Sunday, December 31, 2006

The Private Lives of Hedge Funds

The Private Lives of Hedge Funds
December 29, 2006

Hedge fund managers, let us toast the triumphs and travails of your secretive world as the year draws to a close.

Tom Starkweather/ Bloomberg News
Phillip Goldstein was an unknown hedge fund manager at Bulldog Investors until he sued the Securities and Exchange Commission.
Already I can hear some of you yelping. You hate being called secretive. You insist that it is federal laws that prohibit you from talking to the public, and in fact you would like the world to know more about you (except who you are, what you trade and what kind of returns you have generated).

In 2006, however, some of you discovered the one thing more valuable than your secrecy: permanent money. The Fortress Investment Group, which runs both hedge funds and private equity funds, and Citadel, a multi-strategy hedge fund, both filed prospectuses this year to offer securities to the public. To some, this is preferable to raising more money from investors in the fund because they can redeem their money, with certain restrictions, when they want.

The trend to lock down permanent capital gained even more traction abroad. Funds and funds of hedge funds raced to market, ready to sop up all demand for investments deemed alternative. Exchanges in Britain and Amsterdam raised $4.2 billion in 2006, compared with $454.2 million in 2005, according to Dealogic.

That outpouring of money into hedge funds mirrors another trend in hedge-fund land: that institutions like pension funds and endowments continue to dump money into the sector. But that means hedge funds are themselves becoming institutions, real grown-up businesses, with offices around the globe and extensive legal teams, rather than a few traders and a Bloomberg terminal.

Institutional or not, hedge funds are still more colorful, more outrageous, more impressive and more bizarre than other asset managers. They are the new, new money thing. And they deserve special recognitions of their own.

So let’s hand out the hedge fund awards for 2006.

THE HOUDINI AWARD To Amaranth Advisors and its founder, Nicholas Maounis, for overseeing the evaporation of $6 billion in less than one week at the hands of a 32-year-old Ferrari-driving energy trader. Amaranth had been a respectable fund; investors loved it for its high returns and energy exposure, until the high returns turned into epic losses and its energy “exposure” turned out to be a bunch of concentrated bets on the direction of natural-gas prices (bets that did not work out well).

Soon after $6 billion went poof, Mr. Maounis tried to pull a rabbit out of his hat. On a brief, carefully lawyered phone call with investors, Mr. Maounis suggested that he intended to win back the trust and faith of his investors. “We have every intention of continuing in business generating for our investors the same consistently high risk-adjusted returns which have been our hallmark.” Right.

THE BETTER-THAN-BARINGS BLOW-UP AWARD Amaranth’s energy trader, Brian Hunter, blew through more cash in less time at Amaranth than, well, than anyone I can think of. When Nicholas Leeson, a young trader at Barings Bank in Singapore, blew up Barings, he burned through $1.3 billion. When Long Term Capital Management imploded in 1998, its $4.8 billion quickly shrank to $600 million (although enormous leverage magnified the losses and brought the financial system to its knees). Bayou lost $460 million, $100 million less than Amaranth lost on Sept. 14.

THE BRAVEHEART AWARD Phillip Goldstein was an unknown hedge fund manager at an unremarkable hedge fund, Bulldog Investors, until he sued the Securities and Exchange Commission, contending that the agency did not have the authority to regulate hedge funds, and won. As a result, the court vacated the controversial registration requirement and left the S.E.C. with little authority over hedge funds.

The S.E.C. is now contemplating a rule that will prohibit all but 1.3 percent of Americans from investing in hedge funds. It also rewrote a fraud provision that at least allows it to go after, well, fraud.

THE DEBUTANTES AWARD The Citadel Investment Group filed a prospectus to raise as much as $2 billion in bonds, a creative financing strategy that when accomplished, makes Citadel slightly less dependent on Wall Street and slightly more similar to a normal company that has various forms of debt. The Fortress Investment Group also announced its intention to sell shares to the public. The upshot from its offering documents? The people running alternative investment groups make boatloads of money.

THE GRETA GARBO AWARD She just wanted to be left alone. So did Christopher Hohn, the founder and brainpower behind the Children’s Investment Fund, a $9 billion activist fund based in London that donates a portion of its fees to a foundation run by Jamie Cooper Hohn, Mr. Hohn’s wife. When provided an opportunity to talk about the fund’s charitable work, neither Hohn returned any calls — those who did answer phones would not acknowledge that a foundation existed; yet, in June, former President Bill Clinton spoke at a fund gathering and praised the foundation.

THE BUYER BEWARE AWARD Shakespeare questioned the power of a name and so should investors. Viper Capital Management, a fund in San Francisco, has been sued by the Securities and Exchange Commission for fleecing investors out of $5 million. Pirate Capital, whose letters to investors discuss “treasures” and “shipwrecks” accompanied by matching pictures, suffered a mutiny of talent and disappointing returns (5 percent through November for the flagship Jolly Roger fund). Investors not tipped off by the name perhaps should have been warned by a New York magazine article that featured one of the fund’s 27-year-old analysts, a former snowboarding champion, yelling at a chief executive that he was the boss. Capt. Jack Sparrow take heed.

THE $100 MILLION WEEKEND AWARD On a Friday in November, a $13 billion fund, Atticus Management, owned or controlled through options 9.9 percent of Phelps Dodge. Two days later, when Freeport-McMoRan Copper and Gold announced that it would acquire Phelps, Atticus made over $510 million. That number understates the fund’s real return, which is based on its previously acquired stake, done when the stock was cheaper. Since hedge fund managers take 20 percent of the profits, Timothy Barakett, Atticus’s founder and lead manager, made more than $100 million. New television series: Who Wants to Be a Decamillionaire?

THE HYPOCRITE’S AWARD For all the talk about wanting to be more open, a lot of you are still secretive. One of you stopped me on my way into your Greenwich, Conn., offices and insisted: “You were never here, right?” I joked that such metaphysical requests were beyond my abilities. Upon gaining entry into your secret kingdom, you suggested the press was unfair, perhaps even inaccurate, for calling hedge funds secretive.

And for that, I award you the hypocrite’s award for 2006.

Saturday, November 25, 2006

If These Are Bubbles, Where Is All That Hot-Air Money Coming From?

by Katy Delay

If These Are Bubbles, Where Is All That Hot-Air Money Coming From?
November 25, 2006

Katy Delay is a freelance columnist in economics and government, and maintains a blog at

Most people and even most economists believe it is the Fed that controls the money supply, and that it is Fed know-how that is maintaining our CPI within historically "reasonable" limits. A minority of us, however, think our present economy is in a falsely optimistic booming phase of a bubble-and-burst cycle started more than ten years ago by excessive credit and money creation, and that the excess dollars are camouflaging themselves in assets and speculation rather than in the CPI.

There's plenty of evidence to support this idea, starting with the dot com and stock market bubbles that burst in 2001, the global real estate bubble that has started to turn in the US and is still strong globally, and now the still growing US bubbles in corporate profits, bond issuance, M&A activity, finance industry bonuses, and hedge fund and credit derivative frenzies.

Statisticians will try to disprove the bubble conjecture pointing to stats from the Fed and relative government entities, because the figures don't all corroborate the nature of the bubbles we think we're observing. There are two hypothetical market dynamics that might explain this: (1) Money- and credit-creation mechanisms could exist outside Fed control; and (2) the excess purchasing media may be sidestepping the statistics. Hereafter are three scenarios that illustrate how this might be happening.

One Potential Non-Fed Source for Money: Mishandling of Securitization and Credit Derivatives

Doug Noland is one of my favorite bubble theorists. He maintains that money creation has gotten away from the Fed's monopoly at this point, and that it is now manipulated in great part by a pyramid-scheme-like banking game involving the mishandling of a good thing called the securitization of risk. His November 10, 2006 commentary (Monetary Developments vs. Monetary Aggregates) paints a gaudy credit bubble that I'll describe here in layman's terms.

Securitization is a fabulous tool invented by the financial industry to survive and evolve under existing banking regulations. As they were first envisioned, these transactions had -- and still have -- great potential as a safety net to insure healthy lender risk. Unfortunately, and probably through lack of experience, the financial community has let them evolve into a monstrous money-making machine. Here's how it works.

1. A bank receives deposits, and its function is to lend that money out at a profit. (We won't go into fractional reserve banking here, although this multiplies the problem when things go awry. For now, however, let's just assume the bank lends a fixed multiple of what it takes in.)

2. The bank (or other type of financial institution with access to funds) finds good borrowers with at least a decent credit score to whom they lend the money for purchases, say for a house, a car, or whatever the borrower fancies.

3. Instead of following up on the repayments through their own loan department like they used to, the banks now transfer those loans to an agency that will fulfill this task. At the same time, they package the loans according to the degree of risk, and then they sell the loans to the general marketplace.

4. The buyers of these packaged loans can then buy "insurance" to cover the risk, from individuals and companies who want to assume that risk for a price (a piece of the interest action) and who are supposedly able to come up with the cash should a default occur. So far so good.

5. The bank now no longer has any loans on the books, so it is free to make a second set of loans based on the same fractional-reserve multiple of the deposits it holds -- but this time in effect using 100% of the loan-package buyers' funds to do so, i.e. so far, this is still a good thing; but as we'll see, it's good only up to a point.

6. As you can imagine, this doubling, tripling or quadrupling of loans allows for an expansion of the lending industry; and the market pool of good borrowers (and the good borrowers' credit appetite) eventually maxes out. To palliate this inconvenience, and since the bank is no longer shouldering the risk from its own loans, the bank now lowers the bar for borrowing so that those with a lower credit score may become borrowers. This expansion has presently extended into what some believe is dangerous territory; but this is only half of the problem.

7. The other half occurs when the buyers of these packaged loans either do so with what is called leveraging, i.e. they buy on credit themselves; or they sell these loans to others who do the leveraging. Hedge funds, for example, have sometimes been a source of unwisely leveraged funds that are not yet under industry control. And hedge funds are very popular these days.

8. According to Doug, much of the credit risk involved at this higher level is also "insured" in the same manner as in Stage 4, only this time the insurers never actually pay for the loans they are "insuring." As with real "insurance," they only need to pay in case of default. And this so-called "credit derivative" process is repeated over and over again, in effect allowing the loan-package insurers to borrow to the degree of the "insurance" market's willingness to take on risk.

The fundamental unknown here is that because this type of risk insuring is a new industry, there are few standards such as those found in the ordinary insurance industry or in banking, where safety-net reserves are required. Therefore, the loan and credit insurers in Stage 8, above, who do not have to come up with the principal of an insured loan unless there is a default, are leveraged beyond reason. It's true, when things are booming in the economy, defaults are rare. But what happens if things start to turn sour?

Free market laissez-faire would have us accept that these market players know the risks they are taking and are in a position to accept the consequences. The problem is that, if there were a large enough blow-out in this important sector of the economy, the Federal Reserve is not going to stand by and watch the economy tank. If the past is any indication, they would very likely step in to inflate the problem away.

And a huge problem it could be indeed. These two industries, loan risk securitization and leveraging risk securitization, are booming at a pace that is off the charts. No one really knows to what degree the "leveraging insurers" are capable of covering their positions, i.e. whether or not they could actually come up with the dough in a pinch. Obviously, a normal economic downward cycle could become violent, if there has been distorted and excess credit creation beyond what these new industries can stand to lose; and in that case our figurative falling house of cards becomes real.

As Doug puts it: 'When current perceptions change - when $ trillions of Credit instruments are reclassified and revalued as risky instruments as opposed to today's coveted "money" - Dr. Bernanke will learn why a central bank's monetary focus must be in restraining "money" and Credit excesses during the boom. And the longer this destabilizing period of transforming risky Credits into perceived "money" is allowed to run unchecked, the more impotent his little "mop-up" operations will appear in the face of widespread financial and economic dislocation - on a global scale.'

Melodramatic? Maybe. But only maybe.

A Second non-Fed Source of Money: Influx of Other Countries' Excess Liquidity

There are other sources for the hot-air money. For example, there's the overflow of credit coming from outside the US, in other words the cumulative input of investment into US assets coming from the world's larger economies' collective loose monetary policy combined with their pegging support of the US dollar.

As an illustration, let's take just one asset class. Half of American Treasury debt is held in the hands of foreigners, a third of that being held just by the Japanese. The Japanese central bank has been pumping yen full throttle into their economy for several years now, with no end in sight. Complicating the Japanese problem is the fact that there is a dispute going on between the Bank of Japan and their Treasury Department. The Bank would like to continue raising rates and destroying all those excess yen, but the Treasury doesn't want that to happen, even going so far as changing the statistics the Bank uses to calculate inflation, which undermines the Bank's argument. [The changes were made in August 2006.]

Why isn't that money "benefiting" the Japanese economy? For two reasons. First, because Keynesian economics doesn't work; and second because it's no surprise that the Japanese investor prefers American debt. They can borrow at next to nothing and buy American Treasuries yielding over four percent. It's called the Japanese carry trade, and it's going on like there's no tomorrow.

But this game only works as long as the dollar holds its value next to the yen, and the trend is now towards a weaker dollar in spite of their pegging efforts. So why do they continue?

It's all a question of timing. If America and the dollar can hold onto their "tallest dwarf" status for the mid-term and only allow a smooth slip instead of a sudden drop, maybe foreign investors can continue holding onto our assets with impunity "until things get better" (or at least until the foreign speculator can pull out his marbles and go home.) That's what they're saying to themselves. But keep in mind that this combination of inflationary credit creation and short-term profiteering led us up to 1980.

Along this same line of reasoning is the recycling of at least partially inflated petrodollars. Petroleum prices are climbing probably for two reasons, the first being an increased worldwide demand, and the second the devaluation of the dollar through excessive credit creation. As the price of the barrel climbs, producers are raking it in at a record rate and must invest the dollars somewhere.

They may not want to push any more strings in their own economy, so they look for ways to exchange them for assets. Much of it is going into the purchase of companies around the world, and a lot more may be going into hedge funds, which brings us to the third point.

A Third Contributor Behind The Stats: Hot-Air Money Can Avoid the Statistics

Sears just revealed that one-third (sic) of their before-tax and minority-interest profit "came from investments as sales fell." According to an article by Coleman-Lochner at Bloomberg, Sears is no longer just a retailer, they are now the "Lampert Hedge Fund." This is tongue in check, but there's some truth to it.

Sears is most likely not the only one doing this. Profits have been huge all over the business spectrum, and the GDP and wage increases seem only moderate in comparison. Speculative investment profit and losses are not included in the CPI. Production can take a back seat to other activities when management judges that more hard capital investment and hiring just doesn't make economic sense.

Hedging and derivative investing are activities that may be useful to some degree, but they also tend to explode in times of excessive monetary supply. It's as if Fama's Efficient Market Hypothesis somehow causes the hot stuff to shoot to the top, momentarily making a few people very rich, alighting onto a few asset sectors, and then just disappearing into thin air in the form of losses on the next throw of the dice. The hot money bypasses the normal production channels, and the CPI remains relatively unaffected. In the Great Depression general prices were not rising; nor are they rising quickly now.

The Fed has become a group of mathematicians who believe firmly in the accuracy of their statistical tools, but who have forgotten the old rule: "Garbage in, garbage out." (See my blog post on the subject.) The push-the-string Keynesian policies of the Fed could indeed be causing the bubbles without their knowledge, because their interpretation of the statistics on which they judge their policy's performance understates the reality of the money they and the global system have created.

For a good understanding of money, the Great Depression, and the business cycle, I suggest reading a small booklet written by Edward C. Harwood called "Cause and Control of the Business Cycle," published by the American Institute for Economic Research. It's out of print, but they may still have a copy available if you ask. Tell them I sent you.

Opinions expressed are not necessarily those of David W. Tice & Associates, LLC. The opinions are subject to change, are not guaranteed and should not be considered recommendations to buy or sell any security.

Friday, October 13, 2006

Autumn Chills the Goldilocks Economy

Autumn Chills the Goldilocks Economy
by Max Fraad Wolff

Max Fraad Wolff is a Doctoral Candidate in Economics at the University of Massachusetts, Amherst and editor of the website GlobalMacroScope.

Naturally, the passage of summer into autumn entails a chilling of the air. Less natural and more pronounced this year is the cooling of the macroeconomy. Profit and GDP growth, as well as, housing numbers and durable goods reports, point to falling temperatures. Fed rate hikes on pause and cooling commodity prices offer more evidence- if that were necessary. Thus far, the stock market’s response has been to heat up to August-like temperatures. Renewed geo-political risk suggested by recent events in Shanghai, Mexico City, Budapest and Bangkok be damned, the Dow is in record breaking mode. Could this be a sign of agreement with my cautionary thesis? The Dow is populated by larger more global and defensive firms with higher credit ratings than the S&P. Thus, some of its rise may be rotation from even more dangerous positions elsewhere in the US equity orbit.

Sadly, it seems clear that most are driven by the goldilocks outlook. This “understanding” became popular in 2002. According to the goldilocks story, we will artfully and profitably dodge inflation and recession as we hop from sweet spot to sweet spot. It is a mutant form of the new economy/new era conception popularized and universalized in the heady days of the late 1990’s. The US does not have to save; we can run huge external imbalances forever; the Fed can endlessly run expansionary monetary policy; there are no equity, bond, real estate bubbles; and we can have rapid growth without inflation. Goldilocks adherents believe this is being done as we thread the needle between various risks. How well does the macroeconomic data confirm this outlook?

Early winter would seem the correct analogy here. Housing starts, permits, mortgage applications, prices and housing company stock prices are down, foreclosures are up. Durable goods orders fell 0.5% in August, widely missing consensus forecast of a 0.5% increase. Bright spots were autos and defense spending, yet neither is likely to be a source of macroeconomic strength moving forward. Excluding transports, durable goods orders declined by 2.0%. The Mortgage Bankers Association (MBA) announced on September 22, 2006 that its seasonally adjusted index of mortgage applications declined 5% on the week despite half-year lows in listed mortgage rates. The 5% one week decline masked a more worrisome 21% year-over-year slide. Home sales declines in August were sharp in several vital and once hot markets. The California Association of Realtors (CAR) reported a 30% drop in sales for August 2006. This is the largest decline since 1982. The Florida Association of Realtors reported a 50% August decline in sales in Palm Beach County and a 6% fall in median home price there. The Massachusetts Association of Realtors revealed a 20% decline in sales and an 8% decline in median price. It is possible some of this weak performance is related to the total lack of growth and dynamism in personal income and spending growth. The September 29, 2006 Personal Incomes and Outlays release form the BEA reveals that August was a low point for wage growth and personal consumption expenditure. Only core inflation stayed strong. Earnings and spending growth were anemic while prices stayed high. This is the mirror image of goldilocks. August 2006 marks another month with a negative private savings rate (-.5%). [1] This has caused little concern, likely because consumption is a relatively unimportant 70% of US GDP.

The September 28, 2006 release of Q2 2006 GDP and national economic data has confirmed more skeptical outlooks and spurred hardened optimists to new levels of creativity. Consensus estimates from private sector economists of 2.8% GDP growth and advanced estimates of 2.9% growth were disappointed as the Commerce Department announced actual growth of 2.6%. The Fed-preferred price index for personal consumption expenditure- excluding food and energy- increased 2.9% in Q2 down from 3.0% in Q1. Thus, our present goldilocks economy most recently displayed a 3% drop in the rate of price increase and a 53% decline- quarter over quarter- in GDP growth. This must be why indexes are soaring and the soft landing, benign inflation environment expectation has become dominant! What of corporate profits, long a bright spot in our economy?

Profits from current production (corporate profits with inventory valuation and capital consumption adjustments) increased $22.7 billion in the second quarter, compared with an increase of $175.6 billion in the first quarter. Current-production cash flow (net cash flow with inventory valuation and capital consumption adjustments)--the internal funds available to corporations for investment--increased $1.1 billion in the second quarter, compared with an increase of $125.3 billion in the first.[2]

It is fair to say that the corporate profit picture is defined by deceleration in Q2. This was particularly true for non-financial corporations that underwent a rather profound reversal of profit fortunes across the quarter. Reported domestic profits for non-financial corporations dropped by $32.8 billion in Q2 on the heels of a strong $94.5 billion increase in Q1. The profit picture, while still a relative strong spot in the economy, is less hot than it has been. The most recent data, like the first cold winds of autumn, are a reminder that winter is approaching. Stagnant earnings, pressured private consumption, decelerating profit growth and robust price inflation are showing up in the macro data.

So we are left to ponder a widely popular consensus on the economy that is influencing equity performance. It runs as follows: eureka! The Fed has stopped tightening and the economy is still growing well and highly profitably. Of course growth and profitability are still in respectable shape- particularly the later. However, they have remarkably cooled of late. Much like rate increases. When rate increases slow we celebrate the end of inflation risk, despite the price change metrics reported. When GDP and profit numbers slow, we refocus on their strength in long run, global comparisons. Thus, the goldilocks consensus is sustained. The economy is not too hot, not too slow and just right!

Remember the Goldilocks story? Cool days and warm porridge lure Goldi into the bears’ house. There are two endings to the fairly tale. In the friendly version she wakes and flees in terror. In the harsher version she is eaten by the bears. Either way, advocates of the goldilocks economy may have much to learn from the fable they have invoked. Cooler data may be driving them to follow in goldilocks’ footsteps. It might be just right now, but there is trouble lurking in the near future! After all, the bears return in all the versions of the story.

Thursday, September 14, 2006

China's Pegging - Mercantilism Plus

China's Pegging: Be Careful What You Wish For
by Sybil Star

Certain countries peg their currency to the dollar, most notably in Asia and in the Middle East. The measure has short-term advantages for the peggor and/or the peggee. Some peggors peg to avoid reevaluation upward of their currency, as this allows them to sell their exports at an artificially maintained low dollar price, guaranteeing export sales growth for the near future. In this instance, the peggee is also a short-term winner, getting to continue buying those products at that low price, for the near future.

The problem is twofold. First, the dollars accumulate in the pegging nation's coffers, because to sell them back to the exchange marketplace would lower the dollar's exchange rate and put pressure on the peg. So pegging central banks either use them to buy American goods or American assets, like treasury bonds, stocks, securities or real estate, and they just store some of them in their reserve accounts to use as backing for their own monetary unit, just as banks used to do with gold in the good old days.

This is all fine and good for a while, and some peggors see this as a golden opportunity. But there is a limit to how many dollars they can dispose of and store in this way. At some point, something's gotta give, because they're gonna have either internal inflation themselves, or if they limit money creation, they'll end up with a huge foreign exchange account full of dollars and American assets whose exchange price may not always be the same if things were to reverse all of a sudden, as has happened with past peg scenarios.

But there is another ramification of not selling the dollars in the exchange market and thereby not allowing the dollar to find its natural level. When the dollar sinks relative to its trading partners, American exports become less expensive, i.e. more competitive on the international marketplace. However, if the peggors prevent it from sinking or slow the sinking down, American manufacturing prices remain relatively high on the international market. This hurts American manufacturers and their employees, and puts pressure on salaries in general. The CPI remains low and the Fed loosens money, making more dollars for the Chinese to store (and devaluing the real value of the dollar in the process, albeit imperceptibly at first.) It also makes America's trade imbalance grow, which it has recently done to a record $68 billion in July.

The Chinese and a few others have been pegging their monetary unit to the dollar for some time now. In July of 2005, someone managed to persuade China to begin letting it slide, and they have allowed the yuan to rise a total of about 4% since then. It still has a long way to go to represent reality, so Congress is getting impatient.

As described in this article at Breitbart:

"The administration is pushing China to move more quickly to allow its currency to rise in value against the dollar as a way to narrow the yawning trade gap by making American exports cheaper in China and Chinese goods more expensive for U.S. consumers. Congressional critics of China's trade policies have warned that if China does not act, they plan to push for a Senate vote before the end of this month on legislation that would impose 27.5 percent penalty tariffs on all Chinese imports. That would drive up the price American consumers would have to pay for Chinese clothes, toys and consumer electronic products, but supporters of the legislation contend a strong U.S. response is needed to force China to stop manipulating its currency to gain unfair trade advantages."

But either way, we have a problem. If Congress puts the tariff in place, American CPI would shoot upward, with the increase in prices of imports from China. But if China were to let its yuan go and reevalue upwards, American CPI would also shoot upward with the increase in prices of imports from China.

Can't win for losin'. And Goodness knows what the Fed would do then. They'd be forced to tighten, but at the wrong time from a business cycle point of view. And yet something's gotta give here. And it will give, either through the door or through the window, as they say in France.

Thursday, August 24, 2006

The New World of Over-Demand and Under-Supply

Towards Energy Autarky

Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005) -- details can be found on the Web site

The collapse of the Doha round of trade talks in July raised fears that the world might be about to descend into 1930s style autarky, with a huge negative effect on prosperity. Unless things get very much worse, that’s unlikely in trade as a whole, if only because the historical memory of the 1930s remains strong. However in the energy sector autarky increasingly appears a rational strategy, and free-trading globalization an unattainable and dangerous alternative.

The theoretical economic superiority of globalization rests on a number of foundations, some of which are rather shaky in the modern world. However, its principal requirement is that states themselves (to the extent that they control resources) be economically rational, acting to maximize their own wealth through entering into trade agreements with each other. In such a world, the doctrine of comparative advantage dictates that a country should not worry about losing a particular industry to cheaper competition, because the purchasing power created overseas through outsourcing will increase demand for other products for which it is the low cost producer. In a world of free markets and economically motivated actors, a country will always be able to get the supplies of a particular product or commodity it needs, at a price that reflects the global marginal cost of production.

However, we don’t live in such a world. Not only economically marginal countries such as North Korea and Cuba, but major producers of valuable goods such as Iran and Venezuela are governed by political forces more or less hostile to the United States, and to a lesser extent to the West in general. Other countries, notably Russia and China, are by no means so well disposed to the West as to miss an opportunity to use any economic weapon that falls into their hand – and with great effectiveness too, as has been shown by the collapse of the Orange Revolution government in Ukraine after Russia unilaterally imposed a new pricing regime on natural gas exports in mid winter.

In most manufactured goods, this doesn’t much matter. If China imposes an embargo on the world’s socks, in which it has through aggressive pricing acquired a substantial market share, it may damage Wal-Mart’s profitability for a time but it will cause no long term or even medium term economic damage – other sock producers will take China’s place. Even a strategic item such as steel, in which China now has by far the world’s largest production capacity, is pretty well invulnerable to embargo – iron ore is plentiful all over the world and steel producing capacity remains sufficiently widespread that there is unlikely to be more than a temporary effect from such an embargo.

Thus in manufactured goods, and in most commodities, the free trade globalization model is both the most efficient and relatively invulnerable to supply side shocks. Trade would be disrupted by a major war, but a simple embargo or “cold war” situation would not have a major effect on trading patterns or costs. Protectionism in agriculture or textiles, for example, is both strategically unnecessary and economically counterproductive. Only in a few high-intellectual-property sectors such as software does outsourcing lead to the possibility of economic damage to the outsourcing country that is greater than the benefit it obtains from buying cheaper products. (David Ricardo’s Doctrine of Comparative Advantage falls down if by outsourcing to a cheaper labor environment you allow the outsourcee country to change its relative factor position and thereby gain comparative advantage in the remainder of your product range that you hadn’t outsourced.)

However, in a limited number of commodities, notably oil but also including some metals whose sources are relatively geographically concentrated, both product sources and substitutability are limited, so the globalization model doesn’t work. If all participants in the market were “economic men” this wouldn’t matter – suppliers would compete with each other, and disruption of supply in one area would (possibly after some delay) be made up by one of the other suppliers, who would utilize higher prices to ramp up production. This was the idea between the Athabasca tar sands in Alberta; they required a high oil price to be economically viable, but when that high price was attained they became an economically viable and attractive source of petroleum products. Much of the rejoicing behind the collapse of Communism in the 1990s stemmed from the idea that a capitalist Russia would form a source of supply for the world’s oil needs that was independent of the Middle East and could be relied upon to pump at full blast provided the price was right.

It’s now clear that a large portion of the world’s oil production volume derives from countries whose motivations are not primarily economic. Venezuela under its current government is motivated primarily by dislike of the United States, while Russia is motivated by the strategic leverage brought by its position as a major oil producer. Iran’s motivations are unclear; dislike of the United States and the West is certainly part of them, however. More ominously, the long term political stability and pro-Western orientation of Saudi Arabia, the world’s largest oil producer, cannot be assured in an era when radical jihadism commands substantial popular support across the Middle East. Thus a moderate share of the world’s oil production is already controlled by governments motivated by political/strategic rather than economic objectives; if Saudi Arabia were to fall, the non-economic portion of the world’s internationally traded oil production would become a majority.

While the quixotic resistance of the U.S. Congress to oil drilling in the Arctic National Wildlife Refuge continues, in other respects consumer governments are joining producer governments in autarkic behavior, seeking to control a greater proportion of their energy needs even if this is economically sub-optimal. China is generally fairly autarkist; thus it is no surprise that it has reached a long term supply arrangement with Iran and is seeking others in Latin America. China’s surging oil needs represent the largest single share in the projected increase in oil consumption to 2025; thus “cold war” style conflict with China over oil resources is likely to continue.

Of particular interest in this respect is Wednesday’s Wall Street Journal report that South Africa’s SASOL oil from coal project is in detailed talks with China about technology transfer. There is a certain “Back to the Future” quality about energy news generally – the topics being discussed often had their origins 30 years ago, in the middle 1970s – and SASOL as a major source of world energy is no exception to this; it was a highly fashionable idea in the late 1970s as the gold price soared to $800 per ounce and South Africa appeared the wave of the future. However it should be noted: the last two societies to make substantial use of oil-from-coal technology were apartheid-era South Africa and Nazi Germany; if China is consciously following their road the forces of autarky are strong indeed.

The United States, being at least marginally concerned with global warming, is unlikely to go for oil from coal, which according to the National Resources Defense Council emits 49.5 pounds of carbon dioxide per gallon compared with 27.5 emitted by burning conventional gasoline. Instead, the U.S. has focused attention on ethanol, which its proponents claim is “clean” although they’re only able to reach such a conclusion by counting the carbon dioxide absorbed by the growing plants as well as that emitted in burning the ethanol (unless you grow the plants in the Sahara, or on Arctic tundra, they replace other vegetation and so produce little or no net increase in carbon dioxide absorption.)

However, in a particularly autarkic move, the George W. Bush administration has sought to encourage domestically produced ethanol from corn, which even at $70 per barrel is only marginally competitive, rather than moving to ethanol produced from sugar cane, about half the net price (and less now world sugar prices have dropped from 18 cents to 10 cents a pound) but requiring to be grown in tropical countries, thus mostly outside the United States. Economically, this makes no sense – unless Bush expects a jihad to erupt in the Caribbean – politically, it’s the same old protectionist story.

The use of oil as a political weapon by producers, and the attempts by consumers to lock up long term supply contracts or move to other energy sources that are only marginally competitive even at present prices will keep oil prices at or above $70 much longer than they need to be. Eventually, of course, the oil market will break, reducing Russia once again to a second class power with a bankrupt economy, removing the Middle East almost entirely from the world’s headlines, and producing a fawning Venezuelan government that begs for World Bank handouts to feed its starving people. However that outcome, so devoutly desired by armchair strategists of the neocon persuasion, will only happen in only one way: through a really devastating world recession that slashes oil demand.

Friday, July 21, 2006

Is Japan’s Past Our Future?

Is Japan’s past our future?

Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005) -- details can be found on the Web site

The decision by the Bank of Japan Friday to raise the Overnight Call Rate from zero to 0.25% marks the definitive end of Japanese recession, which has lasted more than 16 years. Its onset was caused by excessive monetary expansion, and a consequent tsunami of speculation in stock and real estate markets. Here in the United States, we’ve had the monetary expansion and the speculation, so are we due to rot in near-recession until 2022?

We now have a pretty good handle on what caused the Japanese economy to under-perform for 16 years. The Bank of Japan expanded money supply too rapidly in the late 1980s, causing stock and real estate bubbles that reached peaks higher than had ever been seen in a major market. When the stock market index is selling at 100 times earnings, and the Emperor’s palace is worth more than the state of California, the overvaluation is not debatable, only the extent and timing of the crash to come..

In the early 1990s, stock prices approximately halved, and real estate prices began to decline. The Bank of Japan dropped interest rates, and the Japanese government expanded the public sector, indulging in Keynesian deficit spending as had become the accepted cure for a deflationary recession. As a result, the Japanese economy did not sink into deep recession, as might have been expected by those looking at the 1930s, but simply underwent mild deflation combined with low growth. As the 1990s proceeded, the economy’s refusal to recover properly became increasingly worrisome and the stock market, which had stabilized for several years at about 50-60% of its peak level, began to decline further.

In 2000, the apparent beginnings of recovery caused the Bank of Japan to attempt to raise the Overnight Call Rate above zero, but the move backfired. The banking system was now overburdened with bad loans, and the continuing recession was undermining the strength of borrowers previously thought invulnerable. A further burst of public spending (primarily on infrastructure in rural districts with important Liberal Democrat party Diet members) caused Japan’s public debt to rise above 130% of Gross Domestic Product and the state budget deficit to soar above 7% of GDP, but economic growth stubbornly refused to reappear.

That was the position when Junichiro Koizumi became prime minister in April 2001. He correctly diagnosed the main problem: the inevitable deflationary effect of declining stock and real estate prices had been exacerbated by the increases in public spending. If as in most countries the private sector is more productive than the public sector, continually increasing the public sector’s share of output produces a major drag on growth. This is common sense; it can also be demonstrated by regressions which show that in advanced OECD economies the growth rate is inversely correlated to the size of the public sector and its growth as a percentage of the economy. Thus in 2001 the public sector needed to be reined back while monetary policy remained loose to allow asset values to stabilize and begin to recover, which in turn would prevent the further erosion of the banking system.

That was the policy Koizumi followed, and after a delay of about two years, it worked. Public sector infrastructure spending had reached 8% of Japan’s GDP, the highest in the OECD and more than twice the level of the OECD’s next heaviest spender on public infrastructure, France. By cutting it back, resources were redeployed to the private sector, which at last had room to grow. Corporate profits began to recover as, after a delay did stock prices and asset prices. The Tokyo Stock Exchange bottomed out at about 20% of its peak value, and then doubled over the next 3 years.

Since the beginning of 2006, the Bank of Japan has decided that the economy is strong enough to bear a normal monetary policy, and the excessive easing of the previous few years is thus gradually being removed. With Japanese economic growth per capita as rapid as in the United States and inflation positive there is little reason to fear a return to recession.

Since the long Japanese recession began in a period of over-extended asset prices and monetary easing, we need to ask to what extent the Japanese experience might be repeated in the United States or the world as a whole, and what steps can be taken to avoid it. That’s not to assume that Japanese policy was uniquely incompetent, far from it. The last U.S. episode of such an overvaluation terminated in the Great Depression. Even if in retrospect a tighter Japanese fiscal policy, combined with its loose monetary policy, could have made its economic downturn shorter than it became, avoiding the Great Depression is itself an achievement worth celebrating.

Start by exploding a myth. The United States has not been enjoying a period of exceptional productivity growth, such as would justify sky-high valuations and allow them to remain elevated. Nor has Japan been a uniquely sluggish economy, such as would explain its 16 years of malaise and allow the U.S. to feel comfortably superior. In the 14 years following the Japanese market peak in 1990, according to OECD statistics, Japanese labor productivity grew by 2.1% per annum while U.S. labor productivity grew by 2.0% per annum. Remember: in the United States that period included a decade of cheap money, bullish markets and huge capital investment, while in Japan it included 14 years of recession and very little of the subsequent recovery.

Moreover, this is labor productivity not total factor productivity; to the extent the United States threw capital at the economy, as it did in dot-coms in 1997-2000 and housing in 2003-05, it got a “free ride” of labor productivity improvement as the economy became more capital intensive.

Like the United States since 1995, Japan in the 1980s enjoyed low inflation – an average of 1.9% per annum in 1981-1991. The Bank of Japan was thus able to reduce interest rates from 6% to 0.5% in 1990-95 without worrying overmuch about inflation. By reducing interest rates, the BOJ was able to cushion the decline in stock and asset prices, without reigniting the 1985-90 bubble.

It’s fairly clear that the U.S. stock market in 2000 was suffering from an overvaluation similar in kind although maybe less excessive in degree to Japan’s in 1990. On the other hand, the U.S. housing market was not particularly overvalued in 2000, since it was still recovering from the tight money recession of the early 1990s.

The Fed reduced interest rates much more aggressively in 2001-02 than had the BOJ in the early 1990s. This cushioned the decline in the stock market, at the cost of inflating a housing bubble, and causing U.S. savings rates to swing negative (this had not been a problem in Japan; savings rates declined from their previously high levels but never became negative.) Public spending increased moderately, less than in Japan, and taxes were cut, which they weren’t in Japan. Thus after 2003 the U.S. economy recovered more robustly than had the Japanese economy in the early 1990s. U.S. stock prices once again approached their bubble levels but on broad based indices did not reach them. Cheap money and tax cuts also caused a rise in corporate profits, although over-flexible accounting played a role in this.

We are now in the equivalent position of Japan not in 1990 but in 1995, with some differences. The stock market and the economy in general have been propped up by loose money and stimulative fiscal policy, so that the decline in stock prices from the peak has been only moderate and house prices are higher than in 2000.

On OECD figures, for comparability, the Japanese budget was in surplus by 2.0% of GDP in 1990; in 1995 it ran a deficit of 4.7% of GDP. The U.S. Federal budget ran a surplus of 1.7% of GDP in 2000 and a deficit of 4.8% of GDP by 2004. A pretty close correlation there between the post-peak fiscal stimulus in the two countries, though in the United States the fiscal gap was widened by tax cuts as well as spending increases.

In the U.S. today, unlike in 1995 Japan, housing prices are considerably higher than they were at the top of the boom, inflation appears to be making a comeback and the trade deficit is enormous.

We know what happened in Japan in 1995-2000 – the bottom fell out. The stock market index halved again from its reduced 1995 level, the budget deficit and public debt spiraled out of control, the economy remained mired in recession and bank bad debts endangered the entire financial system. If the Fed puts up interest rates far enough to beat inflation (a Fed Funds rate of around 8% is about what it would take at present) the U.S. will probably follow a similar trajectory.

If as is more likely the Fed sees recession arriving and therefore wimps out on inflation, the stock and asset price declines will be somewhat less, but the economy will lapse into 1970s style stagflation, with inflation spiraling upwards towards 10% per annum.

The federal budget deficit in either case will increase rapidly, probably to the $750-800 billion level at which it becomes difficult to finance. If as in Japan in 1995-2001 the George W. Bush administration then attempts to cure the stagflation by increasing public spending further, it will choke off capital availability to the private sector, because the federal deficit will take up too much of the financing pool. If that happens, the United States is due for a long and punishing recession, similar to the 1930s and worse than that in Japan because of the lack of domestic savings and the dangerous trade deficit.

If fiscal discipline is maintained, a 4-5 year recession, accompanied by a substantial decline in the dollar to correct the trade balance (which will itself be inflationary) is probably what we can look forward to -- an unpleasant future, like Japan in 1990-2003, but not a wholly disastrous one, and ending considerably sooner than Japan’s 16 year trauma.

That’s not too bad – IF we can rely on the Administration and Congress to maintain fiscal discipline. Otherwise, better not start your new business before 2022!

Saturday, April 29, 2006

Finally: Rebalancing Legitimized!

Rebalancing Legitimized!

Time For A New Global Architecture

by Stephen Roach (Hong Kong)

At long last, global rebalancing is center stage in the world policy theater. That’s an important conclusion to take out of the results of April’s power councils — the G-7 meeting as well as the annual gathering of the full complement of some 184 members of the IMF. This is good news for an unbalanced world. It is not, however, the silver bullet for dealing with a very tough problem. The road to global rebalancing is likely to be long and arduous, and the new approach still has some problems. But as someone who has led the charge in worrying about the pitfalls of an unbalanced world, I am delighted that the Wise Men have finally seen the light.

Policy makers have always communicated in strange and almost ritualistic ways. That’s true at the national as well as at the global level. Statements typically are steeped in jargon and opaque phraseology. Nuanced language allows for multiple interpretations — providing the cover, or hedge, if things go awry. All those caveats aside, there can be no mistaking a very important message sent on 21 April by the G-7 finance ministers and central bank governors after their recent meeting in Washington: Global imbalances have now been officially anointed as a major concern by the stewards of globalization. Not only were they given prominent mention in the official G-7 communiqué, but they were also the focus of a rare “annex” to the statement. In G-7 circles, that’s about as loud as an alarm ever gets.

The annex lays out three basic principles that shape the G-7’s approach to global rebalancing: One, it is a shared responsibility — an obvious but very important statement that readers of my work will also recognize. It is policy jargon for saying “no” to scapegoatting — pinning the blame unfairly on a nation like China. Two, rebalancing requires, first and foremost, a realignment of global saving and investment flows; this identifies disparities between current account surpluses and deficits as the major source of global instability — again, quite consistent with my own thinking and clearly putting the US, with its world record current account deficit, at the top of the problem list. Three, the G-7 annex stresses that rebalancing strategies must be designed with an aim toward maximizing sustained economic growth; in my view, that’s the weakest element of the G-7’s proposed strategy. While rapid growth is an understandable goal, its emphasis may obscure the heavy lifting that will ultimately be required of an effective global rebalancing strategy.

This latter point deserves elaboration. Economic growth has become the elixir of political angst — the perceived remedy for all that ails a nation’s economy. Pro-growth politicians win elections — and re-elections — while the anti-growth set is doomed to a quick oblivion. Growth has become such an important part of the policy rubric that it has spawned its own theoretical framework — supply-side economics. A broad array of pro-growth policies — especially tax cutting — has come into fashion as the rising tide that lifts all boats. Supply-siders believe that self-financing budget deficits, narrowing income inequalities, and surging productivity are all part of the growth miracle. Never mind America’s gaping budget deficit and the recent widening of disparities in the US income distribution — the pro-growth principles of supply-side economics have taken on almost a religious fervor in Washington and on Wall Street.

America’s current account deficit — the world’s most serious imbalance — is, first and foremost, an excess consumption problem. I make that statement on the basis of three facts: One, tradable goods imports by the US are currently 89% larger than its exports of tradables. That means exports now have to grow twice as rapidly as imports just to hold the US trade deficit constant. Two, import penetration has reached very high levels in America; tradable goods imports now account for a record 37% of US expenditures on goods. That means that the faster US domestic demand grows, the faster imports will grow — implying that faster growth begets an ever-widening US trade deficit and ever-mounting global imbalances. Three, US consumption is currently holding at a record 71% of US GDP — a huge breakout from the 25-year average of 67% that prevailed over the 1975 to 2000 period. These three points imply that it will be extremely difficult for the US to accept its role in the shared responsibility of global rebalancing without coming to grips with its excess consumption problem. And that, I’m afraid, could well spell slower economic growth in America. Such a conclusion not only flies in the face of the pro-growth principles of the G-7’s newly-articulated rebalancing strategy, but it is also very much at odds with the supply-side policy biases that currently dominate the Washington consensus.

I don’t want to come across as too negative in assessing the implications of the G-7’s epiphany. As an unabashed champion of the imperatives of global rebalancing for longer than I care to remember, I believe the 21 April communiqué was something close to an historical breakthrough. Moreover, it was followed by an equally impressive effort from the IMF at its companion annual meeting — an endorsement of the principles of “multi-lateral surveillance and consultation.” This is policy jargon for a big change in the modus operandi of the Fund, which has long conducted its work mainly on the basis of single-country missions and consultations. By taking its functionality to the multi-lateral level, the IMF is accepting the very important task of coming to grips with the “spillovers” across nations that arise from imbalances of trade and capital flows. The surveillance aspect of this task essentially empowers the IMF to sound warnings when multi-lateral imbalances reach dangerous levels — a welcome development for a world that is inclined to ignore such problems until it is too late. The multi-lateral consultation function will undoubtedly be a good deal thornier to execute, since it could conceptually involve arbitrating the costs and benefits of a shift in US fiscal policy versus structural reforms in Europe, weighing in reserve management practices of the oil producers and Asian exporters, and so on. Globalization is not just about integration — it is also about navigating the ever-contentious waters of cross-border structural and policy tradeoffs.

For the IMF, this new role could well be a key to its survival as a relevant global institution. In my view, it is unconscionable that the stewards of globalization could have allowed the world’s imbalances to reach such dangerous proportions. The Fund will now be able to demonstrate if it is up to the challenge of its mandate. The IMF, in effect, has been charged with the execution of the G-7’s newly stated principles of global rebalancing. By accepting this important responsibility, the IMF has the opportunity to provide an unbalanced world with legitimate hope on the road to rebalancing. Success could lay the groundwork for a major breakthrough in the reform of the world’s policy architecture. Failure could spell curtains for the IMF as we know it — portending a painful slip into the obscurity that Governor Mervyn King of the Bank of England has raised as a worrisome possibility (see my 24 April dispatch, “Time for a New Global Architecture”).

There’s one element of this new rebalancing agenda that continues to gnaw at me — the insistence on Chinese currency flexibility as an important element of the global adjustment process. I definitely believe that China has an important role to play in global rebalancing. I also think that China accepts its responsibility to do just that. As I have noted, the newly enacted 11th Five-Year Plan has rebalancing written all over it, as China attempts the Herculean task of shifting the mix of its economic growth from exports and investment to private consumption (see my 24 April 2006 Special Economic Study, “China’s Rebalancing Challenge”). Instead of fixating on the currency as the main lever of rebalancing — and implying that a sharp revaluation of the RMB is needed — the G-7 and the broader global policy councils need to give China credit where credit is due: China is attempting to do something that Japan, Korea, and the rest of the so-called Asian dynamos have utterly failed to do — embracing and delivering on a pro-consumption growth strategy. Success of this plan will turn China into a very positive force in the rebalancing sweepstakes. Conversely, large currency movements — especially for a poor country with a still shaky financial system — borrow a page right out of the script of the “yen blunder” that Japan acceded to in the 1980s (see my 21 April dispatch, “Bad Advice”). Global rebalancing needs enlightened policies from China — not a replay of the painful mistakes that led Japan astray 20 years ago.

Globalization is a complex and challenging transformation of the world order. The stewards of globalization have been asleep at the switch — allowing unprecedented imbalances of trade and capital flows to mount. The G-7 and the IMF have finally come together to recognize the dangers of these problems. In doing so, they have rejected (thankfully) the “new paradigm” views of those who argue that imbalances are a perfectly sustainable attribute of a new world order. The long march down the road of global rebalancing may have just begun. Notwithstanding some of my quibbles noted above, this is excellent news for an unbalanced world. If the G-7 strategy works, it is also good news for financial markets. In particular, a successful rebalancing should lower the risks of a global hard landing — tempering the fears of a crash in the US dollar and/or a related sharp increase in real long-term US interest rates. So far, the hope is all on paper — buried in the rhetoric of a communiqué. Now it’s time for the heavy lifting.

Thursday, April 20, 2006

The Politics of Money

Hazel Henderson:

Hazel Henderson

The word is out that economics, never a science, has always been politics in disguise. I have explored how the economics profession grew to dominate public policy and trump so many other academic disciplines and values in our daily lives. Economics and economists view reality through the lens of money. Everything has its price, they believe, from rain forests to human labor to the air we breathe. Economic textbooks, Gross National Product (GNP) and the statistics on employment, productivity, investment, and globalization – all follow the money. Happily, all this focus on money is leading to the widespread awareness of ways money is designed, created and manipulated. This politics of money is at last unraveling centuries of mystification.

Civic action with local currencies, barter, community credit and the more dubious rash of digital cybermoney all reveal the politics of money. Economics is now widely seen as the faulty sourcecode deep in societies’ hard drives….replicating unsustainability: booms, busts, bubbles, recessions, poverty, trade wars, pollution, disruption of communities, loss of cultural and biodiversity. Citizens all over the world are rejecting this malfunctioning economic sourcecode and its operating systems: the World Bank, the IMF, the WTO and imperious central banks. Its hard-wired program: the now derided “Washington Consensus” recipe for hyping GNP-growth is challenged by the Human Development Index (HDI), Ecological Footprint Analysis, the Living Planet Index, the Calvert-Henderson Quality of Life Indicators, the Genuine Progress Index and Bhutan’s Gross National Happiness… not to mention scores of local city indices such as Jacksonville, Florida’s Quality Indicators for Progress, pioneered by the late Marian Chambers in 1983.

As with politics, all real money is local, created by people to facilitate exchange, transactions and is based on trust. The story of how this useful invention, money, grew into abstract national fiat currencies backed only by the promises of rulers and central bankers is being told anew. We witness how information technology and deregulation of banking and finance in the 1980s helped create today’s monstrous global casino where $1.15 trillion worth of fiat currencies slosh around the planet daily via mouse clicks on electronic exchanges, 90% in purely speculative trading.

US President Bush embraced former chief economic advisor and new Fed Chairman, Ben Bernanke’s opinion that the mystery of low bond yields and interest rates was due to a “global savings glut.” Former Fed Chairman Greenspan, whose zero real interest rates flooded the US economy with excess liquidity and helped create the dot-com, housing and global asset bubbles, declared himself “perplexed.” The anomaly involves the global economic imbalances between the USA, the world’s largest debtor – borrowing the lion’s share of global capital – and the developing countries of Asia and those exporting oil as the world’s new lenders. I doubt there is a “global savings glut” or a “Shift of Thrift” from indebted U.S. household’s zero saving rates to thrifty Asian savers as claimed in The Economist editorial of Sept. 24, 2005. My view is that there’s a global flood of fiat paper money – mostly trillions of US dollars – amplified by the pyramiding of financial “innovations” (derivatives, hedge funds, offshore “special purpose entities,” currency speculation and tax havens) vis-à-vis real production of goods and services in the real world.

Today, we see worldwide experimentation with local exchange, barter and swap clubs, such as Deli-Dollars, LETS, Ithaca Hours and other scrip currencies in the USA and Canada. Billions of people still live in traditional non-money societies and the world’s mostly female voluntary sectors. I have described these huge unchartered sectors as the “Love Economy” estimated by the Human Development Report (United Nations Development Program 1995) as $16 trillion simply missing from economists’ global GDP that year of $24 trillion. Others have described these non-money sectors, notably Karl Polanyi; in Primitive, Archaic and Modern Economies (1968); Lewis Hyde in The Gift (1979); Genevieve Vaughan in For-Giving (1997); Dallas Morning News financial editor, Scott Burns in Home, Inc (1975); Edgar Cahn’s No More Throw Away People (2004) and his time-banking programs now emulated worldwide (The Time Dollar How To Manual,

All this hands-on experimenting resulted in an explosion of grassroots awareness about the nature of money itself. As local groups and communities created their own local scrip currencies and exchange systems, they learned about economists’ deepest secret: money and information are equivalent – and neither is scarce! As money morphed from stone tablets, metal coins, gold and paper to electronic blips of pure information – the economic theories of scarcity and competition began to be bypassed by electronic sharing and community cooperation. Barter, dismissed in economic textbooks as a primitive relic – went hi-tech. eBay, the world’s largest garage sale, is an example of how to bypass existing markets.

People began to see how central banks and national money-systems control populations by macro-economic managing of scarcity, employment levels, availability of mortgages and car loans, via the money-supply, credit, interest rates and all the secretive levers and spigots used by central bankers. Even Nobel prizes were politicized as mathematicians in 2004 challenged the so-called “Nobel Memorial Prize in Economics” demanding its de-linking from the Nobel prizes and to confess its real name, “The Bank of Sweden Prize in Economics.” The mathematicians, Peter Nobel, grandson of Nobel and many other scientists object that economists misuse mathematics to hide their faulty assumptions – and that economics is not a science but a profession. The row over the 2004 Bank of Sweden Prize was because its recipients had authored a 1977 paper with a mathematical model purporting to “prove” why central banks should be independent of political control – even in democracies. Central banking too, is politics in even deeper disguise, as I describe in “21st Century Strategies for Sustainability”

Today, rapid social learning about the politics of money and how it functions is revealing this key mythology underlying our current societies and its transmission belt: that faulty economic sourcecode still replicating today’s unsustainable poverty gaps, energy crises and resource depletion. Climate change creeping upon us for 25 years is the latest media wake up call, and predictably economists quickly “captured this issue for our profession,” as a UK economics group put it (Henderson, 1996), to promote their pollution and C02 trading “markets.” In spite of such efforts, the defrocking of economics, the deconstructing of money systems and the growth of all the healthy local, real world alternatives is propagating widely. The World Social Forum launched in sunny Porto Alegre in 2000 by Brasilian reformers is one of many such worldwide movements. Argentina’s default in 2001 taught its citizens that they could trust their own local scrip, flea markets and electronic swap systems more than the country’s official currency: the peso. Argentina, Brasil and Venezuela have announced they will repay their IMF loans in full – to free their economies from “Washington Consensus” prescriptions.

I have documented over the years many of the pioneers of money reform, from the Time Store in Cincinnati in the 1890s, Ralph Barsodi’s “constants” in New Exeter, and during the 1930s “bank holiday,” Vermont’s own Malted Cereals Company scrip, issued in Burlington and the Wolfboro Chamber of Commerce’s scrip in New Hampshire.

Margaret Thoren has kept alive The Truth in Money Book by Theodore R. Thoren and Richard F. Warner (from P.O. Box 30, Chagrin Fall, OH, 44022). Other perennials: E.F. Schumacher’s Small is Beautiful (1973); James Robertson’s Future Wealth (1989); Margrit Kennedy’s tireless teachings; Robert Swann’s Community Economics are all in the Schumacher Society’s Library. The Society runs the SHARE credit system while documenting other community credit pioneering, such as Michael Linton’s LETS experiments, Paul Glover’s Ithaca Hours and many other projects since the early 1980s. Bernard Lietaer’s The Future of Money (2001); Lynn Twist’s The Soul of Money (2004); William Krehm’s COMER Newsletter ( and James Robertson and Josef Huber’s Creating New Money (2004) continue to keep these lessons alive and updated. My bookshelf on alternative economics, barter, credit and currency system continues to grow, and includes Ralph A. Mitchell and Neil Shafer’s indispensable eye-opening self-published Standard Catalog of Depression Scrip of the United States in the 1930s (Kranse Publications, Iola, WI) (1984). It contains thousands of pictures of alternative scrip currencies issued in almost every US state and city and many in Canada and Mexico after the Great Crash of 1929 and the bank failures that followed. During the 1980’s in all my talks across North America advocating local self-reliance and alternatives to fiat money, I carried this heavy volume along to show how local inventiveness helped overcome the failures of national banking and finance. People would raise their hands in recognition as I would show on overheads the scrip used in their state. “I remember these in my Dad’s bureau!” “My Mom used that to buy our groceries!”

So, today, as the global casino again reaches crises of abstraction, derivatives, currency futures and financial bubbles – we have been here before. Today’s global imbalances, deficits, bouncing currencies, poverty and debt crises require a systemic redesign of that faulty economic sourcecode. Worried finance ministers and central bankers call vainly for a “new international financial architecture.” They do little but fret about this behind closed doors, at meetings of the G-8, WTO, and in Jackson Hole and Davos. Some clever libertarians try to beat the bankers at their own game with global digital currencies backed by gold, including e-gold Ltd, Gold Money and Web Money. Based in offshore havens, Nevis, Jersey, Moscow and Panama, they have become platforms for cyber-crooks (Business Week, January 9, 2006). The rest of us are redesigning healthy homegrown sustainable local economies – all over the world.

Before we fall into “either/or” errors, we should avoid doctrinaire “smallness,” ideological localism and knee-jerk libertarianism. None can protect local communities from the ravages of market fundamentalist-driven globalization. Like it or not, we are all “glocal” now. Communities, like cells in the body-politic and the body, need boundaries or membranes to keep out elements destructive to the cell’s integrity. But all cell membranes are semi-permeable to allow needed elements, information and energy exchanges from the environment to pass through. In today’s information saturated world, communities need to understand anew which elements to reject and which to embrace. Wholesale rejection can lead to rigidity, xenophobia and misreading of history. Wholesale acceptance of current unsustainable economic global trends will surely lead to loss of local culture, biodiversity and resource-depletion. We humans have been adept at creating new scenarios and technologies that mirror our lack of systemic knowledge and foresight. From such social changes and unanticipated consequences, we must then learn and evolve – or suffer ecological collapse.

Wednesday, April 12, 2006

Banking And The Business Cycle

Banking And The Business Cycle

A Bloomberg headline caught my attention earlier in the week: “Fisher Says Globalization Reduces Inflation Threat.” In his Tuesday speech -- “A New Perspective for Policy” -- Federal Reserve Bank of Dallas’ President, Richard W. Fisher, noted a finding from recent globalization research conducted by the Bank of International Settlements. “…[F]or some countries, including—and to my mind especially—the United States, the proxies for global slack have become more important predictors of changes in inflation than measures of domestic slack.” Mr. Fisher also noted “the realization of the importance of global economic conditions for making monetary policy decisions is becoming more widespread.” Reminiscent of the late-nineties view that extraordinary productivity gains had empowered the Greenspan Fed to let the economy (and financial markets!) run hotter, today it is “globalization” that supposedly keeps “inflation” in check, thereby bestowing the Federal Reserve and global central bankers greater latitude for accommodation.

There is great irony in the fact that U.S. led Global Credit Inflation and attendant Asset Bubbles of unprecedented dimensions are fostering (over)investment in global goods-producing capacity, a backdrop that is perceived by the New Paradigmers as ensuring ongoing “slack” and quiescent “inflation.” This is dangerously flawed analysis, and I find it at this point rather ridiculous that policymakers cling to such a narrow (“core-CPI”) view of “inflation.” I suggest Mr. Fisher, Dr. Bernanke, Dr. Poole and others read (or, perhaps, re-read) the classic, Banking and the Business Cycle – A Study of the Great Depression in the United States, by C.A. Phillips, T.F. McManus, and R.W. Nelson, 1937.

The authors brought a (refreshing) degree of invaluable clarity to complex – and pertinent - economic issues that are today simply omitted from the discourse. In particular, I much appreciate the use of the terminology “Investment Credit Inflation.” It is, after all, the creation of new financial claims (Credit) that augments purchasing power, and analysts must be vigilant observers of the sources and uses of this additional spending. The key is to recognize the nature of the Processes of Credit Creation and Dissemination, especially when marketable securities, leveraged speculation, and Asset Inflation are key facets of the boom. And just as the popular proxy index for the general price level utterly failed during the ‘twenties to indicate the prevailing massive Credit Inflation, the Fed’s favored (narrow) price level indicators today only work to palliate and mislead.

But it is better to just let the timeless insights from “Banking and the Business Cycle” “speak” for themselves.

“It is sought to show that the main cause of the dislocation in trade and industry was, in [T.E.] Gregory’s language, the ‘disregard of the rules of common sense in the treatment of the money supply’ of the United States; the depression is proximately an effect of inflation. The post [First World] War inflation in the United States was an investment credit inflation, however, as distinguished from the commodity credit inflation of War-time.” (page 4)

“The special character of the depression is traced to the hyper-elasticity of the Federal Reserve System, and to the operation of that system as exemplified in the ‘managed currency’ experiment of the Federal Reserve Board… The depression, in other words, was the price paid for the experimentation with currency management by the Federal Reserve Board…” (pages 5/6)

“Through the purchase of investments, commercial banks impart a positive upward impulsion to the business cycle. Coming in as a marginal determining factor in the price of bonds, purchases of investments by banks force down the long-term market rate of interest so that it becomes profitable, in view of the existing realized rate of return to capital at important new investment margins, to float new bond issues and to embark upon new capital development; this results in an investment boom which affects a change in the structure of production… the purchase of investments by banks creates new deposits in the banking system in much the same fashion as does the granting of loans.” (page 6)

“The term ‘inflation’ has long been the subject of interminable and diverse definition. In the view of the writers, inflation applies to a state of money, credit, and prices arising not only from excessive issues of paper money, but also from any increase in the effective supply of circulating media that outruns the rate of increase of the physical volume of production and trade, thus forcing a rise of prices… In the modern world of finance…the most important single cause of inflation is the multiplication of bank credit by the banking machinery, resulting in an increase in the volume of purchasing power…” (page 13)

“‘Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency [quote from Keynes].’ How close the capitalist system in America has come to destruction in consequence of the inflationary debauch of the currency indulged in during and since the [First World] War by the manufacture of deposit currency is as yet uncertain.” (page 34)

“One of the duties devolving upon economists is that of pointing out the errors in fallacious economic contentions…” (page 38)

“Overinvestment, which must be assigned the role of a positive disturbing factor, has its ultimate source in an excess of credit… the policy of overinvestment, with its attendant misapplication of capital, could never have been carried to the lengths that it was during the decade of the ‘twenties' if the banks and the Government had not supplied abundant credits at artificially cheap rates.” (page 68)

“…the position of Professor [Lionel] Robbins: ‘It may prove to be no accident that the depression in which most measures have been taken to ‘maintain consumers’ purchasing power’ is also the depression of the widest extent and most alarming proportions.’” (page 72)

“The fall in prices would in itself serve to constitute an effective check upon inordinate capital development because it would bring about a decline in the rate of return going to capital; as the rate of return to capital declined consequently upon the fall in prices the rate of accumulation of capital goods would tend to diminish. Under such conditions the system is automatically self-corrective. It is just this self-corrective process which is essential to the smooth functioning of the economic machinery. And it is in this way that the system would work were it not for the disturbing factor of credit. The injections of new credit not only permit an increase in the rate of capital accumulation, but also tend to disrupt progressively the normal equilibrium relationships between costs and prices over many sectors of the pricing front. The fundamental disequilibria are not discernable until the new credits are withdrawn or cease to increase, when it then becomes apparent that the anticipated earnings of capital based on the prevailing (artificially pegged) price level will not be realized…” (page 77)

“And for an understanding of the more immediate causes of the depression it is essential that the developments taking place in the American banking system be clearly in mind, as the changes occurring in the banking system were intimately connected with the structural changes in the economic system which led to the depression.” (page 78)

“The immediate effects of this investment credit inflation were marked by important and interrelated changes in the character of bank loans and investment assets. There developed an indirectness in the processes of bank credit financing, bank credit entering into the channels of production and trade through operations in the securities and capital markets… As a result of the plethora of bank credit and the utilization by banks of their excess reserves to swell their investment accounts, the long-term rate declined and it became increasingly profitable and popular to float new stock and bond issues. This favorable situation in the capital funds market was translated into a constructional boom of previously unheard-of dimensions; a real estate boom developed, first in Florida, but soon was transferred to the urban real estate market on a nation-wide scale; and, finally, the stock market became the recipient of the excessive credit expansion. These three booms – the constructional boom proper, the real estate booms, and the stock market hysteria – combined to produce structural changes in the economic system which were directly involved with the immediate origins of the depression. This trinity of booms contributed to sustain a seeming prosperity, the tragic speciousness of which was not widely apparent until after the bubble had burst. Hence the remote effect of the investment credit inflation was depression...” (page 81)

“The growth of deposits for all the banks in the country from June, 1921, to December 1929, was over 19 billion dollars. This is to be compared with 18.6 billion in total deposits for all banks, in June, 1914… The banking years from 1922 to 1929, then, were characterized by a great credit inflation – an absolute quantitative inflation viewed from any angle, and a relative inflation viewed with respect to the needs of trade and in consideration of the price level.” (pages 82/84)

“In the course of the time…increased flotation of corporate securities in an especially favorable capital market virtually surfeited some of the issuing corporations with liquid funds for which they found a profitable use in the stock exchange call-loan market, adding new fuel to the already raging flames of stock market speculation... Real estate bond issues were brought out on a scale unmatched in previous history… Our export trade was stimulated by extensive over-seas lending… All these factors…helped to carry business activity to the false bottom of credit inflation long enough for the term ‘New Era’ to become a byword…” (pages 112/13)

“It was through these various booms of a capital nature that the ‘cheap credit’ policy of this period found its chief outlets. The net effect of these influences was to produce an alteration in the structure of production.” (page 113)

“If the recent cycle has proved so puzzling to so many students of its devious course and manifold phases, it is because the full effects of the creation and operation of this central banking system upon the commercial banks have not been widely nor adequately understood; nor, furthermore, have the influences of the changing structure of the American banking system upon the structure of production been fully realized.” (page 140)

“Most American observers who were concerned with the structural view of business cycles were unable fully to appreciate the monetary aspects of the situation; those who were advocates of the purely monetary theory were so obsessed with the stable-price level complex that they were unable properly to assess the importance of the underlying structural phenomena which were developing… The movement of wholesale prices occupies a central role in the usual monetary theory, and this concentration of attention upon the superficial phenomena of changes in the value of money has militated against an understanding of the channels through which newly created credit entered the economic system and of the effect of this new credit upon the structure of production. Further, there are certain aspects of the recent situation which render the usual monetary theory practically useless… commodity prices as measured by the wholesale prices index in this country were remarkably stable from 1922 to 1929…so that one point definitely established by the monetary experimentation involved is that stability of the price level is a doubtful safeguard against depression.” (pages 147/148)

“In the first place, the depression was as exaggerated and as protracted as it was because the stock market crash itself was the most devastating… In the second place, the alteration of the structure of production…was greater than in any previous depression… And, in the third place, during no previous collapse was there such a complex entanglement of the banking system with the course of the depression… But underlying and supplementing all these factors was a stubbornly persisting lack of equilibrium in the entire economic and price structure.” (pages 150/151)

“It has frequently been argued that the stock market boom was justified on the basis of rapidly rising corporate earnings. Some have contended that profits not only were large in absolute amount but that they were increasing at an accelerating rate… On sober afterthought, however, it appears that the stock market boom was largely a product of bank credit expansion, a mad speculative frenzy which had no rationale whatever.” (page 155)

“Although wholesale commodity prices were relatively steady, prices in a more inclusive sense did rise. That is to say, the emissions of bank credit found expression in a rise of prices other than wholesale commodity prices, the index to which most persons are accustomed to refer when considering prices in relation to increased purchasing media. For ‘credit takes various directions, and the effects of inflation can only be measured best at those points in the business structure where the use of credit has been most active.’ The ‘points’ where credit played its most active part in affecting prices in the period from 1922 onward are those already referred to – real estate, stocks, and long-term investments.”

“…the Board’s policies also had international effects that were of far-reaching import. During the period of the ‘twenties when the United States was not only the most powerful commercial and industrial nation in the world, but also was in possession of the major portion of the stock of monetary gold of the world, our domestic developments and conditions were bound to influence the course of economic events in other countries. The [Fed] in its efforts to inflate purchasing power and to support the price level in this country helped indirectly…to arrest the decline of prices in other important commercial nations…” (page 197)

“As early as June 1927, the effects of the Federal Reserve Board’s domestic credit policies upon the international situation were diagnosed by Professor Bertil Ohlin of Stockholm University as follows: ‘The influx and efflux of gold in the United States has thus lost all influence upon the monetary purchasing power and the prices level in that country. The question of granting credit is instead determined by what the Federal Reserve Board considers suitable from an economic point of view. This implies nothing less than a revolution in the monetary system not only of the United States but of all countries with a gold standard…” (page 198)

“Stability of the price level is no adequate safeguard against depression, it is contended, because any policy aimed at stabilizing a single index is bound to set up countervailing influences elsewhere in the economic system. Although the policy of stabilization may appear to be successful for a time, eventually it will break down, because there is no way of insuring that the agencies of control will be able to make their influence felt at precisely those ‘points’ of strategic importance.” (page 200)

“A sharply contrasting objective of banking policy…and the one here advocated, would be the control of the total amount of credit, such that the violent inflations and contractions of credit would be eliminated, or at least greatly mitigated, and without special regard for any one index of economic activity.” (page 202)

The authors’ delved into considerable detail and analysis elucidating the various factors and mechanisms that supported “a much larger superstructure of credit than was previously possible.” Certainly at the top of the list was the expansion of the Federal Reserve System, along with various factors and avenues that significantly reduced bank reserve-to-deposit requirements and financial innovation generally. To be sure, however, the “hyper-elasticity of the Federal Reserve System” and the fractional-reserve banking apparatus from the ‘twenties is Inflationary Child’s Play in comparison to the virtually unchecked securities-based Credit systems of our day.

The contemporary U.S. Credit system (evolving to the status of the backbone of the global Credit mechanism) comprised of banks, the GSEs, global central bank dollar holdings, brokerage firms, the MBS and ABS marketplaces, hedge funds, finance companies, insurance companies, etc., operate today generally unrestrained from either reserve or capital requirements (not to mention a gold standard). And, in the final analysis, ‘this implies nothing less than a revolution in the monetary system not only of the United States but of all countries…’ Moreover, ‘changes occurring in the [global financial] system [are] intimately connected with the structural changes in the [global] economic system…’

“The stock market crash provided the shock to confidence which definitely and dramatically started the depression on its downward course, revealing to most persons for the first time the inherent instability of the conditions which had prevailed for several years.” (page 161)

And while “Banking and the Business Cycle” does not pursue this line of reasoning, it is my view that the 1929 crash was inevitable due to the extreme nature of speculative leveraging and deep structural maladjustment, and it was as well the impetus for an unavoidable collapse of system liquidity. One never knows from where the shock to confidence will emanate, while today’s intertwined global Credit apparatus has an unknown multitude of highly leveraged marketplaces that would qualify as potential financial dislocation catalysts. Yet one can look to today’s Highly Extraordinary Global Credit and Speculative Boom Environment and state unequivocally that the system is acutely vulnerable to any break in confidence, panicked speculator deleveraging, or even any meaningful downturn in Credit growth. Admittedly, the Global Credit Bubble has quite a head of steam. But, then again, so might global interest rates.

Wednesday, March 22, 2006

Social Evolution and the Future of World Society

Christopher Chase-Dunn

Cycles and Trends In The Historical Evolution of World Orders

This article is about the idea of world society and the possible futures of the world-system in long-term evolutionary perspective. Th ough I share a social constructionist and institutional approach similar to that of the Zurich and the world polity schools, my structural approach to world capitalism and the notion of world society emphasizes the importance of markets, money and geopolitics in the modern system, while seeking to take account of the ideological projects of both the contenders for predominance and those who have resisted domination and exploitation...¹

Thursday, March 16, 2006

Credit Warnings...!

Signs of The Times

Credit Derivatives...

Of course, the Austrian School of Economics has had the best grasp of credit markets and the following is an essay entitled "Dearth of Credit" by Ludwig von Mises:

"An increase in the quantity of money or fiduciary media is an indispensable condition of the emergence of a boom. The recurrence of boom periods, followed by periods of depression, is the unavoidable outcome of repeated attempts to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

The breakdown appears as soon as the banks become frightened by the accelerated pace of the boom and begin to abstain from further credit expansion. The change in the banks' conduct does not create the crisis. It merely makes visible the havoc spread by the faults which business has committed in the boom period.

The dearth of credit which marks the crisis is caused not by contraction but by the abstention from further credit expansion. It hurts all enterprises – not only those which are doomed at any rate, but no less those whose business is sound and could flourish if appropriate credit were available. As the outstanding debts are not paid back, the banks lack the means to grant credits even to the most solid firms. The crisis becomes general and forces all branches of business and all firms to restrict their activities. But there is no means of avoiding these consequences of the preceding boom.

Prices of the factors of production – both material and human – have reached an excessive height in the boom period. They must come down before business can become profitable again. The recovery and return to "normalcy" can only begin when prices and wage rates are so low that a sufficient number of people assume that they will not drop still more."

Sunday, February 12, 2006

The US Economy and Markets May Be Heading For A Bernanke 'Trap'

Rob Lee

..."8. The trap is further deepened by the unfortunate reputation that Mr Bernanke has generated for himself. The following is an well known extract from a speech Mr Bernanke gave in November 2002:

"Like gold, U.S dollars have value only to the extent that they are strictly limited in supply. But the US government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S dollars at it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate... inflation."

It should be emphasised that this was no off the cuff remark, but contained in a set speech while he was already a Fed governor. He has repeatedly expressed these and similar views since. Of course his analysis may very well be correct, but it was not wise of a potential future Fed Chairman to say so. Central bankers around the world were privately aghast. Let's face it, the sobriquet "Helicopter Ben" is not helpful to the man now in charge of the world's reserve currency. Mr Bernanke must be well aware that he has this reputation for being weak on inflation. Is it likely that his first move as Chairman will be to ease policy? No. Does he have less room for manoeuvre than Mr Greenspan, both within the Fed and with markets? Yes.

In summary, I think the US economy is already slowing significantly. Monetary policy is tighter than it appears. Mr Bernanke's Fed will (partly inadvertently) tighten policy even further and initially be slow to react"

Thursday, January 26, 2006


Theory of Everything - Why Do Intellectuals Oppose Capitalism?

"Let me state it simply. The mind, the more educated, develops the habit of natural equilibriating logic. This logic is against capitalism because it is not equilibriated, it is a dis-equilibriating class system, even though I support it more than the other wrecks. What may be required is a mixed equilibriated economic system of truly balanced supply and demand, then maybe the intellectuals could support it. But don't tell the intellectuals, they fear what they don't think of!"

Just a hint,