bin, what was the market return over a short subsequent period like a week or a month. Each bin then can be associated with a particular expected return and risk profile. Our basic practice is to align our investment position with the set of conditions that we observe at each moment, and to shift our position as the evidence shifts.

Rather than treating the next week, month, quarter or year as a horizon that demands a specific “forecast,” we simply treat each realization as part of a “repeated game,” and rely on the law of large numbers – that is, the idea that if we follow our discipline period after period after period, over time our inevitable errors will average out, and our long-term results will be largely what we expect. The best way to take good care of the future is to take good care of the present moment.

But isn’t E[R | X] a forecast?

One might object that by aligning our investment position with the average return/risk profile associated with a given set of conditions, we must, by definition, be forecasting. This is true in the sense that we do have some expectation that market returns under a given set of conditions will be satisfactory or unsatisfactory, given the risks involved. But we differ from “forecasters” in recognizing that the expected return E[R | X] for any short period of time is overwhelmed several times over by the conditional error term “u”. It is only over many, many repetitions that the error terms dampen out.

This is a property that statisticians call “consistency.” Specifically, if a process is consistent, then as you increase the number of observations some random outcome, the average value of your observations will tend toward the true “population” average.

[Geek's Note: If R = E[R | X] + u, then over N repetitions, the standard deviation of the average error is the standard deviation of the actual error terms, divided by the square root of N. So if your conditional error terms tend to have a mean of zero, plus or minus 2.5% on a weekly basis, you would expect that over 100 weeks, your average error would be zero, with a standard deviation of about 0.25%. Over a full market cycle, you will have made a lot of individual mistakes in your investment position, but as long as your errors are not systematic, the combination of discipline and the law of large numbers will work strongly in your favor. Your results will be largely as you expected despite the fact that you made lots of individual errors along the way].

This is basically the dynamic at work when you sail a boat. If you hop into a sailboat and start across Lake Michigan, it is not particularly helpful to make predictions about the direction and speed of the wind over your entire journey. Much better to align your sails as those conditions change, making numerous modest errors, but getting across the lake.

Inquiry

“Suppose the mind consciousness is observing an elephant walking. During the time of observation, the object of mind consciousness may not be the elephant in and of itself. It may only be a mental construction of the elephant based on previous images of elephants that have been imprinted in store consciousness.

“Inquiry means not using the mental creation, but allowing yourself to get in touch, and to try to see how things truly are. We practice not to be influenced by the name, because when we are caught in the name we can’t see reality.”

Thich Nhat Hanh

It is important that we don’t place so much emphasis on “average outcomes” that we ignore the facts about particular instances. We still have to look carefully at reality to make sure that we aren’t assuming away particular features that are important.

This is a risk that market participants seem to be taking here in a major way. Specifically, we have seen a great number of research reports with the basic thesis of “The recession is over. Here is how the market (or the economy, or employment, etc) has performed after a recession is over.” The difficulty is that these are basically attempts to say “here is an elephant” and then immediately move to describing elephants in general, when in fact, this particular elephant is very likely to be pink, or white. Specifically, valuations here are far different than they have been at the beginning of the typical economic expansion. Moreover, economic expansions have historically always been paced by rapid expansion in debt-financed classes of expenditure such as housing, capital spending, and sustained (not just one-off cash for clunkers) demand for automobiles. In prior recoveries, debt-financed expenditures have turned up quickly and have typically led other classes of expenditure by nearly a year.

If we want to see things as they truly are, we have to look both at the elephant, and at anything that might set this particular elephant apart. With regard to the investment markets, if we suspect that the particular features of the present situation make things “different” than they have been historically, then it is best to look closely and get more data.

As an example, during the late 1990’s, it was often argued that technological innovation had changed the economy so profoundly that the market valuations of the time were actually reasonable, if not incredibly attractive (remember Dow 35,000?). So we had to open ourselves to the possibility that things were different in an important way. But when we actually looked at the data, there was simply no historical example – in any productivity spurt since the Industrial Revolution – that could support the sort of growth rates that were implicitly priced into stocks.

When we look at the current market environment today, it is clear that the enthusiasm about the market here is largely based on the idea that the recent recession is over, and that the economy will form a “V” shaped recovery similar, but much stronger quantitatively, to standard post-war recoveries. This is a very difficult argument to make, because the drivers of economic growth that existed in typical economic recoveries – particularly debt origination and consumption growth – are very compromised at present. Our perspective on the ongoing credit risk in the economy is much like that of economists Kenneth Rogoff and Carmen Reinhart, who foresaw the recent financial crisis, and are far less sanguine about the prospects for sustained recovery.

As I’ve discussed in several weekly comments, this is a subject that I have struggled with in recent months. Even if we could assume that the recent crisis was a standard post-war downturn, and that we are now in a standard post-war recovery, valuations would still concern us because at these levels, stocks are not priced to deliver satisfactory long-term returns in any event. However, we would have a greater willingness to take a moderate speculative exposure based on market action and prospects for sustained economic improvement. On the other hand, when we include other post-crash periods into our data set, and allow for the possibility that those instances better describe present conditions, the case for accepting speculative exposure is much more limited. Of specific concern is the tendency in those periods for strong advances (as we’ve seen in recent months) to be followed by spectacular failures.

So we have to be very careful about how we name things. When people label stocks as being in a “bull market,” the implicit suggestion is that stocks will continue to advance for a sustained period of time. When people say that the recession has ended and we’re now in a “recovery,” the temptation is to look at how the market has performed in previous recoveries, without noting the profound differences between those instances and the current environment.

As Thay says, “We practice not to be influenced by the name, because when we are caught in the name, we can’t see reality.” The picture in our head can be very influenced by the words we attach to it.

As Zig Ziglar says, “You can tell your wife that she looks like the first day of spring, or you can tell her that she looks like the last day of a long, hard winter. There is a difference.”

Koans

In Zen, there is a teaching tool known as a “koan” – a question that serves as the object of meditation, and is intended to reveal something about teachings like mindfulness and interconnectedness. Western observers sometimes mistake these for riddles, non-sequiturs, or nonsensical statements, but if you look at them carefully, they are questions or stories intended to prompt the listener to see things as they really are.

A riddle is something like this:

Q: “How does a Zen monk know his pizza is enlightened?”

A: “It’s one with everything.”

Here is a koan:

A novice monk approaches his teacher and asks, “Is this a bull market or a bear market?”

The teacher replies, “If it is a warm day, and I say that it is winter, will you still wear your heaviest coat?”

Causes and Conditions

“This is, because that is. This is not, because that is not.”

Buddha

“The seed and the fruit are not two different things. The fruit is already contained in the seed. It’s waiting for different conditions in order to be able to manifest. The fruit doesn’t have a separate existence; it’s a formation. Using the word “formation” reminds us that there is no separate existence in it. There is only a coming together of many, many conditions. “

Thich Nhat Hanh

When we think about events, either in our daily lives, or in the market or the economy, it is important that we don’t think of them as simply existing or coming out of nowhere. This is, because that is. This is not, because that is not. We cannot create or remove a condition, expect it to emerge or expect it to disappear, without understanding the seed that produces it, and the causes and conditions that allow it to spring up.

Generally speaking, the seed we water is the one that grows. That’s why if we spend our energy thinking about what we don’t want, what we don’t like, what is wrong – we’ll tend to nurture and strengthen exactly the wrong things. If we water the seeds of peace, understanding, empathy, happiness, and so on, those are the seeds that will grow.

The basic condition for anything to emerge is for the seed to exist. But that is not enough. The seeds of a bear market are often fully present in the later stages of a bull market – overvaluation, excessive speculation, acceptance of risk without sufficient compensation, extension of credit to poor credit risks, belief in the sustained growth of cyclical businesses, overconfidence, and so forth.

But in order to manifest as a flower, or a weed, or as fruit, other conditions have to be present. Buddhists distinguish two kinds – “same direction” and “opposing direction.”

Conditions in the opposing direction tend to hold back the manifestation of the seed, but can also force it to become stronger before it manifests. If you plant a seed in firmer soil, the roots may be forced to dig deeper in order to establish themselves and find water, whereas a seed in easier soil may grow more quickly but have weaker foundations, so it can be uprooted easily. Conditions in the same direction are those like water and sunlight, which provide the background environment necessary for the seed to grow.

Some of our best investment insights have been driven by this focus on causes and conditions. These often take the form of “Aunt Minnies” – sets of conditions that may not mean much by themselves, but have very strong implications when they occur together (a person may have one feature or another, but if you have just the right combination, you know it’s Aunt Minnie). These include, for example, the conditions I noted in A Who’s Who of Awful Times to Invest, and our recession warning composite. To find Aunt Minnies, we look for a seed, identify conditions in the opposing direction (if any) that have made the seed strong, and then look for conditions in the same direction that are capable of bringing the seed to fruition.

Many of my concerns about the markets in recent years have emerged because too often, financial market participants and policy makers focus on manifestations rather than causes and conditions. This is why investors produced the dot-com bubble, the tech bubble, the mortgage bubble, the debt-financed private equity bubble and the commodity bubble without thinking of the seeds of crisis that were latently emerging, or how violently they would manifest. Our policy makers have bailed out poorly run financials by creating massive federal deficits, and think they’ve solved the problem in the same way as someone who runs over a weed with the lawnmower. The roots have simply grown deeper, because the seeds are still there, but we’ve applied a few conditions in the opposing direction. Those of you who have read these missives for a long time know that my geopolitical views are largely the same. This is, because that is. This is not, because that is not.

We can have an overvalued market and the seeds of a bear market, but if we apply opposing conditions in the form of easy money in order to prop up the market and prevent the consequences of bad behavior, the seed will simply grow stronger, and its ultimate manifestation will be more powerful. We can have a mortgage market that is setting new records for delinquencies and foreclosures every month, combined with increasing unemployment and a heavy reset schedule on Alt-A’s and option-ARMs that is just now picking up. But we lower the bar on financial reporting, fail to restructure debt, and ignore the strengthening seed because we’re single-mindedly enthusiastic about the thin-rooted green shoots of stabilization – born solely of a burst of fiscal profligacy – then we’ll predictably be blindsided when the problems re-emerge.

Predictably blindsided. That’s happened again and again in recent years. And it happens when we fail to think about the seeds we are watering. If we look only for fruit and ignore the seeds of crisis, then every bit of fruit will be followed by crisis, and nobody will understand why.

Interbeing

“As thin as this sheet of paper is, it contains everything in the universe in it.”

Thich Nhat Hanh

If you look closely at a sheet of paper, you can see the clouds, the rain, the soil, the sunshine, the mill, the truck, and so forth, because without these things, there would be no sheet of paper. In Buddhist terms, the paper is “empty” and has no self. That doesn’t mean that the paper is not there, but rather that the paper is made entirely of non-paper elements. Empty of self means full of everything non-self.

There’s a phrase alambana pratiyaya – which means that object and subject are always born together. The idea of interbeing is that nothing has a separate existence – that each thing is connected to the others. It’s an inherently peaceful way of thinking, because it recognizes that we are all made of the same substance, that to take care of others is to take care of ourselves, and that we can only understand something if we understand the context that surrounds it.

So here’s a koan – “What is the sound of one hand clapping?”

If you think about it as a riddle, you’ll keep looking for the punch line. But the koan is really about encouraging the listener to consider the true nature of things. Nothing is possible in the absence of interbeing. Subject and object must occur together or nothing manifests at all.

Here’s another one – “If a tree falls in the forest and nobody is there to hear it, does it make a sound?”

Our immediate impulse is to think, of course it makes a sound. But look more carefully. If a tree falls, it certainly will make the air move, but what is sound? Sound is the interpretation that our brains give to those air vibrations. If we are not there, the air vibrates, but is the experience of sound there? One might think, but wait, we could put a microphone there in the forest. But what is the microphone picking up? The air vibrations. If we play that recording on a video monitor with no speakers, you’ll see visual images, but no sound. In order to get sound, you have to have speakers, and the speakers simply take the recorded signals and turn them back into air vibrations, which become what we call “sound” when there is a brain to interpret them. Subject and object have to occur together.

So here’s another koan – “If a share of stock is sold in a forest, and nobody is around to buy it, does it still generate a fill?”

The immediate implication of interbeing is that we are forced to think about “general equilibrium” rather than imagining that one side of a trade can exist without the other. This immediately clarifies all sorts of misconceptions that we could fall victim to if we aren’t careful.

For example, it immediately tells us that “cash on the sidelines” is not a useful concept, except as a measure of issuance. See, whatever “cash” is there on the sidelines exists because government has created paper money, or the Treasury has issued bills, or because companies have issued commercial paper. Until those securities are actually physically retired, they will and must remain “on the sidelines” because somebody will have to hold them.

If Mickey wants to sell his money market fund to buy stocks, the money market fund has to sell commercial paper to Nicky, whose cash goes to Mickey, who uses it to buy stocks from Ricky. In the end, the commercial paper Mickey used to have is now held by Nicky. The cash that Nicky used to have is now held by Ricky, and the stock that Ricky used to have is now held by Mickey. There is exactly the same amount of “cash on the sidelines” after this transaction as there was before it.

Similarly, money never moves “into” or “out of” a secondary market, or from one sector to another. If I bring $1 “into” the stock market, that same dollar goes back “out” a moment later in the hands of a seller. If it did not, there would be no trade, no fill.

We can talk about differences in eagerness or in pressure as moving stock prices. But we cannot talk about money going in or money going out. We cannot talk about supply being greater than demand or vice versa. In equilibrium, the two must be equal.

One of the most useful ways of interpreting price and volume behavior is this: if something makes a given trader want to buy, the price must move in a way that either removes that impulse or induces another trader to sell. There is no other option.

Here’s another koan:

A novice monk approaches his teacher and asks “What is the price movement of one share being bought?”

The teacher holds out a cypress leaf in his palm and asks, “Did I catch the leaf as it fell from the tree, or did I raise it from the ground?”

We are used to thinking that the act of buying necessarily implies rising prices. But think about this for a second. In either case, the teacher gets the cypress leaf. What makes the difference so far as direction is concerned is where the pressure is coming from. If the cypress leaf is being offered down by gravity, it is caught on a decline. If the leaf is being lifted by the teacher, it is caught on an advance. Remember that. It is easy to get trapped in wrong thinking by people who talk about “cash on the sidelines” or talk about “investors” buying or selling in aggregate.

There was no excess of stock that was “sold” in March that has to be “bought” back now. Investors didn’t “get out” of the market last year, and we shouldn’t think that they have to “come into” the market now. Every share that was sold was bought. That has been true for every minute of every trading day since the beginning of the financial markets.

Prices and Volume

A good way to think about prices and trading volume is to abandon the idea that money goes in or out, and to think instead about the market as a collection of various groups. Imagine there being fundamental investors, who are interested primarily in value (buying on weakness and selling on strength), and technical investors, who are interested primarily in trends (selling on weakness and buying on strength). These people also trade on different horizons and base their trading on different extent of movement.

In this sort of equilibrium, trading volume is a measure of strong views and disagreement. As the market turns weaker, trend-following investors typically abandon stocks, while fundamental investors accumulate. The reverse is true on significant strength. So spikes in trading volume tend to occur primarily at extremes relative to the target prices of fundamental investors. Volume spikes also tend to be correlated with a series of positive or negative shocks that then abate. In contrast, dull volume is a measure of low sponsorship, strong agreement, and lack of external shocks.

Equally important is that net incipient buying from both technical and fundamental investors cannot exist, so large price movements are typically required to relieve the disequilibrium. If you’ve got an overvalued market which then loses technical support, the outcome can be extremely negative, because technical investors are prompted to sell, but fundamental investors have weak sponsorship at that point, so large price declines are required to induce the fundamental investors to absorb the supply.

In contrast, if you’ve got an undervalued market where fundamental investors raise their outlook, the demand from fundamental investors is not typically provided by technical investors (who would tend instead to buy on advances in price), so the price must increase enough to induce fundamental investors with shorter horizons to supply the stock.

All of these dynamics have been active in the market over the past two years, but the most significant outlier has clearly been the past few months, where volume behavior has demonstrated much weaker sponsorship than we would have expected for an advance of this size. Normally, the volume characteristics we’ve seen have been much more typical of short-squeezes and less durable advances.

Presently, my primary concern is that stocks are now overvalued, to about the same extent as they were in the late 1960’s, and just prior to the 1987 crash, but certainly less overvalued than they were at the 2000 or 2007 peaks. Our 10-year total return projection for the S&P 500 is centered modestly above 6% annually, even if one assumes that the long-term path of earnings has been unchanged by the events of recent years. If we assume that the economy will require a much longer period to recover than has been typical of post-war recessions, the prospects for long-term returns are lower, but we don’t need to assume this in order to be concerned about valuation here. (The green, orange, yellow and red lines imply terminal price/peak earnings multiples of 20, 14, 11 and 7 a decade from now. The dark blue line charts actual annual total returns over the subsequent decade).

Though rich valuations and a fresh overbought condition last week argue for tepid returns going forward, my expectation is that strong downward pressure would be most likely if market internals deteriorate somewhat – particularly in terms of breadth. Again, if technical investors are prompted to sell in an environment where sponsorship from fundamental investors is weak, large price changes may be required to relieve the disequilibrium.

A quick summary

Present moment, only moment. Sound investment does not require forecasts. It is enough to align the investment position with the prevailing, observable evidence.

Labels can help to classify, but they can also obscure truth. There is no quantitative substitute for mindfulness. That said, if “this time is different,” one should be able to find appropriate parallels using a sufficiently broad set of historical or international data.

The seed and the fruit are not two different things – significant market moves are generally the fruit of causes and conditions that latently precede them.

Everything, including the market, is ultimately empty of a separate self. One market can only be understood and analyzed in the context of other markets and conditions. Supply and demand, in particular, should not be considered in isolation.

Finally, Thay would add something more, which is to breathe, bring yourself back to the present moment, and recognize that even the smallest, simplest thing can be the basic condition for your happiness.

“If you touch one thing with deep awareness, you touch everything.”

‘WHERE ELSE ARE YOU GOING TO GO? ‘ by James Kwak at baselinescenario .com. More about the greed of the ‘Masters of the Universe.’ You think they give one whit about paying someone a $100 million bonus? THINK AGAIN. I’VE LIVED WITH THESE ARROGANT BASTARDS ON THE UPPER EAST SIDE OF MANHATTAN FOREVER.

Where Else Are You Going to Go?

Posted: 19 Oct 2009 04:00 AM PDT

Yves Smith returned from book-writing land to catch up on the Andrew Hall story, which is one that I pretty much decided to ignore from the beginning. Hall is the Citigroup trader who, according to his compensation agreement, was due a $100 million bonus. The bonus was so big because Hall and his team were due 30% of the profits from their trades, which is even more than typical hedge fund fees. (This tradition of particular trading groups negotiating a share of their profits dates back at least to Salomon in its heyday; AIG Financial Products also had this type of deal.)

But Smith focused on one element that got me thinking. Hall’s division, Phibro, was bought by Occidental Petroleum. “Oxy paid $250 million, the current value of Phibro’s trading positions. There was NO premium, zero, zip, nada, for the earning potential of the business. Zero. Oxy bought the business for its liquidation value.” Smith infers that no one was willing to pay more because the success of Phibro depended on its being part of Citigroup and benefiting from Citi’s low cost of funding; in other words, the massive profitability of Phibro was in part due to an accounting error — not charging it an appropriate cost of capital given the risk it was taking.

This made me think of something else, though. The typical excuse for paying traders enormous amounts of money is that if you don’t, they will leave for somewhere else. During the boom, it was certainly true that they would have left. (Whether anyone would have missed them is another question — it seems to me that some of the reasons to be skeptical of mutual fund managers apply equally to proprietary traders.) But after the crisis, the options for someone hoping to leave a major investment bank must have declined.

I’ve written so many times that reduced competition has helped the survivors increase market share and margins, but I never realized the other consequence: it gives them more bargaining power relative to their employees. There are fewer banks to go to; some of them (Citi, Bank of America) are in no shape to be paying top dollar; and while some hedge funds are doing just fine, their cost of funds must have gone up relative to the big banks in the current environment. With less competition for talent, compensation should go down, at least a little.

So why is Goldman reportedly on track to pay record or near-record bonuses this year? I imagine they would say something about how, in order to maximize long-run firm value, they shouldn’t take this opportunity to screw their employees. But if I were a shareholder, I would think a small amount of employee-screwing would be in order. This is a company that claims to live and die by the free market, after all.

By James Kwak

‘REVIEW ESTATE PLANS BEFORE PLANS CHANGE, ‘ at fidelity.com. GET THEE DUCK$ LINED UP NOW. NOT TOMORROW, NEXT WEEK. ‘GOOD FORTUNE FAVORS THE BOLD, ‘ the poet Virgil in about 50B.C.

Review estate plan before the rules change

BY LORI JOHNSTON,  BANK RATE — 10/12/09

A general rule for estate plans is to revisit them when there’s a major change in circumstances, such as a marriage, divorce or the addition of children or grandchildren.

The economic meltdown of 2008 was one of those significant events: It left a great number of Americans looking at lower asset values due to deterioration in the stock and real estate markets.

But changes in the economic landscape and possible estate-tax reform make now a good time to review your plan. And, experts warn, don’t put it off simply because you’re depressed over market losses or you have a natural tendency to avoid discussing death.

“A lot of people, I think, have been putting off their estate plans lately because the market has declined. They’re not feeling as wealthy, or maybe they think it’s not as important,” says M. Everett “Rett” Peaden, an associate with the Atlanta-based law firm of Davis, Matthews and Quigley.

“People are saying, ‘Gee, I had a couple million in my IRA and now it’s only a million. Do I really need to worry about that?’” Peaden says. “One of the answers I give to people is, ‘You never die at the right time, and no one ever expects it.’ People need to stay on top of it.”

Potential moves by Congress that could affect estate plan tax exemption amounts and depressed asset values combined with low interest rates are converging factors that should prompt a review, says Ron Knipping, CPA and managing principal at Rehmann Financial, a Saginaw, Mich.-based business consulting firm.

If you’ve updated your plan within the past couple of years, changes could be “fairly straightforward,” he says.

But if your plan is 7 or 8 years old, it might not make sense any longer, says Ted Kurlowicz, professor of estate planning at The American College in Bryn Mawr, Pa. That’s because the federal estate tax exemption has been steadily rising, from $675,000 in 2002, for example, to $3.5 million in 2009. It is scheduled for repeal in 2010, and then will revert to $1 million in 2011, unless Congress enacts reform.

“Everybody has had a significant change in the amount they can pass (to heirs),” Kurlowicz says. He expects estate-tax reform to be enacted by the end of the year.

Although all estate plans — and changes to plans — will vary based on your circumstances, here are five steps experts say people should consider to bring them up to date.

Do fact-finding first

Before you contact your attorney, determine what has happened to your asset values, how you own your assets, what amounts you are planning to pass on to beneficiaries and other information that will help you determine your net worth, Kurlowicz says. It’s probably not going to be as high as you would like, but you need to know what you have.

Look at heirs in need now

If you can help heirs financially, you may want to shift some money out of your estate. Maybe a child or grandchild has lost a job and is in need of some financial assistance.

You’ll reap the benefits as well. For example, you can pay medical expenses or tuition directly to the institution for a beneficiary and not have to pay gift tax.

But make sure you don’t jeopardize your own financial situation.

“You should be looking not only at yourself but others who are going to be inheriting from you and making some adjustments,” Kurlowicz says. “Maybe (you’re) comfortable and can help them out, but it’s going to change (the plan).”

Consider your cash flow

Knipping says some people delay analyzing cash flow out of denial and the fear there’s not enough money in the estate. “Emotionally and realistically, it’s a hard discussion,” he says.

But looking at your cash flow could help you determine what you can gift now, and what you want to keep as part of your estate. “The big thing is never give away more than you can afford,” Knipping says.

Take advantage of the depressed values

Peaden has been encouraging clients to consider gifting the reduced value of their shares in a business, property or other assets if they’re worried about the estate tax. They remove the asset from the estate — thus lowering the amount subject to tax — and shift future appreciation to the recipient.

“Most people agree that values are … a little tight now, and they’re expecting — or hoping at least — that things are going to rise over the next few years,” he says.

Consider a living trust

“When you have a lot of flux, I like living trusts,” Kurlowicz says. A living trust combined with power of attorney allows aspects of an estate plan to be changed after an individual loses mental capacity, unlike a will, which is not as amenable to change, he adds.

In a trust, you name a successor trustee or co-trustee who can take over if you become incapacitated.

If you decide on a living trust, you still need a will — called a pour-over will — that will transfer any assets to the trust that weren’t transferred before death.

If the probate process in your state is onerous, a living trust may simplify the distribution of your estate because it bypasses probate.

“GETTING A GOOD RETURN ON WHERE YOU PARK YOUR CASH, ‘ from Kiplinger Personal Finance, fidelity.com. MINE IS AT FIDELITY SPHIX PAYING 8% ON A 30-DAY YIELD BASIS. –HIGH INCOME FUND.

Move your money to a higher-yielding account without sacrificing safety.

Still have cash parked in a money-market mutual fund? It’s time to move it out. A year ago, when the stock market was in free fall and investors were seeking refuge, money funds were earning 2% or more. Now the yields, which track short-term Treasuries, are below 0.4%. Yet money funds still hold $3.5 trillion in assets, just about the same amount as they held a year ago, according to Money Fund Report newsletter. Prospects for higher rates are better at a bank, but even if you’re willing to tie up your money for five years in a certificate of deposit, you’ll be hard-pressed to find yields higher than 3.5%. And top one-year yields are only 2% or so.

Even as market forces undermine the earning power of your savings, don’t let inertia add insult to injury. To find decent, supersafe yields now, you have to think outside the box. For example, you’ll find some of the highest interest rates at community banks and credit unions. And your money is safe, as long as you know the limits of deposit insurance. If you’re willing to step up the risk pyramid for a decent shot at higher returns, consider a short-term bond fund.

Safety plus high yields

You can earn as much as 5% on balances up to $25,000 (and sometimes more) at a community bank or credit union. For example, Union State Bank in Atchison, Kan., pays 5.01% on up to $25,000 in its My Rewards checking account. And you need a deposit of just $25 to open an account. (To find banks and credit unions with high-yielding accounts, visit CheckingFinder.com, and enter your zip code.)

Yes, there’s a catch to high-yield accounts: They come with a laundry list of restrictions. All banks and credit unions that offer them have more or less the same requirements. You must receive monthly statements by e-mail, use online bill pay, set up one monthly direct deposit or automatic payment, and use your debit card for purchases from ten to 15 times a month. The interest rate drops to around 0.3% at most institutions in any month that you do not meet the account’s requirements, but it reverts to the higher rate if you meet them the following month.

Bobbi Bechtold of Godfrey, Ill., opened a free eSmart checking account at Liberty Bank, a small community bank in Alton, Ill. The minimum deposit to open the account was just $1, and she’s earning 4.01% interest on balances up to $25,000 (for higher balances, the rate drops to 1.25%). Liberty Bank reimburses ATM fees  from other banks up to $20 a month. To help meet the 15-times-a-month debit-card requirement, Bechtold’s husband, Don, uses his card when he picks up his morning cup of coffee at McDonald’s. Bechtold keeps the account balance as close to the $25,000 limit as possible by replenishing the funds from savings after she and Don use their debit cards.

Bechtold found Liberty Bank when she searched the Web for the best rates. She used to have accounts at megabanks, such as US Bank and Bank of America, but now she prefers doing business at a community bank “where you know everybody.”

Credit unions are in stiff competition with banks for deposits. On average, they currently offer higher yields than banks on deposits and lower rates on loans and credit cards, according to a recent survey by Datatrac. When some of their CDs came due, John Eckley and his wife, Kathleen, each opened an Xtraordinary checking account at Connexus Credit Union in Wausau, Wis. “I could earn far more than on any other checking or money-market account,” says John. Connexus accepts members from anywhere in the U.S. (you can join the Connexus Association for just $5). Or you could join Pentagon Federal Credit Union, even if you’re not a member of the military, by paying a one-time, $20 membership fee to the National Military Family Association.

Bank money-market deposit accounts, which are also insured by the Federal Deposit Insurance Corp., are another option, but they yield 2% or less. You can open an MMDA at Flagstar Bank, in Michigan, with just $1 and pay no monthly fees. The account, which recently yielded 1.82% on balances up to $1 million, comes with a Visa  debit card that you can use surcharge-free at more than 32,000 ATMs. By law, you can transfer funds or make withdrawals from a deposit account only six times a month, and only three of those transactions may be made with your debit card.

If you don’t need to write checks, consider a savings account. For example, you can earn 2.3% on up to $100,000 in deposits at Tennessee Commerce Bank. Keep $250 in your account, and you avoid all monthly fees. You’re entitled to one free ATM withdrawal a month; you pay $2.50 for each subsequent withdrawal.

Create a CD ladder

For sums above $25,000, certificates of deposit still offer the best combination of safety and yield. CD rates keep “slip-sliding away,” says Greg McBride, of Bankrate.com. So shopping around is more important than ever. Yields from the top-paying banks range from 1.8% to 3.5%, depending on maturity.

A bank that offers a high yield in one maturity typically offers the best rates in other maturities as well. State Bank of India, in New York, which is the U.S. operation of India’s largest bank and a member of the FDIC, is among the top yielders in five of the six maturities from six months to five years. Ally Bank, formerly known as GMAC Bank, and Discover Bank are among the institutions offering the best rates in all six categories — although neither offers the highest rate in any maturity.

A good way to invest in a CD portfolio is to create a ladder of CDs with maturities that range from six months or a year up to five years. That way you can take advantage of higher rates when you reinvest your shorter-maturity CDs, while still earning higher yields on longer-term CDs. CD rates are likely to rise when the Federal Reserve raises short-term interest rates, but that probably won’t happen until a year from now, if then.

As of January 1, 2014, deposit-insurance limits revert from $250,000 to $100,000 per depositor per bank or credit union. If you have more than $100,000 to invest in CDs that mature after 2013, divide your cash among several institutions.

More risk, more reward

No uninsured financial instrument is bulletproof. But that doesn’t mean you should rule out all funds that invest in short-term bonds and bank loans. Yes, a few short-term bond funds lost more than 20% last year during the credit crisis. But for the most part, the types of funds designed to yield a few percentage points more than certificates of deposit and money-market funds without great swings in net asset value (or NAV, a fund’s share price) have kept up their dividends. And as credit conditions improve, NAVs are recovering.

If your priorities are to make sure your principal is safe and obtain a small yield advantage over a bank account, look for three things: a long record of steady monthly payouts, low expenses and stable net asset value. Steer clear of any fund that’s using borrowed money (leverage) or trading exotic instruments such as interest-rate swaps. And because of the risk that higher interest rates pose, focus on funds that invest mostly in short-term bonds (bond prices move inversely with interest rates; in general, the longer a bond’s maturity, the greater its price swings with changes in rates). In that regard, several funds stand out.

A good place to start is Vanguard Short-Term Investment Grade (VFSTX |. Vanguard bond funds rarely play games — what you see is what you get — and they benefit from low fees, which are particularly important in a low-interest-rate world. This fund’s annual expense ratio is just 0.21%. Despite investing in bonds with an average credit quality of single-A and an average maturity of less than three years, the fund lost 4.7% last year-disappointing but tolerable considering the damage many other short-term bond funds sustained. Vanguard Short-Term (VFSTX | has recovered nicely in 2009, gaining 12.2% through September 22. The fund sports a current yield of 2.8%.

Technically, you can’t call Ginnie Mae funds cash substitutes, but they play the part as if they were born to it. Ginnie Mae funds own packages of home mortgages, not short-term debt, but the funds kept their value through the financial crisis. That shouldn’t come as a surprise because Ginnie Maes are backed by the full faith and credit of the U.S. government, making them much sounder than other mortgage-related investments. Vanguard GNMA (VFIIX has a much lower duration (a measure of interest-rate sensitivity) than GNMA indexes or other funds, so rising mortgage rates shouldn’t hurt much. Vanguard GNMA (VFIIX | returned 7.2% in 2008 and has gained 4.5% so far this year; it yields 3.8%. In addition to Vanguard, Fidelity, Payden, Pimco and T. Rowe Price all have fine GNMA funds.

If you’re willing to take on more risk, consider a bank-loan fund. Fidelity Floating Rate High Income (FFRHX , with a current yield of 4.4%, is once again an attractive place to store some cash now that we’ve seen the worst of the recession. The fund, which invests in loans made by banks to companies with below-average credit ratings, lost 16.5% last year because of the credit crunch. But it’s rebounded with a vengeance this year, gaining 25.9%. Monthly cash payments are half what they were a year ago because the interest rates on those bank loans reset periodically and have trended down along with other short-term rates. When the Federal Reserve starts raising short-term rates, Fidelity Floating Rate (FFRHX will make bigger distributions.

Among tax-free funds, consider Alpine Ultra Short Tax Optimized (ATOIX |, which owns tax-exempt securities close to maturity. It actually made money last year, producing a total return of 3.6%, and it’s gained 2.9% so far this year. Manager Steve Shachat says that one way he guards against losses is by refusing to buy sharply discounted bonds in hopes of capturing a capital gain. At last report, Tax Optimized (ATOIX ) had more than 70% of its assets in variable-rate demand notes — long-term debt securities with floating interest rates. The fund yields 2.7%, which is equivalent to 4.2% from a taxable investment for someone in the 35% federal tax bracket.

Another standout in the tax-free arena is Fidelity Intermediate Municipal Income (FLTMX | , a member of the Kiplinger 25. As the name indicates, the fund invests in medium-maturity bonds (as of September 22, its average duration was 5.2 years, suggesting that the fund’s NAV would drop 5.2% if interest rates were to rise one percentage point). But rates aren’t likely to be heading up anytime soon, and the fund, under manager Mark Sommer, has been a steady performer. It eked out a 1% return last year and so far this year has gained a solid 8.7%. The fund yields 2.8% tax-free, equivalent to a taxable 4.3% for an investor in the 35% federal bracket.

© 2009 The Kiplinger Washington Editors

‘MUDDLE THROUGH R.I.P.?, ‘ by John Mauldin at Frontline Security.

I first wrote about the Muddle Through Economy in 2002, and the term has more or less become a theme we have returned to from time to time. In 2007 I wrote that we would indeed get back to a Muddle Through Economy after the end of the coming recession. If you Google the term, at least for the first four pages more than half the references are to this e-letter. I get a lot of flak from both bulls and bears about being either too optimistic or too pessimistic. Being in the muddle through middle is comfortable to me.

Last week I expressed my concern that we as a country are taking actions that could indeed “Kill the Goose” of our free-market economy. I rightly got letters asking me how I could maintain Muddle Through in the face of that letter. I have given it a lot of thought and research. How likely are we to muddle through in the face of $1.5 trillion and larger deficits? Today we take another look at Muddle Through. It should be interesting.

But first, two housekeeping items. I want to welcome the 150,000 members of the National Association of the Self-Employed to this letter. They have asked me to be a special consulting economist to their group, and they will send this letter each week to their members. Since its beginning in 1981, the National Association for the Self-Employed has pioneered support for micro-businesses and the self-employed, and been a forceful advocate for small business in this country. (www.nase.org) I am honored. I am pleased to add you to my 1 million closest friends. I hope you find it useful.

Second, I will be going to South America at the end of next week, to Buenos Aires, Montevideo, Sao Paulo and Rio. I will be speaking in those cities and traveling with my new Latin American partner, Enrique Fynn of Fynn Capital (based in Uruguay). If you would like to find out about this tour or what services he can help you with, you can go to www.accreditedinvestor.ws and sign up and Enrique will get in touch with you. And as always, if you are an accredited investor, you can go to that website and one of my partners in the world will get back to you. (In this regard, I am president of and a registered representative of Millennium Wave Securities, LLC, member FINRA.) And now to the letter.

Muddle Through, R.I.P.?

I defined a Muddle Through Economy in the past as one of slow growth (in the area of 1-2%) and a slack employment environment, such as we had in 2002 and the early part of 2003. In early 2007, I suggested we would return at some point to such an environment at the end of the recession I was predicting.

I am not surprised about the response of the Fed to the current recession and credit crisis, whether it’s the large monetization of debt or the low interest rates. Assuming they more or less remove the monetary easing in a reasonable manner, there is nothing that would make me think we do not eventually recover, albeit at a very slow Muddle Through pace, with a jobless recovery that lasts for several years. It will not be pleasant, but we’ll survive.

However, gentle reader, never in my wildest dreams did I think we could be looking at government deficits of $1.5 trillion dollars and actually budgeting future deficits of over $1 trillion as far as the eye can see. And there is real reason to think that under current plans, $1 trillion deficits are optimistic. Look at the graph above from the Heritage Foundation. They suggest that current policy would bring us closer to a $2 trillion deficit by 2019.

And that assumes nominal growth that is north of 3% and unemployment dropping back below 5% in reasonably short order. If you make less optimistic assumptions, the number can become much larger rather quickly. Where do we find that much money to finance that large a deficit? We will look at what might be the answer, but first we need to look at a basic concept in economics.

You can calculate national savings as GDP minus consumption and government spending. That means that investment equals savings plus net exports. If there are no net exports, then money must come back into the US from outside the country to finance investments, along with savings.

This equation is known as an identity. An identity is an equality that remains true regardless of the values of any variables that appear within it. That means it is not a guess or an approximation. It is simple reality.

Thus, if there is a government deficit, there must be savings by both consumers and businesses, plus capital flows from outside the country, to offset that deficit in order for there to be any money left over for investments.

In the short run, an increase in government spending can offset a decline in consumption (a recession), but absent savings a government deficit crowds out investment in the long run. There must be savings in order for there to be investment. And without investment, you do not get job growth or economic growth.

Japanese Disease

Some readers wrote this week telling me I am far too worried about a rising government deficit. Right now we are at roughly 42% of debt to GDP. In 1989, at the start of the lost decades, Japan had a debt-to-GDP ratio of 51%. Now it is at 178%, and the world has not come to an end for them. In fact, they are running massive government deficits today and plan to do so for a long time. Why, I am asked, can’t we be like Japan? And my answer is that it is possible, but the cost that Japan has paid has been high.

In 1989, private Japanese debt (businesses and consumers) was at a debt-to-GDP ratio of 212%. Now it is at 110%. And the total of both government and private debt is roughly the same (within 5%) of where it was 20 years ago. Along with running large trade surpluses, private debt has been exchanged for government debt. Savings have fallen from the mid-teens to about 2% today, as the country is rapidly aging and now using its savings to live on. And how much has all that government spending helped the country? Before I answer that, read these paragraphs from Hoisington Asset Management’s latest letter (last week’s Outside the Box):

“The federal government’s promise to extricate the U.S. economy from this recession involves more spending (increasing public debt) and more subsidies for consumers, such as car rebates and home buying incentives (more private debt). In other words, more debt is supposed to solve the problem of over-indebtedness. The truth is that this policy merely indentures its citizens further without providing any income for repayment of debt. In previous letters we have discussed the fact that the government spending multiplier is zero (read Professor Robert Barro’s book, Macroeconomics – a Modern Approach, p. 370).

“This means there is no long term income benefit from stimulus programs. According to the latest academic research, the most recent $800 billion stimulus plan will boost economic activity in the short run, but will surely depress economic activity over time. The government problem is complicated by the fact that the tax multiplier is 3, meaning that a 1% change in taxes will change GDP by about 3% over time. More recent research (Barro & Redlick, September 2009, “NBER Working Paper 15369″) suggests that a 1% cut in the marginal tax rate would raise GDP in the ensuing year by 0.6%. With the deficit rising due to a zero spending multiplier, the tendency will be to try to raise taxes to pay for this higher level of expenditures, which will further depress aggregate spending and output.”

For all intents and purposes, Japan has had no growth for almost two decades. Their nominal GDP is where it was 17 years ago, and the number of employed people is at 20-years-ago levels. An aging population has masked their unemployment problems, as older citizens retire. Their savings went to government debt. Taxes were raised numerous times. Since government deficit spending has no long-term multiplier effect, growth has been nonexistent. (By the way, that research about multiplier effects has also been done by Christina Romer, the chairman of the current President’s Council of Economic Advisors, and further explored by European economists. There is general agreement on these facts.)

In 1998, the US had a total debt- (government plus private) to-GDP ratio of 260%. Today it is 373%. We have added over $15 trillion in debt, yet total employment today is roughly where it was 9 years ago. But the current economic leadership wants to solve the problem of too much debt with even more debt. I am sympathetic with the idea that in the short run the government should step in and the Fed should print (within limits) money to keep us from deflation. But the equation we spent time on earlier suggests that if we continue to run massive deficits, we run the risk of catching Japanese disease – a decade-long (or longer) period of slow growth and high unemployment, especially since our population is growing and our Boomers are going back to work (and surveys suggest they intend to work longer).

Large government deficits choke off the very investment that we need to create jobs. In the name of doing good, the unintended consequence is to make it more difficult for small businesses to start up and create jobs. And we all know that small business is the engine for job creation.

The way out of the current morass is to create jobs and increase productivity. But if the government runs deficits of $1.5 trillion, that means whatever savings (corporate and consumer) we have will not go into the investments we need, but into government debt.

Who Will Buy the Debt?

Now, let’s go back to the problem of who will buy the debt. How can we find $1.5 trillion each and every year? Some of it will come from foreign central banks, as we continue to run a trade deficit. Once those dollars leave our shores, they do not disappear. They can only go back into a dollar-denominated investment. Up to now, that has typically been US government debt. If China decides to use its dollars to buy commodities or other assets, whoever sells them the assets now has the dollars and must decide what to do with them. So give or take a few billion, about $400 billion will come back to the US from our trade deficit next year. That still leaves $1.1 trillion.

Upon reflection, and cutting to the chase, I think that the buyers of the debt could be US banks for quite some time. The next graph shows commercial and industrial loans at US banks falling precipitously. Banks have (correctly) tightened lending standards, but that means that small and medium-sized businesses, which account for over 85% of all jobs, have been cut off from the life blood of growth. Is it any wonder they are cutting jobs at a prodigious rate?

The next graph shows bank credit (of all types), going back to 1974. Notice that even during recessions (gray shaded areas) bank lending either grows or at the most goes flat. But now we are experiencing something new: bank lending is falling. Notice the sharp increase in lending in 2008 as corporations decided to draw down their banks’ lines of credit, afraid that the banks might cut back. And with good reason, as banks did exactly that.

So where do banks put their cash and reserves they are not lending? At the Fed and in Treasury debt. If you can leverage capital at ten to one (as banks can) and if you get 2% (for longer-term debt) and if you only have costs of, say, 50 basis points (or 0.5%), you can make a return on equity of 15% with no risk.

And that is what we are seeing. Banks are taking the money the Fed is printing and the government is giving them and putting it back at the Fed. Bank reserves at the Fed are exploding. And they are likely to continue to do so, since bank balance sheets are still deteriorating, especially at smaller and regional banks exposed to commercial real estate loans. Banks own 45% of commercial real estate loans, compared to only 21% of single-family loans. Banks (in general) are going to have to raise capital and reduce their loan portfolios in order to keep within the guidelines for adequate reserve capital. Small wonder that my friend Chris Whalen (one of the real experts on banks) thinks we will see over 400 banks fail in this cycle.

One quick chart to further highlight the problem that banks are facing. I have been writing for several years that commercial real estate loans will be the next shoe to drop. Moody’s calculates that commercial real estate prices have dropped 30%. Over a trillion dollars in commercial real estate loans are coming due in the next few years. Banks are going to continue to reduce their loan portfolios in order to deal with the massive write-offs they are going to have to make. And my bet is they put those reserves they are not lending into government debt.

Given that the current Congress is hell bent on massively raising taxes in 2011, we are likely to dip back into recession by then, if not before. Remember, taxes have a multiplier effect of three. That means tax cuts increase GDP (over time) by three times their amount. But tax increases reduce GDP by three times the increase. That will make deficits worse, and unemployment will again start to rise from already high levels. Twenty states have already raised sales taxes, and more are raising other taxes. It is a vicious spiral.

The New Muddle Through Economy

This is not a prescription for a return to normal growth. We are headed for a New Normal that is less than what the market currently believes. Unless the deficit comes under control at some point, we face the real prospect of catching Japanese Disease and suffering yet another lost decade. Can we Muddle Through? We have no choice but to do so. But it will not be fun. It will not be long-term 2% growth and employment going back to 6% any time soon. Can we reverse the course? With a different attitude and leadership in Congress, maybe we can. But it won’t happen next year, and it’s unlikely in 2011.

I am afraid we will have to put my old friend Muddle Through, as I previously defined him, back in his box for a while. But wait, if my friend at PIMCO, Mohammed El-Erian, can tell us we are going to a “New Normal,” then I can decide that we are going to a “New Muddle Through Economy.” Just not one as benign as I used to think.

In the end, that is what we will do. We will figure out how to deal with the environment in which we find ourselves. That is what free markets and entrepreneurs do. Things will sort out, but not before we have what could be an even more difficult crisis, which will force us to make hard choices.

As an aside, I am not expecting that we will see the crisis I am thinking of any time soon. We can move along with positive GDP for some time. I am thinking of the longer term, 1-3 years out. We will become complacent. I will get letters telling me I am too pessimistic. Just as I did in late 2006 when I said we would be in a recession by late 2007. But I firmly believe we will see a double-dip recession within another 18 months (at the most). Stock markets drop on average about 40% in a recession. Adjust your portfolios accordingly.

On the Road Again

I am writing tonight from Detroit. Tomorrow I will be in New York watching the Yankees/LA game. I will be the guy in the second row behind home plate in the Dallas Cowboys jacket. I will be on Yahoo Tech Ticker on Monday morning, so you should be able to go to Yahoo and see me later that afternoon. Then Philadelphia on Tuesday, speaking at my partner Steve Blumenthal’s CMG conference for investment advisors. They have a very interesting platform of trading advisors. You can see them at http://cmgfunds.net/public/mauldin_questionnaire.asp

I had a great deal of fun at the New Orleans conference, being with old friends and meeting new ones. David Tice (of the Prudent Bear Fund) was an exceptional host for dinner at Emeril’s. I was surprised that Karl Rove actually remembered me after nine years. I thoroughly enjoyed spending some quality time with my friend Ron Paul. We share a lot of concerns about the future of the Republic. I was pleasantly surprised by how thoughtful Howard Dean was. And very personable.

I go to Houston on Wednesday, Orlando on Thursday, and then South America on Saturday. I will be doing a lot of writing from hotel rooms, but all in all it will be fun. You have a great week, and remember that in 10 years none of us will look back and want to return to 2009. 2019 will be better than we can possibly imagine. We just have to make sure we all get there!

Time to hit the send button and find an adult beverage. All the best,

Your going to miss the Old Muddle Through analyst,

John Mauldin

John@FrontLineThoughts.com

Copyright 2009 John Mauldin.

‘TAKING THE EMOTIONS OUT OF INVESTING,’ from SmartMoney at fidelity.com. VERY IMPORTANT THAT YOU STUDY THIS, REMEMBER IT, AND PROFIT FROM IT.

In the markets, a few simple steps can help keep one’s emotions at bay.

We don’t just battle the markets, but our own emotional stability and mental health. Open trades are a relentless feedback loop. For six-and-a-half hours a day, at a minimum, you get a real-time reading of how smart or idiotic you may be, and markets don’t discriminate based on experience, expertise or net worth. No matter what level you play the game, when you’re wrong, its agony, and when you’re right, it’s like getting a kiss from the world’s most beautiful girl.

We always point out that losing positions, while painful, actually provide a benefit in giving an immediate indication of which strategies aren’t working. Nobody likes losing money. But a small loss, if handled appropriately, is normal and perfectly manageable. Nobody is right all the time.

Where the wheels go off the track is it’s no longer our heads making investment decisions, but our hearts. Emotional investing never ends well.

So we have a fight with our significant other and decide to sell our winners to boost our spirits. Or we get bored with our mutual funds and decide to dive into leveraged exchange-traded funds for more action. Unsatisfied with our own performance, we double down on losing trades in the hopes a small pop will put us “back to even.” In my experience, all will set you back more money than the best therapist money can buy.

Given the stressors of investing, there are a few simple tricks to ensure your decisions are being made based on the economic realities of your portfolio – not your emotional stability.

Stash some cash

There’s nothing particularly exciting about an emergency fund, the six to 12 months worth of living expenses every investor should have stashed away in a money-market or savings account. It’s even less thrilling when you’re earning nearly nothing on that cash.

Yet like fire insurance, an emergency fund is beneficial even if you never end up using it. Investment involves risk; any potential for profit comes along with the possibility of a loss. The emergency fund makes you, in effect, a much stronger hand in the marketplace. Risk is much easier to face when you know that month’s mortgage payment or gas bill isn’t riding on shares of iShares FTSE/Xinhua China 25 Index .

Keep your cool

In many states, you can’t simply walk into a gun store and walk out with a pistol. Local and federal laws mandate a “waiting” or “cooling off period” to diffuse any immediate — and potentially dangerous – rush someone might have to use a firearm.

No similar restrictions exist for investments. And while emotional decision making can’t take anybody’s life, it can quickly wreck his or her portfolio.

In the heat of the trading day, it’s very easy to feel pressured to reallocate assets, either to jump on a momentarily hot trend or dump existing holdings. As a young amateur investor, I embarrassingly recall mornings in which I’d wake up and learn about a company on CBNC…and have already bought hundreds of shares for my portfolio before the end of “Live with Regis and Kathy Lee.”  That’s not investing. It’s craps.

When you trade for the big moves, and not the short-term scalps, it’s rare a portfolio allocation must be made at that very instant an idea pops into your mind. This is where a “cooling off” period can help you keep your head.

So, at the very least, I advocate taking a short breather or walk about the block before making monumental changes to your portfolio, especially when it comes to adding new positions. When you’re frustrated and hungry to win, there’s an emotional temptation to “throw on a few shares” of anything that’s moving the hour you happen to switch on your screen. Even a few moments consideration can help to determine if the trade is being considered out of profit-seeking self interest…or boredom.

When it comes to exiting trades, I advocate controlling my emotions by using stop loss orders pre-set below the current market price that will be triggered regardless of my emotional state. I know that, for whatever reason, I’ll sell XYZ should it drop 20% from my purchase price. It’s almost a relief to have that burden lifted off one shoulders.

When less is more

Finally, although it might seem counterintuitive, one effective means of controlling our emotions about an investment is to avoid learning too much about it.

Sounds crazy? In reality, what we trade – what matters — is the stock price itself. And after spending hours researching, evaluating and immersing yourself in one particular company, it’s easy to become enamored while completely missing the actual price action of the market itself.

Sirius , which peaked near $70 a share in 2000 and fell as low as five cents earlier this year, provides an excellent example. Many shareholders – fans of both Howard Stern and the radio service, held the stock the whole way down over nearly nine years.

Stocks are not companies – they are simply pieces of paper. And the more annual reports we read and conference calls we monitor, the more likely we are to give a losing trade the undeserved benefit of the doubt.

Don’t think of an investment as a relationship but a business transaction. When a new cell phone company comes along and offers a more cost-effective plan, more of us don’t hesitate to kick our current carrier to the curb. The same dispassionate and unflappable approach should be brought to bear when it comes to shares of XYZ.

© 2009 SmartMoney.

‘THE CHAMBER OF COMMERCE HAS IT BACKWARDS,’ by Simon Johnson at baselinescenario .com.

The US Chamber of Commerce is opposing the administration’s proposed Consumer Financial Protection Agency, on the grounds that it would hurt small business.  Their argument is that this agency will extend the dead hand of government into every small business.

For the Chamber of Commerce, government is the enemy of small business and should always and everywhere be fought to a standstill.  Chamber Senior Vice President (and former Fred Thompson campaign manager) Tom Collamore sees this as “advocacy on behalf of small businesses, job creators, and entrepreneurs” (quoted in the WSJ link above), and the Chamber has launched the “American Free Enterprise” campaign.

Somewhere, the Chamber’s senior leadership missed the plot.  What brought on the greatest financial crisis since the 1930s?  What has hurt, directly and indirectly, small business of all kinds to an unprecedented degree over the past 12 months?  What is killing small and medium-sized banks at a rate not seen in nearly 80 years?

It’s the behavior of the financial sector, particularly big banks and their close allies – by consistently mistreating consumers.  And the letter and spirit of the regulatory regime let them get away with it.

Some members of Congress honestly believe that consumers should have a free choice, unfettered by any kind of restriction, regarding the financial products they buy.

But spend time talking to any marketing professional or call them to testify before your committee – or just ask Mr. Collamore, who was previously at Altria.  The state of knowledge regarding how to persuade people to buy stuff is impressive, the degree of potential manipulation for consumer preferences is simply stunning, and the “innovations” in this area are not slowing down.

The scope for taking advantage of consumers in subtle ways, or outright duping them, is probably higher for finance than for any other sector.  For fairly obvious reasons, people are more likely to misunderstand credit than, say, furniture.  Ambitious executives have therefore hammered hard on borrowers.  And the implications – as you have seen and are still seeing – of systemic financial misbehavior are awful in terms of human impact and essentially without limit in terms of ultimate macroeconomic downside.

Unscrupulous Finance has brought us down and will do it again.  Those most damaged now and in the future include small and medium-sized business owners who are trying to treat customers fairly.

The Chamber of Commerce is fighting the last war (or the one before that).  Their small business membership should wake up to the current reality and press the Chamber hard to change its position before it is too late.

President Obama needs to go over the heads of the Chamber’s leadership, reaching out to and running ads directly targeted at its small business membership.  The White House has to tackle this head on, framing the issue clearly for people with the help of very clear TV and radio ads.  The Chamber of Commerce is arguing that unfettered finance is good for small business.  They are wrong.

By Simon Johnson

‘SEVEN LESSONS FROM THE BULL MARKET,’ from Kiplinger’s Magazine at fidelity.com.

You’ve probably read a spate of articles on the lessons of the financial crisis, the Great Recession and the devastating bear market. Now, for something entirely different, I’d like to discuss the lessons of this bull market.

Yes, I know some of you think that the recent merrymaking is nothing more than a bear-market rally and that more pain is on the way. You may be right. The nation — indeed, the world — still faces plenty of economic challenges. And the stock-market selloff on October 1 in response to a weaker-than-expected report on manufacturing activity is certainly worrisome.

But when stocks suddenly reverse course in an atmosphere of pervasive gloom and ascend nearly 60% without pause for seven months, I have to assume that a lot of investors were caught napping, their money best kept — so they thought — beneath their mattresses. Let’s face it: Whatever you call it, missing a rally of this magnitude (and an even bigger advance in foreign stocks) is a serious error of omission.

So it’s worth examining the lessons of the stock market’s amazing recovery. They could come in handy the next time we’re in the midst of a bear market that appears unlikely ever to end but (barring the collapse of our basic way of life) surely will.

Lesson 1. The stock market turns up when pessimism is rampant. Around the time stocks bottomed last March, fear and even panic were pervasive. The Conference Board’s index of consumer confidence for February, announced late that month, hit a record low. Retail sales were in the pits, home sales were awful and first-time claims for unemployment insurance were near their peak.

Investors? They were fearful, to say the least. A survey by AAII (formerly the American Association of Individual Investors) found that an unusually higher percentage — 70% — were bearish on the future. As my colleague Bob Frick notes in his terrific story about how emotions lead us astray when it comes to financial decisions (see “Be a Better Investor”), the greatest monthly outflow from stock funds in the past two years occurred last February.

Another way to get a sense of the mourning in America last winter is to examine media coverage. A nearly perfect contrarian indicator, the cover story in the March 9 issue of Time was a special report on the economy headlined “Holding On for Dear Life.” The cover of BusinessWeek’s March 16 issue was titled “When Will the Bull Be Back?” The subtitle: “Most signs point to more stock market pain. But opportunities are emerging for very, very long-term investors” (emphasis BusinessWeek’s). As it turns out, shareholders have endured little pain since March 9. And I wonder whether seven months qualify as “very, very long-term.”

Lesson 2. A bear market associated with a recession almost always ends in the middle of the economic downturn. The stock market is what the pros call a discounting mechanism. This means that stock prices tend to anticipate the future. Looking back at 11 significant declines starting with the one at the end of World War II, the only time this rule failed was early in this decade: The 2000–02 bear market didn’t end until 11 months after the conclusion of the 2001 recession.

The U.S. economy contracted 6.4% in the first quarter of 2009 and 0.7% in the second quarter. But thanks to various Federal Reserve Board policies and Uncle Sam’s assorted stimulus programs, including “cash for clunkers” incentives for new-car purchases and tax breaks for first-time homeowners, the economy almost certainly grew in the third quarter (see Lesson 4 for more). On average, economists believe that real (that is, inflation-adjusted) gross domestic product jumped 3.0% in the July–September period, and they see expansion of 2.4% in the fourth quarter — not exactly ripsnorting growth, but growth nonetheless.

Lesson 3. Don’t obsess over earnings; they always lag the stock market. I’ll let Jim Stack, a money manager in Whitefish, Mont., who also edits the InvesTech Research Market Analyst newsletter, explain: “No matter how many times it is said, and everyone says they know it, for some reason lousy earnings always become an emotional block for investors in a new bull market. In the huge bull market of the 1990s, the stock market climbed for over a year (throughout 1991) before corporate earnings even hit bottom! One of the most valuable historical lessons is to completely ignore earnings and forecasts in the first six to 12 months of a new bull market.” Incidentally, Stack, who had warned of a coming bear market in July 2007, a mere three months before the peak, called the market’s March bottom almost to a T.

Lesson 4. Don’t underestimate the power of government intervention. Remember all the talk about how we were on the verge of another Great Depression? Well, we’ve come nowhere near it.

For instance, the U.S. unemployment rate is now at 9.8%; in the 1930s, the jobless rate topped out at about 25%. Much of the credit goes to the aggressive steps taken by the Bush and Obama administrations, Congress, and the Federal Reserve Board. The list of actions is endless: enactment of a $787-billion economic-stimulus program; the rescues of AIG (AIG

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), Fannie Mae (FNM

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) and Freddie Mac (FRE

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), not to mention General Motors and Chrysler; the Fed’s move to cut short-term interest rates to zero and to buy more than $1-trillion worth of Treasury bonds and mortgage securities to hold down borrowing rates for home loans; the injection of emergency capital into dozens of banks; and the Treasury’s decision to insure money-market mutual funds.

And let’s not forget what policymakers did not do: raise taxes or initiate overly protectionist measures to defend U.S. industries. In short, policymakers learned well the lessons of the Great Depression. (Of course, the long-term implications of their actions, particularly regarding their potential to fuel inflation, are another matter.)

Lesson 5. The worst are often first — at least at the outset. Stocks of companies that are small and weak, which often have had the stuffing beaten out of them during the down period, typically lead the way at the start of the bull market. Investors’ dash to such trash has been particularly noticeable during this rebound, as Kiplinger columnist Steve Goldberg notes in a recent column.

Lesson 6. Once you decide to get in, don’t wait for a correction — there’s no telling when it will come. With the market up significantly, you may be feeling more confident about stocks, but you’d like to see them come down a bit before you commit some money. History, however, shows that, on average, a correction — defined as a drop of 10% — comes 285 days after the start of a bull market, according to the Leuthold Group, a Minneapolis investment-research and money-management firm. In the case of the great bull market of the 1990s, which began in October 1990, the market rose 249% over 1,724 days before experiencing a correction.

Lesson 7. Pay attention when bears who had it right turn bullish. Several longtime pessimists — including Jim Stack, the newsletter editor, hedge-fund manager Douglas Kass, and Jeremy Grantham, co-founder of GMO, a Boston-based investment manager — began turning positive on stocks in late winter of 2009. This, of course, guarantees nothing (and it’s worth noting that other longtime bears, such as economist Nouriel Roubini and David Tice, of what is now called the Federated Prudent Bear fund, remained downbeat throughout the recovery).

But when well-regarded professionals start singing a different tune, you should try to find out why. Kass, for example, made his call in early March on the basis of favorable valuations, extremely negative investor sentiment and his expectation that the economy would stabilize in early 2010. (Kass withdrew his bullish call on September 29, saying the market had reached the target price he had established in March.) Stack, among other things, cited horrible investor- and consumer-sentiment figures as contrarian indicators.

© 2009 The Kiplinger Washington Editors

‘DIANA FARRELL & WHITE HOUSE THEORY OF BANK SIZE, ‘ by Simon Johnson at baselinescenario .com.

Diana Farrell And The White House Theory Of Bank Size

Posted: 13 Oct 2009 03:07 AM PDT

On Friday morning, Diana Farrell – a senior White House official – made a significant statement on NPR’s Morning Edition, with regard to whether our largest banks are too big and should be broken up.

“Ms. DIANA FARRELL (Deputy Assistant for Economy Policy): We understand Simon Johnson’s views on this, and I guess the response is the following….

“Ms. FARRELL: We have created them [our biggest banks], and we’re sort of past that point, and I think that in some sense, the genie’s out of the bottle and what we need to do is to manage them and to oversee them, as opposed to hark back to a time that we’re unlikely to ever come back to or want to come back to.” (full transcript)

Ms. Farrell is Larry Summers’s deputy on the National Economic Council and the former director of McKinsey Global Institute, and she has a strong background on banking issues – based on extensive professional experience with global financial institutions.

Her statement contains three remarkable points.

First, “we have created them” is exactly right.  Today’s mega-banks were not created by any market process.  They are the result of a series of government actions and inactions, particularly over the past 18 months.  Banks failed due to their own mismanagement but how those failures were handled – bankruptcy vs. bailout – was a conscious official decision.  This administration deliberately chose to be very nice to the biggest banks and to the people who run them.

Second, “we need to… manage them and oversee them”.  Here she is presumably referring to the administration’s regulatory reform plan, which does not appear to be going well.  Once the massive banks were created, and implicitly backed by the government, it became (already by April or May of this year) very hard to reregulate them.  As Joe Nocera pointed out on Saturday, the biggest banks have essentially bitten the Obama administration hand that fed them – most obviously by opposing the new Consumer Financial Protection Agency.  It is already abundantly clear that the White House cannot control our big banks.  What hope do mere regulators have?

Third, “we’re unlikely to ever … want to come back to”.  Ms. Farrell’s specifics on this point were summarized by the interviewer, Alex Blumberg, “The problem with Johnson’s approach, [the administration] decided, is that bigness also has its benefits. Sure, the economy used to be simpler and financial institutions weren’t so big and dangerous, but GDP was smaller then, too, and people were poorer.”

I’ve reviewed the available work of Ms. Farrell, the McKinsey Global Institute, and other publicly available sources on this issue (e.g., this book, profile, and article).

I haven’t found even an assertion that our largest banks should get bigger, in absolute size or relative to the economy, let alone any facts or relevant empirical evidence.  If I have missed a convincing quantification for “bigness also has its benefits,” please draw that to my attention.

Perhaps there is a reason that today’s nonfinancial companies need a financial sector that is more concentrated and more powerful politically than ever seen in living memory – maybe this emerges from the Financial Services Roundtable or the government’s more confidential interactions with CEOs.  But my conversations with people who run companies or who work closely with nonfinancial executives suggest quite the opposite – they see our current financial system as dangerous, with the likely costs of big banks (e.g., future bailouts) greatly outweighing any benefits.

Here’s the end of the NPR segment, where Alex Blumberg gives a fair summary:

“BLUMBERG: In the end, what we should do about the genie comes down to how you think about it. Farrell’s view and the view of economists like Calomiris from Columbia is that the genie does lots of good things for us and that we can learn to restrain it.

For Johnson, the good things that the genie does are outweighed by the bad things and we should be thinking hard about how to get it back in that bottle before it wreaks havoc once again.”

If Ms. Farrell and the White House (or anyone else) has hard numbers we can put on the benefits of big banks, please make these public.  We can then weigh these against the obvious costs of running our financial system in this fashion – on this round alone: fast approaching 40 percent of GDP, i.e., the increase in government debt as a direct result of our financial fiasco; plus persistently high unemployment; millions of homes lost; likely permanent loss of output, etc.

Philipp Hildebrand, now head of the Swiss National Bank (SNB), expressed a more moderate official position in June, “A size restriction would of course be a major intervention in an institution’s corporate strategy… Naturally the SNB is aware that there are advantages to size. [But] in the case of the large international banks, the empirical evidence would seem to suggest that these institutions have long exceeded the size needed to make full use of these advantages.”

By Simon Johnson

‘THE FOUR STAGES OF A MARKET RECOVERY,’ by Doug Kass at thestreet.com. Check out website for free subscription.

In March, I argued that stocks were at or near a generational bottom and I recently opined that U.S. equities have topped for the year.

It can be argued that there are four classical stages in a move from market bottom to market top and then back again.

Stage One: It is important to recognize that market bottoms are made when investors lose all sign of hope, and fear is the dominating emotion. At bottoms, bears are deified and bulls (like Legg Mason’s Bill Miller) are rebuked. Seven months ago, prices were beaten down, and the news flow was consistently reinforcing in its negativity. Economic expectations were uniformly bearish, as the credit and financial system seemed broken. Investors no longer believed. The fear of being in the markets overwhelmed market participants — so much so that on the day of the yearly low, a poll indicated that more than half of Americans believed we were entering the Great Depression II. Importantly, decades of buy-and-hold investing seemed to vanish and gave way to a preferred strategy of opportunistic trading.

Stage Two: As stocks began their ascent from the March lows, signs indicated that things were getting less-worse as the second derivative recovery commenced. The liquidity put into the system in late 2008 and early 2009 began to flow into the capital markets. Credit spreads improved as the curse of cash began to manifest. In time, fiscal and monetary stimulation began to assert a hold, and improving economic conditions followed.

Stage Three: In time (and with the impetus of higher stock prices and recognition that there were signs of economic improvement), the fear of being in began to be replaced by the fear of being left out. As deflated company forecasts turned out to be too pessimistic, the news (importantly influenced by aggressive cost-cutting) improved, and share prices moved comfortably above the March lows.

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‘A CASE FOR COMMODITIES,’ by Fidelity Viewpoints at fidelity.com. A simple primer to inform yourself.

Around this time last year, Americans were fretting over $4-a-gallon gasoline. Flash forward one year and gasoline is averaging around $2.50 a gallon according to the Energy Information Administration. Crude oil prices—the raw material in gasoline—have dropped from a high of about $145 a barrel in July 2008 to around $70 according to the New York Mercantile Exchange.

Such price swings illustrate the extremely volatile nature of oil prices and other commodities. Despite such volatility, long-term, risk-tolerant investors may want some exposure to commodity-related investments because they may provide diversification benefits, protection against both inflation and the loss of global purchasing power, and the potential for capital appreciation. Commodity-related investments include commodities, the stocks of commodity-producing companies, and the mutual funds that invest in them. Before we analyze the current picture, we’ll cover what commodities are, what drives their prices, and their investment risks.

What they are

Commodities are typically raw materials derived from the earth that people consume directly (food and energy), or use to create products that people buy, use, or consume on a regular basis. This includes natural resources (oil, natural gas), industrial metals (copper, aluminum), precious metals (gold, silver), and agricultural products (wheat, corn, soybeans, and livestock). Commodities are the foundation of most consumers’ needs as opposed to services or wants.

What influences commodity prices?

The overall strength of the global economy and supply-and-demand levels are the most important drivers of commodity prices. These factors have led to multi-year bull and bear market cycles for commodities. For example, during the great bull market for stocks from 1982 to 2000, ample supplies of many raw materials, such as oil, kept a lid on the price of many commodities and economic growth was the driver from the service-based developed economies in Europe, the U.S., and Japan.

Over the past nine years, however, commodities, and commodity stocks, as measured by the S&P Goldman Sachs Commodities Index and the MSCI All Country World Commodity Producers Sector Capped Index respectively, have outperformed the S&P 500® Index (.SPX) due in part to surging needs-based demand from fast-growing economies in China, Brazil, India, and other developing nations.1

As credit markets worldwide froze up during the financial crisis the past year, many economies across the world seized up and contracted. This led to a dramatic collapse in commodity prices, along with stock prices for many commodity-producing companies, until the credit, financial and economic systems began to normalize in the spring. Despite this pullback, Joe Wickwire, manager of the Fidelity Global Commodity Stock Fund (FFGCX), believes the long-term outlook for commodities remains strong.

“I believe commodities are a good long-term global story, especially from a portfolio diversification standpoint. While economic growth in China, India, and Brazil has slowed of late, the industrialization of these and other developing economies has not come to a complete halt—and probably will not—so demand, albeit somewhat more muted, hasn’t been entirely choked off,” Wickwire says. “Further supporting commodities is that they have relative degrees of strategic importance attached to them. In many growing areas of the world where economies are not resource self-sufficient, governments can’t afford the risk of not having enough food, energy, and infrastructure for their populations and will thus seek to ensure sufficient supplies of each,” Wickwire explains. “The strongest economic growth in the world going forward is likely to be in developing economies, and these economies are disproportionately needs- or commodities-dependent at this stage of their economic growth. This should provide a very supportive environment over time.”

Just as people in the U.S. and other developed nations demand new roads, schools, and access to healthy food, people in developing nations around the world want to eat better, drive cars, and live in more comfortable homes. With a finite supply of many economic natural resources, the world will likely see expanding competition for commodities.

As the global economy stabilizes and begins to grow again, demand for commodities may expand. Already, massive domestic and foreign stimulus plans are triggering growth in infrastructure-related projects around the world, boosting global demand. At the same time, some commodities may remain in short supply.

“There are finite economic amounts of many natural resources, and the recent low commodity price environment forced many commodity industries to slow their production and cut spending on exploration and development,” says Wickwire. “Once demand really revs up, supply could be constrained, thus putting upward pressure on commodity prices.”

Because they are usually priced in U.S. dollars, commodity prices can be influenced by currencies as well as economic and credit conditions. Additionally, the global fiscal and monetary stimulus plans around the world could allow commodity prices to rise higher as many are aimed at projects and initiatives that are needs/commodity based.

Imperfect correlation to other investments

History has shown that the performance of commodities and commodity producers are not perfectly correlated to stocks, bonds, or currencies. Correlation measures the performance of two investments and the degree to which they move in the same—or opposite—direction. For example, during the 10-year period ending June 30, 2009, the S&P Goldman Sachs Commodities Index had a correlation of just 0.21 versus the Russell 1000 Index (.RUT). Performance of commodity producers had a higher, but still imperfect, correlation with that of broad domestic and foreign stock indices. As shown in the graphic below, commodity stock performance showed a similarly low correlation to that of fixed income investments.

Keep in mind, however, that correlations can change. Recently, the correlation between commodities and U.S. large cap stocks (Russell 1000 Index) was substantially higher than that seen over the last full ten years; it was 0.49 for the three year period ending June 30, 2009.2  Despite this recent rise in correlation with large-cap U.S. stocks and with equities in general, allocating a small portion of an already well-diversified portfolio to commodities or commodity stocks may offer the potential to reduce risk and add returns over a long time horizon.

A degree of protection against inflation

Additionally, because commodities are typically priced in U.S. dollars and they are the raw input to many of our expenditures, such as food, fuel, cars, and housing, they may also offer some protection from the impact of significant inflation on the purchasing power of a portfolio.

During past highly inflationary periods, commodities and commodity stocks have performed well relative to other assets. For example, during the 1970s, when inflation rose sharply, a diversified basket of commodities outpaced inflation while large cap U.S. stocks did not. The performance of two sectors containing the vast majority of commodity-producing companies provided an even greater cushion against the impact of inflation. While a commodity stock focused index did not exist in the 1970s, most commodity-producing companies can be classified within the energy and materials sectors.3  Over the period shown in the chart below, the returns of these two sectors outpaced inflation, and were also greater than those of commodities themselves. Energy stock performance was undoubtedly also affected by the Oil Crisis of the 1970s, which helped drive crude prices as high over $80 per barrel during that time.

What are the risks?

The commodities industry can be significantly affected by commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions. Apart from the risks associated with general commodity investing, there are risks to investing in the common stocks of commodity-producing companies. You should be willing to accept the risks that come with exposure to foreign and emerging markets, including political, economic, and currency volatility.

How to invest in commodities

Sophisticated and risk tolerant investors might be interested in trading commodity futures contracts or investing in the individual stocks of commodity-producing companies, but they’re likely too complex and volatile for most investors. A practical solution may be to invest in commodity-focused mutual funds and ETFs that either track the performance of commodities indices or invest in the stocks of commodity-producing companies.

Some investors may already have commodity investments in their portfolios. While not exclusively focused on commodities, some asset allocation funds also maintain a strategic allocation to commodities and commodity-linked investments. Some international and diversified equity funds with high weightings to the energy and materials sectors may also have considerable commodity exposure.

It’s also important to remember that commodities and commodity stocks can be extremely volatile. One way to help mitigate volatility is to consider investing in commodity-related investments using dollar-cost averaging to build a position over time. With this strategy you invest a set amount of money on a regular basis. This structured investment plan might help you put the volatility in the asset class to work for you, buying more shares when prices are low and fewer shares when prices are high. Keep in mind, however, dollar-cost averaging won’t guarantee you investment gains in a declining market or ensure against a loss.

Due to the potential for extreme volatility, an allocation to the commodities asset class should be a minority component of a well-diversified portfolio that is primarily composed of stocks and bonds.

‘WHO NEEDS BIG BANKS?, ‘ by James Kwak at baselinescenario .com.

Who Needs Big Banks?

At a panel discussion at the Pew Charitable Trusts (captured for posterity by Planet Money), Alice Rivlin floated the idea of breaking up big banks. Luckily for us, Scott Talbott of the Financial Services Roundtable (a lobbying group for big banks) was there to slap that idea down.

Talbott: “We need big companies, and they can be managed, and they are being managed …”

Alex Blumberg (Planet Money): “But why, why do we need big companies?”

Talbott: “They provide a number of benefits across the globe. We have a global economy, and these institutions can handle the finances of the world. They can also handle the finances of large, non-bank institutions like General Electric or Johnson & Johnson. They need these institutions [that] can handle the complex transactions. Simply breaking them up … then you’re discouraging a company from achieving the American Dream, working hard, earning money, producing products, and getting bigger.”

There are two things I object to strongly. The second is easy. The American Dream is for people, not companies. And people dream of working hard, being successful, making money, and having an impact on the world. The American Dream does not imply any particular company size. There are situations in which your products are just so much better than anyone else’s that your company becomes big as a result; Google comes to mind. But Citigroup is the product of no one’s American Dream. When Talbott says “American Dream,” what he really means is “American Bank CEO’s Dream” — because, as we all know, CEO compensation in the financial sector is extremely correlated with assets.

The first is this “we need big banks to serve global corporations” line. I’ve heard this before and I don’t buy it, for a number of reasons.

First (sorry, I have this habit of embedding numbered lists inside numbered lists), how global is Bank of America? Until it bought Merrill Lynch, it was pretty much a midget overseas compared to, say, Morgan Stanley, which was a small fraction of its size. How global is Wells Fargo? Yet those are two of our four biggest banks.

Second, the argument doesn’t pass the test of basic business logic. My company did (and does) business in many countries around the world. We had different alliances and different service providers in each one. There were overlaps — we worked with some consulting firms in multiple countries — but we made the decisions independently in each country, because every country is different. And in each country, you want the people who are the best in that country. Sometimes that will be a division of an American multinational; often it won’t. If I’m “General Electric” or “Johnson & Johnson,” I’m not going to do all my banking with Citigroup out of some misplaced customer loyalty.

Third, what global services is Talbott talking about? Sure, as an individual, it would be nice if my bank had offices in every country I might ever travel to. But that’s because I’m an individual, and I don’t want to have more than a few bank accounts. I would guess that General Electric has, oh, thousands of bank accounts around the world, with dozens if not hundreds of banks. The “one-stop shop” idea applies — barely — to people like me, who would like the convenience of doing all of our financial stuff with one company, but generally figure out that it’s impossible, because my bank offers crappy investment products, and crappy insurance products, and … you get the idea. It’s laughable for a big company, which has hundreds of P&Ls, each of which is different, and has different objectives and preferences.

Fourth, let’s take a big, global transaction — say, a debt offering. Here, arguably, it might be good to have a single bank with global scale, since you want to sell bonds in as many markets as possible in order to get the broadest possible pool of investors. In 2008, J&J issued $1.6 billion (face value) of bonds. Who got the deal? Goldman, JPMorgan, Citi, Deutsche Bank, Bank of America, Morgan Stanley, Williams Capital Group, BNP Paribas, HSBC, Mitsubishi UFJ, and RBS Greenwich Capital. Eleven investment banks based in five countries, including five U.S.-based banks. (In 2007, J&J issued 500 million pounds of debt, using thirteen underwriters — six of whom were not involved in the 2008 offering; two out of three book-running managers were European banks.) So when push comes to shove, our beloved mega-banks are nowhere near up to the task. What this tells me is that it’s the big companies that call the shots, and they like parceling out business to lots of banks. This is another basic principle of business: it’s better to have multiple suppliers than one supplier, so you can keep them in competition.

This whole argument, that global companies need massive banks, is one of those things that sound plausible until you actually start thinking about them. Is there something big that I’m missing here?

By James Kwak

‘A BOUNCE? YES. A BOOM? NOT YET, ‘ by Robert J. Shiller in the Sunday Times.

THE sudden rise in home prices suggests that the psychology of the market has shifted substantially. But what should we expect in the months ahead? Not necessarily that we’re entering a new housing boom. To a large extent, where we’re heading depends on what home buyers are thinking.

Some clues are found in the annual home-buyer surveys that Karl Case, the Wellesley economics professor, and I have run for years. For the surveys, we canvas recent home buyers in four cities — Los Angeles, San Francisco, Milwaukee and Boston; the surveys are now being conducted under the auspices of the Yale School of Management. We have just received the 2009 results, with responses from June and July.

This year’s survey coincides nicely with the upturn in home prices, the sharpest change in direction we have ever seen. The data show that the Standard & Poor’s/Case-Shiller 10-City Composite Home Price Index for the United States rose 3.6 percent between April and July. While that is not a whopping increase, it followed a decline of 4.8 percent in the previous period, between January and April.

The suddenness of this shift surprised me. In my column in June, I wrote that home prices might well continue to decline for years. As of that time, the S.& P./Case-Shiller price index had fallen every month for almost three years. Add to that the prospect of continuing high unemployment and a weak economy for years to come, and the prospects for home prices did not seem rosy.

But the new data are startling. Since the indexes began in 1987, the closest parallel to such a change came at the conclusion of the last housing bust, at the end of the 1990-91 recession. Home prices rose 2.3 percent from April to July 1991 after having fallen 2.1 percent from January to April that year. By July 1996, five years after that “turnaround,” home prices were down 0.6 percent from their July 1991 level, and down 13.8 percent in inflation-adjusted terms.

Could the more extreme recent shift mean that home prices will just keep rising this time? Here is where our new survey results are helpful.

We looked at both the long- and short-term attitudes of home buyers. In our survey, we ask, “On average over the next 10 years, how much do you expect the value of your property to change each year?” The average answer among 311 respondents in 2009 was an increase of 11.2 percent. The median response — with half above, half below — was 5 percent, also high. That sounds rather like bubble thinking.

For a home buyer who borrows 90 percent of the money to acquire a house, an appreciation rate of 11.2 percent offers an investment bonanza. By putting a small amount of money down, investors stand to make a large gain if home prices climb. That is the power of leveraging. Recently, however, home buyers have also experienced the unpleasant consequences of leverage when home prices fall. Investing in a home during the wild past few years has been like gambling in a casino: You can leave with riches or empty pockets.

In our survey data from one year earlier, when prices were falling at an annual rate of nearly 20 percent, buyers were still expressing long-term optimism. Then, the average answer to the question about expected yearly increases in home values was 9.5 percent a year, with a median of 5 percent — high figures indeed for that time. The bubble thinking is not new.

Those long-term expectations may not have changed much in character, but short-term expectations certainly have. In the survey, we also ask, “How much of a change do you expect there to be in the value of your home over the next 12 months?” Here, the average answer for June-July 2009 was a 2.3 percent rise, versus a negative 0.4 percent a year earlier. That was a dramatic change.

Another survey question is this: “If you think that present trends will not continue forever, what do you think will stop them?” Respondents were asked to answer in their own words. In 2008, when the current trend was unambiguously down, people nonetheless made it clear that they thought a housing recovery would come as the recession ended, with a new president after the election, and after home prices have come back down. What has changed in 2009 is that they suddenly see this anticipated scenario as actually playing out.

An additional question pertains to short-run considerations of market timing. We have been asking respondents whether they agree with this statement: “I bought now because I felt that I had to even though I might have done better financially if I had waited.” During the housing boom in 2004, only 17.9 percent agreed with that statement. That figure doubled, to 36.7 percent, when prices were dropping fast in 2008, and now has come back to 24.8 percent.

WHAT should we conclude? Given the abnormality of the economic environment, the sudden turn in the housing market probably reflects a new home-buyer emphasis on market timing. For years, people have been bulls for the long term. The change has been in their short-term thinking. The latest answers suggest that people think the price slide is over, so there is no longer such a good reason to wait to buy. And so they cause an upward blip in prices.

At the moment, it appears that the extreme ups and downs of the housing market have turned many Americans into housing speculators. Many people are still playing a leverage game, watching various economic indicators as well as the state of federal bailout programs — including the $8,000 first-time home-buyer tax credit that is currently scheduled to expire before Dec. 1 — in an effort to time their home-buying decisions. The sudden turn could signal a new housing boom, but is more likely just a sign of a period of higher short-run price volatility.

Robert J. Shiller is professor of economics and finance at Yale and co-founder and chief economist of MacroMarkets LLC.

‘BILL MOYERS’ JOURNAL ON PBS 9TH OCT.’ PLEASE DO SEE THIS SHOW WITH REP. MARCY KAPTUR (D.OH) & FORMER IMF CHIEF ECONOMIST SIMON JOHNSON. EXCEPTIONALLY GOOD.

www.pbs.org/moyers/journal/    blog/

‘THE ANNUAL TASK OF CHOOSING AN INSURANCE PLAN, ‘ in today’s N.Y.Times. PLEASE PASS THIS ON. GREAT INFO ON MAKING HEALTH BENEFIT & INSURANCE CHOICES.

IT’S that time of year again. In a few weeks, if you have health benefits through work, you will probably receive e-mail messages and brochures from your employer about your benefit options for 2010.

Once again you will have to decide whether you want to switch to a new health plan. Or finally enroll in a flexible spending account. Or take that biometric test your company has been urging you toward. (More on that below.)

If, like many people, you typically default to your current options, I have one word of advice: Don’t. Health insurance costs will be higher, and doing nothing could potentially cost you hundreds of dollars.

My job today is to highlight the main trends this year in employee health benefits. Over the next few weeks, my colleague Walecia Konrad and I plan to delve into more specific elements of open enrollment, including the pros and cons of high-deductible health plans and how to select a new health insurer.

This year, as you face higher prices on insurance premiums, brand-name prescriptions and more, your employer will be nudging you to take more interest in managing your health and your health insurance. Sometimes those nudges might feel more like shoves.

What you probably won’t see are many major changes to your health plan’s overall design. That is mainly because employers are waiting to see what shakes out from the health care debate in Washington before they take any big cost-saving steps, says Mike Miele, president of the benefits consulting firm, GBS Healthcare Analytics in Princeton, N.J.

But here’s a rundown on the changes you probably can expect.

YOU’LL PAY MORE — AGAIN Health care costs keep going up and up, and the slow economy and rocky job market have not helped.

Last year, the recession jolted many employees into get-well-quick frenzies. Fearing layoffs — and the loss of health coverage — employees got check-ups, teeth cleanings and various long-deferred procedures at a higher-than-normal pace.

That use-or-lose stampede translated into a spike in medical costs for employers — which they are now passing on to those still fortunate enough to have jobs, according to Joan Smyth, a principal with Mercer, a health and benefits consulting firm.

If you are in an H.M.O. — a health maintenance organization — or P.P.O., a preferred-provider organization, your out-of-pocket costs, including premiums and co-payments, will probably rise by about 10 percent in the coming year.

In addition, many companies will raise deductibles by $50 to $100 — some even more.

DEPENDENTS? DEPENDS … Even if your spouse or other dependents have been on your health plan, be sure to look for changes in the coverage rules. Some companies are raising premiums for working spouses — or even eliminating coverage for spouses and dependents.

FEWER CHOICES Many large companies with employees in a number of states are consolidating their health plans into one or two national carriers, rather than various regional ones.

In the same vein, some companies will jettison inefficient H.M.O.’s and either replace them with more efficient ones or get rid of them altogether, replacing them with lower-cost plans, either P.P.O.’s or high-deductible plans.

PUSHING HIGH-DEDUCTIBLES More employers will be nudging workers toward high-deductible health plans because they cost less — about 20 percent less than a P.P.O. or an H.M.O. — and they force employees to take more responsibility for their health care.

Here’s a mini-refresher on how high-deductible plans work: Typically, they have a high annual deductible, of $2,500 to as much as $5,000. Many employers may put $500 to $1,000 into a health savings account for you to offset that high limit.

If you spend all the money in the health savings account, you then have to dip into your own pocket to pay your medical bills until you exhaust the deductible. But if you don’t spend the money, it stays in the account for next year’s expenses.

To push workers toward high-deductible plans, employers may raise the premiums on P.P.O.’s and H.M.O.’s even more than the underlying cost increase might warrant.

GOING GENERIC In another move to steer employees toward lower-cost health care, many employers will increase the co-payment on brand-name medications, while making generics more affordable. Some plans, in lieu of co-payments, may even require that you pay a percentage of the cost of brand-name drugs.

Let’s say you now make a $30 co-payment when filling a Nexium or Lipitor prescription. Next year, your co-payment could rise to $40 — or even higher if your plan requires you to pay a percentage of the actual cost.

At the same time, though, some plans may lower the cost of maintenance drugs (say, for asthma) that have been proved to reduce overall health costs, according to Tom Billet, a senior consultant at Watson Wyatt, a benefits consulting firm.

WELLNESS AND MORE Prepare to be doctored. Employers are determined to make you healthier and, thereby, less expensive to insure.

“Employers are not backing away from wellness programs,” Mr. Billet said. “They are a core component of their long-term strategy to control costs and improve productivity of their work force.”

Your employer will probably suggest that you (and your spouse if she or he is covered on your plan) fill out a detailed health risk questionnaire, including your height and weight and your family history for several diseases. The company might even reward you with cash or some other incentive for doing so.

Many employers are also strongly urging their workers to get biometric tests — blood work-ups that identify whether a person is at risk for diseases like diabetes or atherosclerosis.

The results of these tests and exams are sent to your insurer or a third-party administrator, and your employer is not supposed to have access to the information.

BEWARE THE AUDIT As another cost-saving strategy, more companies are conducting audits to ensure that only eligible dependents are covered by their health plans.

You may get an e-mail message or letter that asks you to verify the ages of your children or the marital status of you and your covered spouse. Completing the audit may be as simple as calling an 800 number and answering some prompts, or it may be as complicated (and annoying) as sending in copies of birth and marriage certificates to your insurer.

Remember, most policies cover your children only until age 19, or 23 if they are in college.

Why are companies going to all this trouble? Audits routinely reveal that 5 to 8 percent of covered individuals are actually ineligible, according to Mr. Miele, who expects his audit business to double in 2010.

Typically, the issue is one of confusion rather than fraud. “Employers have not done a great job of explaining who is covered,” says Mr. Miele, who adds that most of the people who get “kicked out” are college grads still living at home. You can also expect to see much more specific coverage guidelines in 2010.

‘HAVE BANKS NO SHAME?,’ by Joe Nocera in today’s N.Y. Times. Go to nyt.com for complete article. UNBELIEVABLE THESE SLEEZEBAGS ACTING LIKE GREED-MONGERS.

A few months ago, I asked Simon Johnson, the former International Monetary Fund economist, now a prominent critic of the banking industry, what he thought the banks owed the country after all the government bailouts.

“They can’t pay what they owe!” he began angrily. Then he paused, collected his thoughts and started over: “Tim Geithner saved them on terms extremely favorable to the banks. They should support all of his proposed reforms.”

Mr. Johnson continued, “What gets me is that the banks have continued to oppose consumer protection. How can they be opposed to consumer protection as defined by a man who is the most favorable Treasury secretary they have had in a generation? If he has decided that this is what they need, what moral right do they have to oppose it? It is unconscionable.”

I couldn’t have said it better myself.

•

Starting on Wednesday, the House Financial Services Committee will take up a number of reforms proposed by the Obama administration, hoping to push them through the committee so they can be voted on the House floor as part of a larger financial reform package. Among the proposals the committee will tackle is, yes, the establishment of a new consumer financial protection agency.

The administration’s outline for this new agency — which would regulate mortgages, credit cards, debit cards, installment loans and any other product issued by a financial institution — was sent up to Capitol Hill in July. Since then, Barney Frank, the committee chairman, has made a number of substantial changes, none of which, I have to say, have strengthened the proposed legislation. He stripped the bill of the much-promoted “plain vanilla” provision, which would have forced, say, mortgage brokers to offer customers a 30-year fixed mortgage alongside any exotic option A.R.M. mortgage they wanted to push.

He has changed the nature of an oversight panel, so that it would consist of the top bank regulators — the very same regulators who did such a miserable job looking out for consumers during the housing bubble. He has tinkered with the way the agency will be financed, making it less onerous for the banking industry and more onerous for nonbank financial institutions that will come under the agency’s purview.

Saddest of all — at least from where I’m sitting — he abandoned the so-called reasonableness standard, which would have forced bankers to make sure their customers both understood the products they were buying and could afford them. Mr. Frank has said that such a provision would put bankers in an “untenable position.” Yet that is precisely what brokers are required to do when they sell a stock or a bond to their customers. Why shouldn’t the same standard apply to a banker making a mortgage loan?

Part of the reason Mr. Frank made those changes is that he needs the support of conservative Democrats if he hopes to turn this bill into law. But it is also because he felt a need to mollify, at least to some extent, the bank lobby, especially the community bankers who populate every Congressional district in the country. Indeed, in a recent missive to its members, the American Bankers Association trumpeted its success in helping make the bill more palatable to the banking industry.

Yet even now, despite its success in reining in the proposed agency, the banking industry is still lobbying fiercely against it. Edward L. Yingling, the president of A.B.A., borrowed a line from “Casablanca” to describe the impulse behind the proposed consumer agency. “They’re rounding up the usual suspects,” he complained to me the other day. “We’re the usual suspects.”

Not long ago, the A.B.A. sent an “action alert” to its member banks, pleading with them to call their congressman in a last-ditch effort to stop the bill. (“Passing more laws that will overly complicate and restrict the products our customers need is detrimental to our banks,” the note read in part.) And even if the bill does pass, the industry is hoping to pervert its purpose, so that it will become a means to stifle competition from nonbank financial institutions.

To which one can only ask: Have they no shame?

•

“There needs to be more focus on consumers,” Mr. Yingling insisted. “We agree with that.”

Whenever you talk to bankers or their lobbyists about the proposed agency, you hear some variation of what I’ve come to think of as the party line. It’s not that they’re against consumer protection, they say. (Heaven forbid!) Rather, they say, this new agency — larded as it will surely be with thousands of newly deputized bureaucrats, each one eager to impose burdensome new regulations — is simply not the way to go about it.

((( GO TO NYT.COM FOR THE COMPLETE ARTICLE)))

‘WHAT’S WRONG WITH A PHONE CALL?,’ by James Kwak at baselinescenario .com. SIMON JOHNSON ON PBS WITH BILL MOYERS ON NOW AS I WRITE.

What’s Wrong with a Phone Call?

Posted: 09 Oct 2009 07:52 AM PDT

Yesterday Simon pointed out the AP story highlighting Tim Geithner’s many contacts with a few key Wall Street executives — primarily Jamie Dimon, Lloyd Blankfein, Vikram Pandit, and Richard Parsons — while leading the government’s rescue efforts as Treasury secretary. It’s certainly useful for the nation’s top economic official to talk to people in the banking industry, and it’s also useful for him to talk to banks that are being bailed out by the government. But the AP story did come up with a few important distinctions. Geithner talked to these Wall Street executives more than the key people in Congress — Barney Frank and Christopher Dodd — that he needs to pass his regulatory reform plan. And he talked to them much more than to, say, Bank of America, which is equally big and equally in debt to the government. So to be clear, Geithner is talking to these people more than dictated by the requirements of his job (or he’s not talking to Ken Lewis enough).

Still, you could say, what’s wrong with that? Can’t Tim Geithner talk to whomever he wants to talk to?

Of course he can, in a legal sense, and no one is saying he is doing anything illegal. All the evidence is that Geithner is a man of unassailable integrity, and a modest, courteous guy to boot.

But as the lobbyists have known for decades, the key to political power in the United States is access. Under-the-table bribes are relatively rare. The revolving door (government officials taking lucrative jobs at the companies they used to oversee) is important, but of little use when it comes to the very top people. Paul O’Neill, John Snow, and Henry Paulson were already easily rich enough to overlook such temptations (although Snow did leave Treasury to become chairman of Cerberus); Geithner may not be a mega-millionaire, but he already turned down his shot at being CEO of Citigroup in 2007.

Instead, if you want to sway some of the top people in government, the most important thing is to talk to them. All of us are influenced by the information and opinions that we are exposed to. Many people have a tendency to agree with either the first person or the the last person they spoke to on a particular issue, regardless of what other information they take in. (Where Geithner falls on that spectrum I have no idea.) This is why lobbyists make so much money; they sell access.

If, in the midst of a financial crisis, you get a disproportionate share of your advice from a few select Wall Street veterans with enormous personal interests in your decisions, you will be swayed a certain way. This is particularly worrying if you have spent the last several years even more deeply steeped in that circle, because you will be getting information and ideas that are confirming your prior beliefs. It is also worrying if, as was the case this past year, you do not have the time for detailed fact-finding or empirical studies, and instead you have to make important decisions based purely on logic and conjecture. Instead, you (and the public) would be better served going out of your way to talk to people who do not share your prior perspective and are likely to disagree with you. Now, the Obama administration is nowhere near as bad as the Bush administration, which disdained talking to its critics; this administration has reached out to its intellectual opponents, for example in the famous White House dinner with Krugman and Stiglitz. But one dinner does not balance eighty phone calls.

There’s nothing scandalous about the fact that Tim Geithner talks to the CEOs of Goldman, JPMorgan, and Citi a lot. It’s just a fact. It’s a fact that demonstrates the deep linkages between the thinking inside Treasury and the thinking on Wall Street (and yes, I know Citi and JPMorgan are in Midtown). It’s also one reason I have little interest in conspiracy theories — who needs a conspiracy when you have a sympathetic ear in the Treasury Department that you can get access to regularly? As we’ve said before, the key factor throughout this financial crisis has been political power. And if that power is composed of the power of ideas and the power of relationships, so much the better.

By James Kwak

‘BERNANKE SEES TIGHTER POLICIES AS ECONOMY HEALS ,’ in Reuters.

Bernanke sees tighter policies as economy heals

REUTERS — 3:48 AM ET 10/09/09

By Mark Felsenthal

WASHINGTON (Reuters) – The U.S. Federal Reserve must continue measures to prop up the economy for an extended period but can’t do so indefinitely for fear of triggering an inflationary surge, Federal Reserve Chairman Ben Bernanke warned on Thursday.

The U.S. central bank has cut interest rates to near zero percent and pumped hundreds of billions into the financial system to counter the worst financial crisis since the Great Depression.

At a Fed conference where he discussed the central bank’s ballooning balance sheet, Bernanke made clear that policymakers were thinking how to terminate support as recovery sets in.

“Accommodative policies will likely be warranted for an extended period,” Bernanke told participants at the conference held in the Fed’s headquarters.

“At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road.”

Bernanke sent a signal the Fed is gradually but steadily moving toward an exit from its supportive policies, even while evidence of the recovery has been mixed. A report last week that U.S. employers shed more jobs than expected in September dented confidence in the recovery. But data released on Thursday showed gains in retail sales and a nine-month low in unemployment claims and reinvigorated optimism.

The dollar inched up from 14-month lows against a basket of currencies after Bernanke’s comments.

The dollar has been under pressure as the U.S. economy has lagged some other economies in recovering from a crisis that reverberated around the world. On Tuesday, Australia became the first member of the Group of 20 major industrialized and developing economies to increase borrowing costs, saying that the worst danger for the economy had passed.

In the United States, most analysts do not see the Fed raising rates until the middle of next year.

And the European Central Bank on Thursday cautioned against hopes of a speedy economic recovery in the 16-nation euro zone as it left benchmark interest rates at a record low 1.0 percent on Thursday for the fifth month in a row.

ECB President Jean-Claude Trichet also turned up the heat on governments to rein in ballooning budget deficits, and said he saw hopeful signs of a normalization in money markets given lower demand for central bank loans.

FED PREPARED TO TIGHTEN

Although Bernanke indicated that it is not yet the time to roll back the Fed’s supportive monetary policies, he said the U.S. central bank has the tools and the ability to pull back its flood of cash and loans to the economy and to raise interest rates when the time is right

“When the economic outlook has improved sufficiently, we will be prepared to tighten the stance of monetary policy and eventually return our balance sheet to a more normal configuration,” he said.

Bernanke gave a detailed tour of the Fed’s assets and liabilities, which have ballooned from around $900 billion to almost $2.1 trillion.

As the U.S. economy appears to be pulling out of a painful and lengthy recession, observers are watching closely for signs of when and how quickly the Fed intends to pull back its help.

Bernanke said the Fed could remove its easy money policies even while its balance sheet remains bloated.

To do so, it would raise interest rates on reserve balances that banks keep at the Fed and by other actions — specifically reverse repurchase agreements, term deposits to banks, and sales of holdings of longer-term assets. Those steps would drain cash from the system and help raise short-term interest rates, he said.

Other Fed officials on Thursday sounded cautiously optimistic notes on the healing of the economy while saying it is too soon to pull back the life support system.

“We’re going to look at the data as it comes in. Right now I don’t think it’s time to raise interest rates,” Richmond Fed President Jeffrey Lacker told reporters after a speech.

Another regional president of the U.S. central bank system, Richard Fisher of the Dallas Fed, echoed Lacker’s comments.

“We’re going to move when we have to move. But it’s not now,” Fisher said in an interview with The Wall Street Journal.

Kansas City Fed President Thomas Hoenig noted likewise that the Fed’s policies would need to remain accommodative as the economy works back to recovery, but added that the Fed’s policies must be forward looking.

Speaking in Phoenix, Fed Governor Daniel Tarullo also backed the idea of keeping interest rates low for some time, if only because the economy’s prospects are so unsettled.

“With the effects of the February stimulus package diminishing next year, bank lending that is still declining, and continued dysfunction in some parts of capital markets, there is considerable uncertainty as to how robust growth will be in 2010,” he said at a community leaders lunch.

While the Fed has been under fire from Congress and other critics who believe its lenient oversight of financial institutions and lending practices contributed to the crisis, Bernanke got a significant political boost on Thursday when a key senator said he saw nothing in the way of his confirmation for a second term as Fed chairman.

Senate Banking Committee Chairman Christopher Dodd, asked if he saw any roadblocks to the Senate reconfirming Bernanke, whose four-year term expires in January, said, “No, I don’t think so.”

“I’ve indicated I want to be supportive. I think Ben Bernanke’s done a very good job, particularly in the last year or so. I think that view is embraced by a lot of people,” Dodd, a Democrat, told Reuters Television.

(Editing by Leslie Adler)

(c) Reuters 2009.

‘THE SQUARE ROOT RECOVERY,’ by Jurrien Timmer, Dir. of Investment Research, co-portfolio manager of Fidelity Dynamic Strategies Fund, at Fidelity Viewpoints. ((I bought Fid. Dyn. Strategies two weeks ago!!!))

BY JURRIEN TIMMER, DIRECTOR OF INVESTMENT RESEARCH, CO-PORTFOLIO MANAGER OF FIDELITY DYNAMIC STRATEGIES FUND, FIDELITY VIEWPOINTS — 10/07/09

Editors’ note: The editors of Fidelity Interactive Content Services (FICS) chose this article to help investors weigh the impact of the economic recovery on financial markets.

Here we are six months after the end of one of the worst bear markets ever, and the S&P 500® (.SPX) has rallied 62% from the March lows through the September 23 high. This makes it one of the strongest and fastest rallies ever, prompting the inevitable question of what’s next? Was it all a sucker’s rally that is about to unravel, or are we in the middle of an as-yet incomplete bull market?

For me it comes down to two basic questions: One, now that the recession is ending, how strong will the recovery be and what comes after? Will it be a “V”, a “W”, a “U”, or something else? Two, how much of the improving economic fundamentals are already reflected in the price of risk assets? Does the market fully subscribe to the recovery thesis? The way I am looking at things, there is good news on both fronts. Translating the above into a highly scientific mathematical equation, I get: strong “V” + skeptical investors = higher stock prices. In other words, a myriad of leading indicators suggests that the economic recovery is for real and is taking the shape of a classic V-shaped inventory cycle. At the same time, sentiment remains surprisingly (or perhaps not so surprisingly) skeptical.  Put these two together and you get a “pain trade” (to use Wall Street jargon) that continues to point “up” for stocks.

Let’s explore this equation a bit further. First the recovery thesis: A host of leading indicators suggests that a bona fide V-shaped inventory recovery is in progress. (This describes the visual created by charting a severe downturn in the economy followed by a strong upturn in economic activity.) The evidence is clear from manufacturing surveys, inventory data, credit spreads, low interest rates, the steep yield curve, stabilizing home prices, and finally the massive doses of monetary and fiscal stimulus which would show a V-like pattern. These indicators paint a compelling picture for the economy over the next year or so. But what comes after the “V”?  The consensus certainly believes that it will be a “W,” where the economy may dip down again in 2010 after the boost from inventory restocking has been realized. This is probably why so many investors have not gone back into stocks. They simply don’t believe the recovery has any staying power.

The thinking goes that the American consumer has been “scared straight” into saving and has experienced a “moment of clarity” in terms of seeing the need to live within his or her means. As a result, the savings rate should continue to climb. It has already risen from 0% to 5% percent, but perhaps it will continue to rise to 10% or so. If that is the case, the economic headwinds stemming from a rising savings rate will continue for undercut growth. With consumer spending composing some two-thirds of GDP, if the consumer doesn’t show up after the “V”, then we could relapse into a “W.”

But who says that this is the way it has to play out? It all comes down to what drives the savings rate. From my perspective, the savings rate is determined by household net worth relative to disposable income. While income is down as a result of rising unemployment, net worth is finally starting to improve again, after a $14 trillion hit in 2007 and 2008. Household net worth is heavily influenced by home prices and stock prices, both of which are now recovering.

This suggests that the rise in the savings rate (from 0% to 5%) may well be ending. If the savings rate stabilizes here, then