‘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.”