TCS: Tech Central Station - How Powerful Is Productivity?
Editor's note: William Lewis is the director emeritus of the McKinsey Global Institute. His recent book, The Power of Productivity: Wealth, Poverty and the Threat to Global Stability, is based on extensive economic, political and sociological study of thirteen countries over a dozen years conducted by the Global Institute.
Through this research, Lewis and his colleagues examined some of the conditions that have led to the disparity between rich and poor countries. His findings about why some countries experience robust growth while others remain stagnant are surprising and insightful. He recently sat for an interview with TCS editor Nick Schulz.
NICK SCHULZ: Mr. Lewis, thanks for joining us.
Describe how you and the McKinsey Global Institute came to do the work that went into this book.
WILLIAM LEWIS: Well, it is unusual that a private sector firm like McKinsey would do this kind of work and so that story itself is interesting. The other aspect that is also relevant here is that none of us anticipated when we started the McKinsey Global Institute that 15 years later we would be looking at a book like this and that I would be talking to you about a subject like this.
The basic idea back in 1990 was that there were several big trends going on in the world, which were not very well understood. Globalization -- people were beginning to use the word globalization -- and it was not very well understood and nobody knew where it might lead. Secondly, there were other changes, maybe more in Europe than elsewhere, with the formation earlier of the common market and then the European Union. Then of course the fall of the Soviet Union coupled with a lot of other economic experiences had led to a wave of market reforms around the world. So the question was what does all of this mean and where is it leading? And for a firm like McKinsey, what are its implications for our clients? Our clients are people who can talk to anybody in the world. You name them and they can talk to them. But they weren't getting answers that were very satisfying and so they were interested in talking to us. But we were being drawn into discussions that we were not prepared to help with very much. We read a little bit more than our clients and we were feeding that back to them, but that only can go on for so long. So we faced the issue of either deciding to invest in this knowledge building that was differentiated from what others could do or getting out of the game. And McKinsey made the strategic decision to get into the game.
SCHULZ: What sort of specific work did you set out to do?
LEWIS: Well, it was a step by step process. I spent six months traveling around the world talking to my partners and to well-informed people of one kind or another, either academics or business people or journalists, about what we should do and didn't get a very clear picture from that. However, serendipitously, I happened to see one Saturday morning before I dashed off to play tennis those statistics in the Economist that are buried at the back that happen to show the latest results of GDP per capita using purchasing power parity exchange rates. What that shows (and this is back in 1990) was that the US still was well ahead of Germany and Japan by that measure. Of course, that was in conflict with all the conventional wisdom at the time. That basically, Germany and Japan had come out of the war with superior economic models and the US was going to have to change or fall behind.
What I realized when I saw those numbers was that if they were right, then the conventional wisdom was wrong. That would be a very, very important thing to get straight for all sorts of reasons. The idea quickly emerged in these discussions that if this is true, given that employment is about the same in many countries, it's got to be a productivity difference; and if the US has a productivity lead, it's got to be in services because everybody knew that US manufacturing had gone to the dogs. That was the conventional wisdom at that time.
SCHULZ: The title of the book came to be the Power of Productivity. Now how did productivity come to loom so large in what you studied?
LEWIS: Well simply because productivity is the best single measure of what leads to differences in economic performance. Even though GDP per capita is the all-encompassing measure, GDP per capita is determined primarily, almost entirely, by productivity. People basically work in order to have a place to sleep and something to eat and so on and so forth. The huge differences around the world are the efficiencies with which they work -- their productivity. So it is the power of productivity that determines what the global economic landscape looks like and because there are such differences, we have quite a number of severe issues that face us today.
SCHULZ: You say in your book that in order to really understand a country's economic performance, you need to conduct analysis at the level of individual industries and sectors. Why is that?
LEWIS: Japan is the best example of that, and I have devoted a whole chapter to Japan. I put Japan first because Japan is in many respects the most interesting country right now to study economically.
The paradox was that in the 90s stories on the front pages of the New York Times, the Wall Street Journal, and the Economist were all about how the Japanese manufacturing industries through trade were driving US manufacturing industries into the ground and virtually wiping them out. And of course that did happen in consumer electronics -- the US basically got out entirely in the consumer electronics business. And the steel industry and the automobile industry came very close to being bankrupt, although not all companies in those industries were in that shape. But the industries themselves as a whole were in very bad shape because of, in large part, competition from Japan, which was able to deliver high quality products at lower costs -- yet the GDP per capita numbers at purchasing power parity exchange rates show that GDP per capita in Japan was roughly 30 percent below the US. So how could this be? And the only way to understand that is to look at the productivity of individual industries in Japan.
What we found is that Japan has a dual economy. Yes, it does have some selected manufacturing industries that have high productivity, much higher than the corresponding US industries and in fact they have the highest productivity in their industries of any country in the world.
And yet, the traded part of an economy is always a tiny fraction of the total GDP. A rule of thumb is that it's roughly at most 15 percent of the GDP.
So what that says is that the standard of living is determined because the productivity of the country is determined by what happens outside these traded goods. Productivity of a country in total -- the average productivity -- is the average productivity of every single worker. So in that sense, every worker is equally important. If you have low productivity in the non traded parts of manufacturing and in the huge domestic service industry -- such as retailing and housing construction and so on -- you are going to have low average productivity even though you may have a handful of industries like automotive and machine tools and steel where you have the highest productivity in the world.
SCHULZ: So even though these may not be the sexiest industries and the ones that journalists especially like to focus on, they can be critically important. Now what did you find in the case of Japan?
LEWIS: Well of course what it showed was that, yes in those industries, Japan had the highest productivity in the traded goods manufacturing sectors. In the rest, the productivity was very low. Say, in retailing, 50 percent of the US; in food processing about a third of the US. And food processing, although it's a manufacturing industry and it's not heavily traded, it has more employment than steel, automotive, computers, and machine tools added together. So it's much more important.
We got these results back in 1992 with our point of view about Japan very early. And this was while Japan was still on its bubble and the implied value of the land of the imperial palace in Tokyo was higher than the whole state of California. But now…
SCHULZ: And people talk about a housing bubble in the US now.
LEWIS: Oh yes now they have forgotten what a real bubble is like.
The way this now plays into the debate today is to say that all these sectors are in the same economy. And all the so-called Washington consensus factors are the same for these sectors -- the same exchange rate policy, same monetary policy, same rule of law, same set of governing institutions, same high quality education system, same infrastructure, same availability of capital. All the factors that the World Bank has said are so important over all these years -- up until Bill Easterly and a few others did some serious regressions on this -- are the same for these sectors, and yet there are huge differences in their relative performance that end up determining the standard of living in Japan, the GDP per capita. Therefore it is just necessarily true that there is something huge going on at the micro level that has to be taken into account when you try to understand a country's performance. Because the macro conditions -- the macro economic stability factors, the budget deficits -- all of those factors are the same for these sectors in Japan. You have to analyze the macro factors and make sure that's okay. But that's easy and people understand that now. But what they don't understand is that there is another equally important factor or set of factors at the micro level which are so very difficult for anybody to get at.
SCHULZ: How can there be such a disparity between the US and Japan in these sectors, such as retailing, in terms of productivity?
LEWIS: When you come to understand retailing, [you realize] that the industry of retailing has gone through its own evolution. 50 years ago or so, retailing was much more similar in the rich countries to each other than it is today in that it was primarily dominated by general stores of relatively small scale and mom and pop small shop operations. And what has happened over the last 60 years is that innovations have occurred in retailing and new formats of much higher productivity then these former formats have developed. The most obvious being the so called big box epitomized by Wal-Mart, which has productivity something like five times the productivity of a normal general store of the 1950's. And so the story in retailing is how many of these high productivity formats are part of the mix of stores in retailing and how much of retailing is still like it was in 1950. In other words, the evolution in retailing has progressed at far different rates in these countries around the world.
So in the US, the fraction of mom and pop general store-like operations that are left is under 20 percent of all employment. In Japan it's over 50 percent still. Even in France, it is down to about 30 percent. So when you put the mix together, you of course get a much lower productivity. So that's at the operational level. Why is productivity different? It's different because the nature of the retailing operations in the different activities of retailing is fundamentally different on a mix basis.
So then you get to the next level. OK, why haven't entrepreneurs and managers of capital and others that have invested in retailing and created businesses of operations and firms and actual formats in retailing [managed to do it] at the same rate? Why has it been different? And there you get into a huge area of micro rules and regulations and incentives on managers so that basically they end up doing different things.
In the US, there is much more level and free competition for the leading consumer's demands. So if Wal-Mart moves into an area, it sets up new operations. Because of its higher productivity, it is able to under price these much less productive operations. And consumers -- as nostalgic as they may be about Main Street and the small shopkeeper and the relationships they may have with those people -- the consumer has shown that he or she will go for the lower prices. So the consumer chooses the more productive format because the prices there are lower and so eventually the less productive format goes out of business and those people or their children end up working elsewhere and a lot of them probably end up working at Wal-Mart. Whereas in Japan, there all sorts of obstacles.
SCHULZ: What kind of obstacles?
LEWIS: In terms of the big operations, they have great difficulty in Japan getting hold of land. The local zoning authorities for a long time just outright banned big box stores, stores of over something like 10,000 square feet. That ban was put in place at the political influence of the small shopkeepers and others. The US objected to that and finally got that overturned, but it just got overturned into something almost equally ineffective which setup a lot of environmental and traffic and other kinds of potential obstacles, with the board determining whether to go forward dominated by local interest, local producer interest, local retailing interest.
So you get the case where I just read in the paper just the other day that Carrefour which is probably the most successful international retailer -- it has high productivity and it has been at the international game much longer than Wal-Mart and it is successful in most places around the world -- has actually just given up on Japan after trying for two decades to build stores and to create what they've been able to create most other places in the world.
At the same time, there are huge incentives for the mom and pops not to close down, to continue to limp along. They come from many directions. First of all, the mom and pops just simply get subsidized loans. And they have no trouble paying off those loans because they are sitting on some of the most valuable real estate in the world, especially during the bubble time. So basically when they die, their estate would have no trouble paying off the loans so they don't have a cash flow problem which they would have if they weren't subsidized in terms of loans. And then there is a strong incentive for them not to sell in the tax code in Japan in that capital gains taxes are very high in Japan and estate taxes are very low so there is a huge incentive for these mom and pops to hang on to their land and basically pass it on to the next generation. So those things are the main factors that have just lead retailing to stagnate in Japan compared to the US and compared even to Europe.
SCHULZ: Now I want to shift gears a little bit and just look at one or two things that you discovered that do not account for diminished productivity from one country relative to another. For example, one finding that might surprise some people is that the education level of the labor force isn't nearly as important for overall economic performance for a nation as commonly thought. You say in the book that importance has been "taken way too far."
LEWIS: Right.
SCHULZ: In other words that education is not the way out of the poverty trap. Now how do you reach that conclusion?
LEWIS: By sifting through evidence primarily from two directions. Interestingly enough, we got the first hint of this when we were studying the US relative to Japan back in the early 1990's when the Japanese were wiping out the US consumer electronics industry and threatening the steel and automobile industries. The conventional wisdom in the US was that it was true, and that was in large part true because the US labor force was so bad. There were many disparaging comments made in the US and maybe even stronger abroad, (and especially in Japan) about how the US labor force was getting what it deserved because it was lazy, uneducated and maybe even dumb. And of course, the Japanese then showed -- the really capable, competent Japanese manufacturing companies -- showed that was wrong by coming here, building their own factories, managing American labor and taking a lot of other local inputs and coming within five percent of reproducing their home country productivity.
So when we first came out with this conclusion, it just really staggered Bob Reich and others. Bob Reich was US Secretary of Labor and a great advocate at that time of the German apprenticeship system and felt like we just needed to train American labor better. And we showed that something like 40 percent of the unemployed in Germany had been through the apprenticeship system.
But more importantly, you can take the US workforce and train it on the job with sufficiently skilled managers to reach within a hair's breadth of the highest productivity in world in these industries. That pattern -- and of course that conclusion back then coupled with the fact that the US wasn't behind -- really got a huge amount of attention and really undermined the initial economic platform on which Bill Clinton was elected.
I am a Democrat, by the way, and I voted for Clinton, but he clearly was wrong about the health of the US economy in his first campaign and in the early days of his being president.
The great bulk of the evidence about education came from competent multinational corporations of any nationality. Showing they could go virtually anywhere in the world and take the local workforce and train it to come close to home country productivity.
And then, sort of the clinching evidence was we then looked at some other industries. We compared the construction industry in the US to construction in Brazil and found that in Houston, the US industry was using Mexican agriculture workers who were illiterate and didn't speak English. So they were not any different than the agricultural workers who were building similar high rises say in Sao Palo. And yet they were working at four times the productivity.
SCHULZ: Wow.
LEWIS: Just because people are not educated does not mean that they are incapable, which is a mistake educated people in the West often make -- and not just the West but probably in Japan as well. These people can be trained on the job to accomplish quite high skill levels and quite high levels of productivity. And that's basically good news because if the World Bank and everybody else had to wait until we revamp the educational institutions of all the poor countries and then put a cohort or two of workers through it, we are talking about another 50 years before anything happens. That's not acceptable and it's not necessary, thank God.
SCHULZ: That earlier comment about your politics leads into one of the next questions I want to ask. This might come as a surprise to some folks who work in development economics, but many people don't realize the destructive power that large government bureaucracies can have on economic development.
Now when I read your book, I did not detect any sort of anti-government ideology at work. And your comments about whom you voted for speak to that. So what are your experiences that led you to this conclusion about the role that the large government and government bureaucracies can have on productivity and economic efficiency?
LEWIS: That's an interesting story. I will try to make it short. We got the first hint of this in Brazil and then got conclusive evidence in Russia and of course found it to be absolutely true in India. And since then, some other works in other countries have shown it, particularly in Argentina.
The problem that we found was that basically the most productive multinationals in some industries were not going into these countries in the way that we expect them to; or they were not expanding in these countries nearly as fast as we thought they had the opportunity to do. And so we tried to get at why is that, because their productivity was clearly multiples of the domestic producers they would be competing against. And we did interviews with these people because thorough McKinsey we know these firms in a different way and so we could talk to them.
And I report about the interview with Carrefour in Russia. That was really a watershed interview because Carrefour said, "Well, we know all about Russia. We can handle most of the problems of Russia. We don't have trouble with red tape and bureaucracy. We can handle bribes. We know all about bribes. We even can worry and handle about any threat to physical security. We've been in tough situations and we can make our people feel secure. What we can't handle is not making money. And you can't make money in Russia." And of course that really left us puzzled. So we went away and we built up a model of their cost structure in Russia, of what it would be, and the cost structure of their competitors. And we found that by and large they were right. Their competitors were able to under price what Carrefour would have to price at in Russia in order to break even, let alone make money.
We found that their competitors were doing a number of things that Carrefour could not or would not do in their business practices. Imports were flooding into Russia and many of the local domestic producers in Russia were selling smuggled goods, on which they had not paid the import tariffs, and they also were selling counterfeit goods. McKinsey did a study of the vodka industry in Russia and found that 40 percent of the Vodka sold in Russia was not made by the company whose label appeared on the bottle -- so much for the value of the brand. And then we looked at the taxes, and taxes have to be collected in the sales price, the final sales price -- what the customer pays -- at the cash register. And Carrefour, as is the case with virtually all multinationals, they pay their taxes because they cannot afford to do otherwise. And it is not just profit taxes, it is in fact the other taxes that make the difference. The sales tax, the value added tax, the employment tax -- all of which were to be rolled into what the consumer pays Carrefour for any given goods or services. When you add all those up and compare it with what their competitors were doing -- who by and large were not paying these taxes -- Carrefour could not make money. So they were right.
That led to the question, okay, but this problem of competing with so-called informal firms, as these kinds of firms were known, has to have been true for rich countries at some stage of their development also. When they were poor, how did they ever get over this problem?
And so you think about it and say, well, I wonder if they got over this problem because it didn't matter. That the taxes were so low because the governments were so small that it didn't matter if there was this differential playing field. If they had productivity four times as high, they basically could make money even though they paid taxes and their competitors didn't because the taxes themselves were so low.
And so we did compare what the size of all governments in the US and France was when these countries were at the same stage of development roughly as Brazil and Russia are today. We found that whereas the poor countries are up in the 30 percent of total government as a fraction of GDP, the US and France were below 10 percent. So basically it didn't matter.
But then you say: well, the rich countries today have high taxes and big government. So why doesn't that matter? Well the reason it doesn't matter today is that everybody is formal. Informality fades out because as you go, the only way you get high productivity operations throughout the whole economy is to have it dominated by big firms of scale where there is substantial division of labor and high productivity and so on and so forth. And so that means that all firms pay these taxes so that the playing field is again equal because everybody pays the same fraction of taxes.
The no man's land that the poor countries have gotten into now is that they've gone to big governments before they can afford it and before informality has been phased out or driven out by high productivity operations, so they have both big government and informality. And that's a recipe for disaster for the reasons I have explained in terms of the competitive dynamics at the micro level. As a result you would predict, well, maybe informality is increasing. And sure enough when you look at it in Brazil, as I show in the Brazil chapter, there's a chart there [that shows that] informality has been increasing for the last 15 years in Brazil. Brazil is going in the wrong direction.
SCHULZ: What can a developing country like Brazil do to get out of that trap?
LEWIS: It is a problem because once you are there, as everybody knows from just simple kindergarten politics, it's very difficult to cut government services for people.
And we look for examples. All our instincts are to look and see who has done this before, rather than to theoretically try to think about how might this be done, how has this been done before? There are four relevant countries -- Ireland, Canada, New Zealand and Chile -- who have significantly cut their government. And actually, all of them have been successful afterwards -- to somewhat different degrees, but they have been successful afterwards. And not only because of cutting government, but because of other things that they have done as well. However Ireland, New Zealand and Canada were rich countries when they did it and they actually were forced to do it in large part by the bond market. The Canadian debt was approaching junk bond levels, so they were facing a crisis, a financial crisis, and they had to do it.
Chile is the only poor country that has done this and unfortunately Chile did it under a military dictatorship.
SCHULZ: Right.
LEWIS: But Chile did what needs to be done. Chile did what Brazil needs to do. Basically it went from where Brazil is today to where Japan was in 1950. Japan had a total government in 1950 of about 20 percent. And nobody has made the argument to me why any poor country needs to have a GDP per-capita -- a GDP for government fraction -- of more than 20 percent. Twenty percent ought to be enough and yet no poor countries come close to it except Chile.
SCHULZ: And the other problem is that we now have instances where the government itself is actively encouraging the informal sectors in some areas. Is that true?
LEWIS: That's certainly true and it gets all wrapped up in other kinds of efforts that are well-motivated but really not going to lead these countries out of their poverty trap, such as micro finance and property rights for squatters and this that and the other. All those things are worth doing but they are not going to solve the problem -- as long as the bigger conditions exist and are preventing the formation of the formal sector at a rapid rate where you can benefit from economies of scale and division of labor and training along particular functional skill lines and so on and so forth. That's the way countries get rich.
SCHULZ: We hear a lot about competition and trade distortions, subsidies and tariffs and that sort of thing. And certainly they exist in the US and Europe, and other developed countries. But another finding that I think might surprise some people is that, from the research you did, that distortions to competition are most severe in poor countries. Is that right?
LEWIS: Well, the distortions to competition in the great width of the economy are more severe in poor countries. As you go to progressively poorer countries, there is that sort of picture that shows up without any question. So yes, India probably has now the most distorted economy of any major economy in the world. Even more than the Soviet Union before. And you go to Brazil and Brazil has actually removed a lot of the market distortion like I described, even in Japanese retailing. Retailing in Brazil is probably close to being as productive as retailing in Japan. But Brazil has this huge problem of informality and so as a result, the more productive enterprises either can't enter or they cannot enter and grow nearly as fast as they have the potential to do so.
SCHULZ: And when you are talking about these more productive sectors and firms, a lot of time you are talking about large western multinational companies. You mentioned Carrefour. But a lot of these companies are perceived sometimes in the media, sometimes by NGOs and the like, as threats to developing countries. And indeed in Brazil for example, Lula sometimes uses rhetoric where he kind of bashes Western firms from the US and Europe. But you don't see them quite as a threat to these developing countries.
LEWIS: Well for the foreign direct investments, it's a win-win game - it's a win for the poor countries because they get capital to expand capacity and produce more goods and services. Because it's investment in the country, it employs local labor. And local labor is always 2/3 of the cost structure of any operation, so 2/3 of the value created by the new firms automatically and immediately goes to local labor through the salaries that are paid to local labor. And their productivity is so high they pay well relative to what you can make as an informal worker in those countries. That's how wages go up as a result of productivity improvement and that's how countries get richer. That's the growth dynamic; that's how growth actually occurs, it's for people to take more productive jobs that lead to higher wages that which then lead to more demand for things that people with higher wages want and that's how you grow - that's the growth dynamic. So that's the winner.
The reason it works is because the consumers in these countries end up getting a better combination of price and service and quality and convenience than they are able to get otherwise and they go to shop at these places. So the consumer is better off because the consumer gets a better deal.
Now that is not true in every case and obviously there have been some multi-nationals who have not done well and not succeeded. But for the last couple of decades the story of the results of foreign direct investment is a win-win story for everybody.
Populism is against this in many of these poorer countries. And one of the reasons that it is successful is because the secret enemies to globalization -- in particular to this foreign direct investment -- are the local domestic producers. And now multi-nationals have shown that they can go and invest substantial amounts of money with the benefits to the economy, the local economy that I have described, across the globe without any questions. And they can operate there at productivity significantly higher than the local producers and under price them and either drive them out of business or force them to improve in the way that the multi-nationals operate. And so, the domestic producers are against this because they don't want this in competition. I mean no producer -- no producer -- ever asked for more competition. So these domestic producers are really the secret enemies of globalization and they are having a lot of influence against it.
SCHULZ: Why are consumer interests so weak, and not just in developing countries but also in developed nations? You touch on this in your book when you talk about domestic producers and their political clout. But what if anything can be done to strengthen the relative status of the consumer to the governing elites and the producers in any country?
LEWIS: I tried to figure this out because the literature on this is actually very weak and there is not much of it. I did have a Yale law school graduate do some research here and I looked into the literature [to see] what had led to the pro-consumer rights laws and regulations in the US that are so different from almost any other country and certainly any poor country. And the startling thing that emerged from this at first was how long ago these laws were actually put in place in the US.
As I say in the book, the Sherman Act of 1890 probably had more good pro-consumer competition policy and direction than most countries in the world have today. And of course it took a long time for the Sherman Act to work its way through the US. It had to be followed by the Clayton Act and some other acts and then interpreted by the courts and the Federal Trade Commission. So it wasn't for two or three more decades until we really got in this country the pieces of the Sherman Act showing in actions of the court.
But certainly by the late 20s and early 30s when all the reforms occurred in US, we were seeing the benefits of this and the example I often give of this is that it was in the early 1930s that insider trading became illegal in the US. Insider trading didn't become illegal in Germany until five years ago. So most of the rest of the world has lagged.
So the question becomes why was the US so far ahead and why has it taken so long for other countries? Now this is all relative. Obviously Europe is much further ahead in many respects that Japan on this. And Japan and Europe are much further than most poor countries. But there, I went back to really the serious students of American history. Gordon Wood at Brown is one of the premiere students of colonial and revolutionary America. And Wood wrote this remarkable book, which I read at the time, called the Radicalism of the American Revolution. It came out in the early 90s I think. It's in my recommended readings list so if you want a reference to it it's there. What he showed was that at the time of the [American] revolution, consumerism exploded in the US. And it was associated with the fundamental notions of individual rights. That prior to that, at least in the feudal societies of Europe, consumption was viewed as a luxury to which only the land owning class was entitled. And everybody else was entitled to subsistence -- enough food and enough shelter to survive and that was it. And at the time of the revolution, because the revolution was so rooted in ideas of individual rights and equality of opportunity and equality of desire and equality of demand, everybody said, 'why not me?'
So you suddenly had a few million farmers beginning to view themselves as consumers. And that thinking didn't have much manifestation because we were primarily an agrarian society for the next 100 years. But certainly by the time the industrial revolution got started, the thinking in this country was so oriented towards consumption and consumers, relative to everybody else -- certainly nothing like it is today -- but relative to everybody else. That these laws naturally came into place when there began to be a need for them as a result of the industrial revolution and the issues that it raised over monopolies and special interests and influence on government and special privileges and this that and the other. And so basically the US was ready, and it was this political philosophy of individual rights that (of course is also in England; and competition law in England is probably further advanced than anyplace else and it may be that now it is as advanced as the US) was very important. And so it has spilled over to other places.
However, the other side of the coin, and the thrust, the modern thrust, that conflicted with this so strongly in the first half of the 20th century and even mid century, was the thrust of, I will call it, planning - the Soviet Union illustrating that to the greatest degree, with a fully centrally planned economy. It is interesting how many economists and how many intellectuals and how many other people really thought that was the way to create the superior economy because smart people could just figure out what should be done.
And I think I have in the book this great quote from Gunnar Myrdal right after he won the Nobel Prize. It must have been back in the 1950s. It said "what the poor countries or the developing countries need is super planning." And that kind of thinking just permeated the poor world, and also the developing institutions. There were vestiges of that thinking left in the middle 1970s when I was at the World Bank and it still echoes around in Delhi when we were there working on India. Nehru was a great admirer of the Soviet Central Planning System. He and the leaders in India thought, and in some respects probably still think, at least some of them are smart enough to figure out how all this should happen.
And of course the way you make a plan happen is by having a plan for production, not for consumption. There is no way you can plan or affect the individual choices that the people make as individuals when they buy things, but you certainly can affect strongly what they have to buy through production planning. And so this whole idea of the producer orientation was aided and abetted in modern times by the planning idea.
It's easy to see where it came from in feudal times -- that basically the people who owned the capital and the landowners could control what happens. They were the only ones who had the ability to do anything. So this whole battle between individual rights, political philosophies based on individual rights, and what immediately comes from those political philosophies -- namely ideas of consumer rights -- have permeated to a relatively small degree around the world.
And yet, as you can tell from my argument, that's the only way I can see for this lock of special interests and privileges that is holding back so many of these poor countries and some of the rich countries. The only way that can be overcome is through this consumer rights notion because democracy is necessary but not sufficient. It is necessary because it's the only way you can affect change of this kind, but it is not sufficient because, democracies have this theoretical weaknesses that lot of people have always recognized, that a majority or an effective majority can gang up on the minority and for short-term or medium-term gains can actually extract privileges or special benefits compared to what the other gets. And in Japan, the LDP [Liberal Democratic Party] is a great example of that, even in a democracy. For 50 years, it is governed from a coalition of small retailers -- the mom and pop shops, small farmers, the backward construction industry, the doctors and the lawyers and sets of other people -- [who] have really ganged up on, what I say when I talk about this, the Tokyo housewife, who really gets screwed as a result of this system. And it just gets worse if you go to poor countries.
So the thing that happens, the way to break that if you put any stock in the US example, is that politicians (in the conditions in the US) learn that they can be successful politically by campaigning on behalf of consumers. Those consumers are a majority. They are the other crosscutting majority. There is enough evidence in US political history, not just early but also through Franklin Roosevelt and even John Kennedy, that they had a clear consumer orientation. In fact, I have this quote from Kennedy in the book when he was campaigning for president when he said on national television something to the effect that "the consumer is the only person in Washington without a high powered lobbyist. I intend to be that lobbyist." And Roosevelt had a more eloquent, detailed quote that I had in there as well. So that's the reason I end up saying this business of becoming rich is not easy; it's amazing anybody does. And we are in for a very difficult 50-year period as a result of the complexity and the difficulty of doing better economically.
SCHULZ: What are you working on now? What are areas that you think where further study or inquiry are required to round out that picture of the path to development and wealth?
LEWIS: Well let me just say first that I don't think additional countries in the sample are necessary. I don't think they will add anything to the fundamental pattern that showed up.
What I am mulling over in the back of my mind is of course where the book left off. Namely, how do you break through the special interests that are holding back development in the poor countries? And if it is rooted, as I argue, in political philosophy, how do you get the spread of this old idea in the West (and in particular in the US) of individual rights and the implication of those rights for consumer rights. How do you get this idea spread around the world better than it has been spread so far? And that's not an economic question. It's a political economy, sociological, political philosophy, almost anthropological question.
And you know, I am not tying it to anything today yet. But you know, the notion that for the US president to come out and say we think democracy around the world is really important. That's probably right. But I think it is naïve because as I said earlier, democracy is necessary but it is far from sufficient. And getting a working democracy that is not captured by special interests is the problem. It is not getting democracy established. And so far we haven't had an American president who talks about the complexity of creating a democracy that is not captured by special interest.
SCHULZ: And just in terms of what you are working on right now, what sort of research are you doing?
LEWIS: I am not doing any new research. The Global Institute, since I retired, has gone to working on things that are more directly associated with our clients and their problems of today. They are not really doing any more country studies. This was a one time event that McKinsey probably will never do again nor will probably any private sector institution do again. And that's the reason every time I speak at the World Bank I say you guys have got to pick this up. You are the right institution; you have the resources; you have the access and you have the charter so you really need to do this.
SCHULZ: I hope Paul Wolfowitz will be giving you a call.
LEWIS: I got Jessica Einhorn, the Dean of SAIS, who succeeded Paul as the Dean of SAIS, to send him a copy of my book, so I hope he does pay attention to it.
SCHULZ: Excellent. Well I think he is the kind of person who might be receptive to these ideas. And I do think they are absolutely critical. I want to thank you for talking to us today.
LEWIS: Thank you.
Saturday, June 18, 2005
Saturday, June 11, 2005
Is the Euro just a Bull Market Phenomenon?
Marshall Auerback
“We lost a lot of our influence. We went too quickly on enlargement. It was a big mistake. The people voted against it last Sunday. Now we have lost our credibility too.”
– An unnamed French diplomat, quoted in London’s Sunday Times in the aftermath of the French EU constitutional referendum
The dual rejection of the European Union’s proposed constitution by the Netherlands and France has been described as a political earthquake. The analogy is appropriate: the underlying edifice holding together the EU has suffered serious structural damage, the extent of which is still unclear. And there is also the possibility of further aftershocks which may ultimately lead to nothing less than the demise of the euro itself.
The tea leaves for Europe’s policy makers have been evident for some time, if they only chose to read them. The EU and its attendant institutions have long been characterised by a huge democratic deficit, which has led to an increasing sense of political alienation of the part of much of the population. Even before the respective French and Dutch referendums, there had been enough hints by the electorates of various member states in a sufficiently large number of national elections to give Brussels a sense that something was amiss. Results across the continent repeatedly reflected the rise of populist, anti-EU parties and a concurrent sense of dissatisfaction with its existing leaders. All of this has occurred against an economic backdrop in which continental European living standards have plunged, national pension plans veer toward insolvency, unemployment remains in double digits and national pride is turning into embarrassment and even shame.
Even when things have apparently gone well, it has not redounded to Euroland’s credit. The appreciation of the euro over the past few years has been widely hailed by the continent’s policy makers as symptomatic of the currency’s growing credibility as a genuine store-of-value alternative to the dollar. But the ultimate impact of such appreciation has been to price European manufacturers out of global markets, if one is to judge by the wretched performance of the export-dependent Italian economy (now in recession), as one significant example. This is a particularly worrisome trend, since EU-wide exports were widely deemed responsible for last year’s economic recovery, given the persistent sluggishness of domestic consumer demand.
Amazingly, the underlying problems have continued to be ignored by the European Union’s leading officials, which in turn has stored up additional trouble for the future. No change in the Commission’s operating procedures have ever taken place in spite of numerous political warnings. Euroland, as a consequence, has continued to function in a huge political vacuum. Indeed, the whole “European project” is increasingly characterised by growing institutional inflexibility, policy paralysis, and tenuous political legitimacy. Today, the whole movement toward an “ever closer union” appears dead and the notion of a “United States of Europe”, standing as a serious political counterweight to the US, risible.
The more relevant question might be: is the euro itself salvageable? The FT’s Lex column lays out the stark alternatives ahead for Euroland:
“[M]arkets are leaning toward the belief that a vicious cycle is taking hold. This will see a weaker euro on the back of a worsening eurozone economy, political uncertainty and higher US interest rates. The European Central Bank, convinced that economic weakness has structural rather than monetary causes, will refuse to lower rates as imported inflation rises. Fiscal laxity as governments try to placate electorates could actually result in rate rises, depressing growth.
But those searching for a chink in the clouds could paint a much sunnier scenario. Elections in Germany this autumn, and the discrediting of the lame-duck French government, could result in a more pro-reform core Europe, which would work more harmoniously with the UK. Italy’s economic meltdown would continue, its debt burden finally forcing it out of the euro. A few years down the line, a leaner, meaner EU, focused on trade rather than political and social integration and expansion, could drive through aggressive structural reform and set the region on the high growth low unemployment path. An EU that regained the characteristics of a free-trade zone, focussing on competition and financial regulation, could more comfortably accommodate Turkey and other new members.”
As the paper concedes, this latter scenario appears unlikely, especially in light of the immediate response to the results in France and the Netherlands. It is worth noting that these two countries are core founding members of the European Union, not traditionally euro-sceptical nations existing at its periphery such as the United Kingdom or the newly accepted nations of Eastern Europe. And the latter are feeling fairly aggrieved at this juncture because the No votes were said to be fuelled by fears over jobs being lost to cheap workers from the east and immigration. Resentment is, therefore, building in the new members that they have been made scapegoats for the economic and social ills of old Europe.
So does “Old Europe” get it? Even before the results of the French referendum were official, Jean-Claude Juncker, the Luxembourg Prime Minister, insisted that the ratification process for the constitution continue until all countries delivered the “right” answer, which is essentially what was tried following the Danish referendum on the euro and the Irish rejection of the Treaty of Nice.
Jean Luc Dehaene, a former Belgian PM, exhibited comparable contempt for popular opinion: In a BBC interview last Monday, Mr Dehaene made the extraordinary remark that the results in France were meaningless because the electorate was not voting against the constitution, but against the French government. Common sense suggests that on the contrary, they were voting precisely against the constitution, a project of politicians such as Dehaene who are determined to pursue an unpopular agenda with or without popular consent. This notion also appears to be confirmed by the British newsmagazine, The Economist, which noted that five of the top 10 best-selling non-fiction books in France were about the Constitution. Millions of people watched television shows discussing it. A huge percentage of respondents in public opinion polls were familiar with its content. There was huge voter turnout (70 per cent) and people had a very good idea of what the issues were.
This obliviousness to public opinion has been the flaw at the heart of the whole "European Project" right from the start. It is scarcely remembered now that France only barely ratified the introduction of the euro in a vote so tight that its adoption by a few tenths of a percentage point gives lie to the word, “democracy" that lifts so carelessly off the lips of the most undemocratic of politicians.
But have France, let alone the rest of the EU, taken on board the message? In the immediate aftermath of the French Non, President Chirac announced a new and strong impetus to government policies, but chose his “political son”, Dominique de Villepin, to be France’s new Prime Minister, rather than someone identified closely with further economic reform, such as Nicolas Sarkozy. De Villepin (best known to Americans for his outspoken opposition to the US-led invasion of Iraq when he was France’s Foreign Minister) is viewed by the markets as fundamentally hostile to “Anglo-Saxon liberalism”, and determined to retain France’s unique “social model”.
“He’s got class and he can recite poetry,” said Jean-Louis Martin, a 59-year-old engineer who lost his job in 2003 when the local metal smelting factory shut down. “But I don’t see what hope it brings us. The people voted for a change — not a return of the nobility, the old regime. This is a joke.” This quote from the London Sunday Times reflects a commonly expressed sentiment. The euro lost a cent against the dollar in the immediate aftermath of the announcement of De Villepin being named French Prime Minister because the markets interpreted his appointment as a sign that France has set its face not just against the European project but against further economic liberalisation and reform. This is not euro bullish.
On the plus side, the contradictory impulse toward both widening and deepening the European Union (and, ultimately, the euro zone), has been demonstrably established as futile. The British belief that more widening of the EU would mean less deepening has essentially been vindicated.
There is little question that for a monetary union to operate successfully, there has to be a high degree of economic and political convergence. But this runs up against the tide of history: Pooled political sovereignty and a concomitantly more cohesive supra-national fiscal policy are far more difficult to implement in a larger currency zone with countries at disparate stages of economic development and correspondingly different political/historical traditions.
Most single-currency zones involve a central or federal government with a tax and public expenditure program of substantial size relative to national GDP and the ability to run significant deficits. A tax and public expenditure program generally involves redistribution from richer regions to poorer ones, whether as an automatic consequence of a progressive tax and social security system or as specific policy acts. The redistribution also has to be sufficiently large in scope to act as a stabilizer with negative shocks, leading to lower taxation and higher social security payments in the region that is adversely affected. The EU’s current budget is a pittance and there is little inclination for member states to pool further fiscal resources in the current political climate. But there is a need for the development of a larger EU tax base and redistribution of tax revenue from richer regions to poorer ones in order to have a genuinely proper functioning fiscal policy at the supra-national level. This is clearly more feasible with a smaller zone of nations with common economic and political philosophies.
In the absence of such a mechanism, it could be expected that economies would adjust to differential shocks and uneven economic performance through a variety of other routes, such as currency devaluation.
With the existence of the euro, that is not an option, but even that is coming into question: In the aftermath of the recent referendum results, issues hitherto considered politically sacrosanct, such as the actual withdrawal from the euro zone, have begun to creep into the public domain. This must surely constitute the ultimate Pandora’s Box for euro enthusiasts.
Of course talk of withdrawing from the euro zone is dismissed as completely unrealistic by EU officialdom. But recall that when the first stirrings of doubt were expressed by Germany back in 2001 about the Stability and Growth Pact, this too was met by a hail of denial. Just four years later, the Stability Pact is all but dead, denuded of any kind of meaningful enforcement mechanisms in the face of persistent violations.
The issue of euro withdrawal has been broached in Italy, of all countries. Ironic, because Rome has effectively had a free ride in the eurozone’s integrated bond markets for years, obtaining Germanic levels of interest rates (as a consequence of Germany’s historic record of fiscal prudence), despite maintaining historically retaining profligate levels of public sector expenditure and debt to GDP ratios well in excess of most of the other founding member states in the monetary union.
In spite of its low cost of capital, the country’s Welfare Minister, Roberto Maroni, told La Repubblica daily Italy should hold a referendum to decide whether to return to the lira, at least temporarily. He also said European Central Bank President Jean-Claude Trichet was one of those chiefly responsible for the “disaster of the euro”: The euro “has proved inadequate in the face of the economic slowdown, the loss of competitiveness and the job crisis,” Maroni said.
In this situation, Maroni contended that the answer was to give the government greater power to defend national industry from foreign competition and “to give control over the exchange rate back to the government”, and specifically cited Britain as a virtuous example of a country whose economy “grows and develops, maintaining control over its currency.”
The dirty little secret of European Monetary Union is that there has never been a proper debate on the pros and cons of the single currency union within the member states. Like so much else in regard to the EU, it was imposed from above. Yet this is a debate that must occur because the European Monetary Union and its attendant institutions, such as the European Central Bank, ultimately cannot succeed in the absence of open, public discussion and acceptance, in lieu of bureaucratic imposition.
It is said that politicians in particular and the democratic process in general cannot be trusted with economic policy formulation because they lead to decisions that have stimulating short-term effects (for example, reducing unemployment via higher government spending) but are detrimental in the longer term (a notable example is a rise in inflation). But comprehensive rejection of the constitution has proved to be an outlet for discontent extending well beyond this particular issue; French and Dutch voters have now shown us the limits of pure technocratic economic management in an environment divorced from political reality.
On the other hand, to debate the appropriateness of a single currency union at this juncture may engender unintended results. It is extraordinary to consider, for example, that the German people never had the opportunity to express their views in a referendum as to whether they ought to abandon one of the most successful post-war monetary regimes in favour of an untried and untested currency. Even if one makes allowances for Germany’s traditional post-war phobia of being perceived as “bad Europeans”, it is almost certain that most would have voted to retain the D-mark, had they been given the opportunity to express themselves in a proper democratic forum.
Already, there are stirrings of euro discontent emerging at the margins in Germany as well as Italy. The referendum results in France and the Netherlands appear to have lit a match on a tinder box of huge continent-wide disenchantment. Consider what is happening to the now discredited EU constitution in the wake of the French and Dutch referendum results: Four separate polls in Denmark and a survey in the Czech Republic indicated the two countries could both vote No in referendums on the constitution. Bild, a leading German tabloid, showed overwhelming hostility in Germany to the constitution. Of the 390,694 readers who responded, 96.9% said they would vote no if a referendum were held there. Now imagine if this discontent were to extend to the monetary union itself.
Increasingly, the euro appears to be nothing more than a bull market phenomenon. Its enthusiasts have over promised and under delivered. In the words of London Times’ correspondent, Anatole Kaletsky:
“The relative economic decline of ‘old’ Europe since the early 1990s - especially of Germany and Italy, but also of France - has been a disaster almost unparalleled in modern History. While Britain and Japan certainly suffered some massive economic dislocations, in the early 1980s and the mid-1990s respectively, they never experienced the same sort of permanent transformation from thriving full-employment economies to stagnant societies where mass unemployment and falling living standards are accepted as permanent facts of life. In Britain, for example, unemployment more than doubled from 1980 to 1984, but conditions then quickly improved. By the late 1980s, Britain was enjoying a boom, the economy was growing by 4% and unemployment had halved. In continental Europe, by contrast, unemployment has been stuck between 8% and 11% since 1991 and growth has reached 3% only once in those 14 years.”
Could the euro, therefore, suffer from the same sort of conflagration of discontent, as is now manifesting in the constitutional ratification process?
How would one re-establish national currencies, given that there exists no mechanism to re-establish them in lieu of the euro (at least none that have been publicly disseminated, for obvious reasons)? Indeed, France and Germany have only recently issued 50-year euro-denominated bonds. The euro itself is becoming an increasingly large component in the reserve portfolios of other central banks, particularly Asia. The prospect of chaos in the bond markets, and consequent severe economic dislocation, cannot be ruled out if this movement to restore national currencies were to gain sufficient political momentum on the back of this current outbreak of anti-EU populism.
What to do in that sort of context? In the past we have described the problems of the US economy ad nauseum. We have also highlighted the problems of the yen and the structural problems inherent in the existing European Monetary Union. Although the euro zone as a whole suffers less from the debt disease prevalent in both the US and Japan, it has largely “earned” its spurs on the foreign exchange markets as a consequence of being the least bad major paper currency alternative. Its acceptance has, until recently, continued unabated, largely by virtue of not being the dollar, as opposed to any intrinsic merits.
Generally speaking, most currency choices faced by market practitioners today are comparable to Keynes’s notion of market speculation: to paraphrase Keynes, one is not seeking to adjudge the most beautiful currency in absolute terms, but merely seeking to guess what the market’s will judge to have the best relative merits . In other words, paper currencies are only “relatively” attractive vis a vis each other and not genuinely attractive as ultimate stores of value. The current problems of the euro (as well as the longstanding problems of the dollar) illustrate that phenomenon.
This points the way toward a potential major paradigm shift in relation to gold, long viewed simply as another variant of the “anti-dollar” theme. Symptomatic of this shift in thinking is the Financial Times, a publication which has usually been viscerally hostile to gold as a legitimate reserve currency asset. In an editorial last April, however, the FT came to a fairly stunning conclusion:
“In truth, there are good reasons for selling all three of the world's main currencies. But could they all fall? Yes, against either gold or the Chinese renminbi. In recent years, gold has been a useful hedge against the dollar, but not against the euro or yen. Meanwhile, the U.S., Japan, and the EU would all like to see the renminbi revalue, but so far, the Chinese are not playing."
The current travails of the euro may change the perception of gold as a barbarous relic from a bygone era For the FT, which has been known as a very anti-gold publication, to come to this conclusion means that many people who have long viewed bullion as economically irrelevant are likely reassessing their viewpoint. This could well point the way forward for gold, notwithstanding the many travails its holders have experienced over the past two decades. Often, seismic shifts in thinking unfold in slow-motion, and are often masked by other “noisier” events, such as the French and Dutch referendums. The “noisier events”, however, could well be catalysing a far more profound change in financial thinking. The rejection of the EU’s constitution in France and the Netherlands, therefore, may well have initiated something well beyond the control of today’s paper currency custodians, much to their ultimate horror no doubt.
“We lost a lot of our influence. We went too quickly on enlargement. It was a big mistake. The people voted against it last Sunday. Now we have lost our credibility too.”
– An unnamed French diplomat, quoted in London’s Sunday Times in the aftermath of the French EU constitutional referendum
The dual rejection of the European Union’s proposed constitution by the Netherlands and France has been described as a political earthquake. The analogy is appropriate: the underlying edifice holding together the EU has suffered serious structural damage, the extent of which is still unclear. And there is also the possibility of further aftershocks which may ultimately lead to nothing less than the demise of the euro itself.
The tea leaves for Europe’s policy makers have been evident for some time, if they only chose to read them. The EU and its attendant institutions have long been characterised by a huge democratic deficit, which has led to an increasing sense of political alienation of the part of much of the population. Even before the respective French and Dutch referendums, there had been enough hints by the electorates of various member states in a sufficiently large number of national elections to give Brussels a sense that something was amiss. Results across the continent repeatedly reflected the rise of populist, anti-EU parties and a concurrent sense of dissatisfaction with its existing leaders. All of this has occurred against an economic backdrop in which continental European living standards have plunged, national pension plans veer toward insolvency, unemployment remains in double digits and national pride is turning into embarrassment and even shame.
Even when things have apparently gone well, it has not redounded to Euroland’s credit. The appreciation of the euro over the past few years has been widely hailed by the continent’s policy makers as symptomatic of the currency’s growing credibility as a genuine store-of-value alternative to the dollar. But the ultimate impact of such appreciation has been to price European manufacturers out of global markets, if one is to judge by the wretched performance of the export-dependent Italian economy (now in recession), as one significant example. This is a particularly worrisome trend, since EU-wide exports were widely deemed responsible for last year’s economic recovery, given the persistent sluggishness of domestic consumer demand.
Amazingly, the underlying problems have continued to be ignored by the European Union’s leading officials, which in turn has stored up additional trouble for the future. No change in the Commission’s operating procedures have ever taken place in spite of numerous political warnings. Euroland, as a consequence, has continued to function in a huge political vacuum. Indeed, the whole “European project” is increasingly characterised by growing institutional inflexibility, policy paralysis, and tenuous political legitimacy. Today, the whole movement toward an “ever closer union” appears dead and the notion of a “United States of Europe”, standing as a serious political counterweight to the US, risible.
The more relevant question might be: is the euro itself salvageable? The FT’s Lex column lays out the stark alternatives ahead for Euroland:
“[M]arkets are leaning toward the belief that a vicious cycle is taking hold. This will see a weaker euro on the back of a worsening eurozone economy, political uncertainty and higher US interest rates. The European Central Bank, convinced that economic weakness has structural rather than monetary causes, will refuse to lower rates as imported inflation rises. Fiscal laxity as governments try to placate electorates could actually result in rate rises, depressing growth.
But those searching for a chink in the clouds could paint a much sunnier scenario. Elections in Germany this autumn, and the discrediting of the lame-duck French government, could result in a more pro-reform core Europe, which would work more harmoniously with the UK. Italy’s economic meltdown would continue, its debt burden finally forcing it out of the euro. A few years down the line, a leaner, meaner EU, focused on trade rather than political and social integration and expansion, could drive through aggressive structural reform and set the region on the high growth low unemployment path. An EU that regained the characteristics of a free-trade zone, focussing on competition and financial regulation, could more comfortably accommodate Turkey and other new members.”
As the paper concedes, this latter scenario appears unlikely, especially in light of the immediate response to the results in France and the Netherlands. It is worth noting that these two countries are core founding members of the European Union, not traditionally euro-sceptical nations existing at its periphery such as the United Kingdom or the newly accepted nations of Eastern Europe. And the latter are feeling fairly aggrieved at this juncture because the No votes were said to be fuelled by fears over jobs being lost to cheap workers from the east and immigration. Resentment is, therefore, building in the new members that they have been made scapegoats for the economic and social ills of old Europe.
So does “Old Europe” get it? Even before the results of the French referendum were official, Jean-Claude Juncker, the Luxembourg Prime Minister, insisted that the ratification process for the constitution continue until all countries delivered the “right” answer, which is essentially what was tried following the Danish referendum on the euro and the Irish rejection of the Treaty of Nice.
Jean Luc Dehaene, a former Belgian PM, exhibited comparable contempt for popular opinion: In a BBC interview last Monday, Mr Dehaene made the extraordinary remark that the results in France were meaningless because the electorate was not voting against the constitution, but against the French government. Common sense suggests that on the contrary, they were voting precisely against the constitution, a project of politicians such as Dehaene who are determined to pursue an unpopular agenda with or without popular consent. This notion also appears to be confirmed by the British newsmagazine, The Economist, which noted that five of the top 10 best-selling non-fiction books in France were about the Constitution. Millions of people watched television shows discussing it. A huge percentage of respondents in public opinion polls were familiar with its content. There was huge voter turnout (70 per cent) and people had a very good idea of what the issues were.
This obliviousness to public opinion has been the flaw at the heart of the whole "European Project" right from the start. It is scarcely remembered now that France only barely ratified the introduction of the euro in a vote so tight that its adoption by a few tenths of a percentage point gives lie to the word, “democracy" that lifts so carelessly off the lips of the most undemocratic of politicians.
But have France, let alone the rest of the EU, taken on board the message? In the immediate aftermath of the French Non, President Chirac announced a new and strong impetus to government policies, but chose his “political son”, Dominique de Villepin, to be France’s new Prime Minister, rather than someone identified closely with further economic reform, such as Nicolas Sarkozy. De Villepin (best known to Americans for his outspoken opposition to the US-led invasion of Iraq when he was France’s Foreign Minister) is viewed by the markets as fundamentally hostile to “Anglo-Saxon liberalism”, and determined to retain France’s unique “social model”.
“He’s got class and he can recite poetry,” said Jean-Louis Martin, a 59-year-old engineer who lost his job in 2003 when the local metal smelting factory shut down. “But I don’t see what hope it brings us. The people voted for a change — not a return of the nobility, the old regime. This is a joke.” This quote from the London Sunday Times reflects a commonly expressed sentiment. The euro lost a cent against the dollar in the immediate aftermath of the announcement of De Villepin being named French Prime Minister because the markets interpreted his appointment as a sign that France has set its face not just against the European project but against further economic liberalisation and reform. This is not euro bullish.
On the plus side, the contradictory impulse toward both widening and deepening the European Union (and, ultimately, the euro zone), has been demonstrably established as futile. The British belief that more widening of the EU would mean less deepening has essentially been vindicated.
There is little question that for a monetary union to operate successfully, there has to be a high degree of economic and political convergence. But this runs up against the tide of history: Pooled political sovereignty and a concomitantly more cohesive supra-national fiscal policy are far more difficult to implement in a larger currency zone with countries at disparate stages of economic development and correspondingly different political/historical traditions.
Most single-currency zones involve a central or federal government with a tax and public expenditure program of substantial size relative to national GDP and the ability to run significant deficits. A tax and public expenditure program generally involves redistribution from richer regions to poorer ones, whether as an automatic consequence of a progressive tax and social security system or as specific policy acts. The redistribution also has to be sufficiently large in scope to act as a stabilizer with negative shocks, leading to lower taxation and higher social security payments in the region that is adversely affected. The EU’s current budget is a pittance and there is little inclination for member states to pool further fiscal resources in the current political climate. But there is a need for the development of a larger EU tax base and redistribution of tax revenue from richer regions to poorer ones in order to have a genuinely proper functioning fiscal policy at the supra-national level. This is clearly more feasible with a smaller zone of nations with common economic and political philosophies.
In the absence of such a mechanism, it could be expected that economies would adjust to differential shocks and uneven economic performance through a variety of other routes, such as currency devaluation.
With the existence of the euro, that is not an option, but even that is coming into question: In the aftermath of the recent referendum results, issues hitherto considered politically sacrosanct, such as the actual withdrawal from the euro zone, have begun to creep into the public domain. This must surely constitute the ultimate Pandora’s Box for euro enthusiasts.
Of course talk of withdrawing from the euro zone is dismissed as completely unrealistic by EU officialdom. But recall that when the first stirrings of doubt were expressed by Germany back in 2001 about the Stability and Growth Pact, this too was met by a hail of denial. Just four years later, the Stability Pact is all but dead, denuded of any kind of meaningful enforcement mechanisms in the face of persistent violations.
The issue of euro withdrawal has been broached in Italy, of all countries. Ironic, because Rome has effectively had a free ride in the eurozone’s integrated bond markets for years, obtaining Germanic levels of interest rates (as a consequence of Germany’s historic record of fiscal prudence), despite maintaining historically retaining profligate levels of public sector expenditure and debt to GDP ratios well in excess of most of the other founding member states in the monetary union.
In spite of its low cost of capital, the country’s Welfare Minister, Roberto Maroni, told La Repubblica daily Italy should hold a referendum to decide whether to return to the lira, at least temporarily. He also said European Central Bank President Jean-Claude Trichet was one of those chiefly responsible for the “disaster of the euro”: The euro “has proved inadequate in the face of the economic slowdown, the loss of competitiveness and the job crisis,” Maroni said.
In this situation, Maroni contended that the answer was to give the government greater power to defend national industry from foreign competition and “to give control over the exchange rate back to the government”, and specifically cited Britain as a virtuous example of a country whose economy “grows and develops, maintaining control over its currency.”
The dirty little secret of European Monetary Union is that there has never been a proper debate on the pros and cons of the single currency union within the member states. Like so much else in regard to the EU, it was imposed from above. Yet this is a debate that must occur because the European Monetary Union and its attendant institutions, such as the European Central Bank, ultimately cannot succeed in the absence of open, public discussion and acceptance, in lieu of bureaucratic imposition.
It is said that politicians in particular and the democratic process in general cannot be trusted with economic policy formulation because they lead to decisions that have stimulating short-term effects (for example, reducing unemployment via higher government spending) but are detrimental in the longer term (a notable example is a rise in inflation). But comprehensive rejection of the constitution has proved to be an outlet for discontent extending well beyond this particular issue; French and Dutch voters have now shown us the limits of pure technocratic economic management in an environment divorced from political reality.
On the other hand, to debate the appropriateness of a single currency union at this juncture may engender unintended results. It is extraordinary to consider, for example, that the German people never had the opportunity to express their views in a referendum as to whether they ought to abandon one of the most successful post-war monetary regimes in favour of an untried and untested currency. Even if one makes allowances for Germany’s traditional post-war phobia of being perceived as “bad Europeans”, it is almost certain that most would have voted to retain the D-mark, had they been given the opportunity to express themselves in a proper democratic forum.
Already, there are stirrings of euro discontent emerging at the margins in Germany as well as Italy. The referendum results in France and the Netherlands appear to have lit a match on a tinder box of huge continent-wide disenchantment. Consider what is happening to the now discredited EU constitution in the wake of the French and Dutch referendum results: Four separate polls in Denmark and a survey in the Czech Republic indicated the two countries could both vote No in referendums on the constitution. Bild, a leading German tabloid, showed overwhelming hostility in Germany to the constitution. Of the 390,694 readers who responded, 96.9% said they would vote no if a referendum were held there. Now imagine if this discontent were to extend to the monetary union itself.
Increasingly, the euro appears to be nothing more than a bull market phenomenon. Its enthusiasts have over promised and under delivered. In the words of London Times’ correspondent, Anatole Kaletsky:
“The relative economic decline of ‘old’ Europe since the early 1990s - especially of Germany and Italy, but also of France - has been a disaster almost unparalleled in modern History. While Britain and Japan certainly suffered some massive economic dislocations, in the early 1980s and the mid-1990s respectively, they never experienced the same sort of permanent transformation from thriving full-employment economies to stagnant societies where mass unemployment and falling living standards are accepted as permanent facts of life. In Britain, for example, unemployment more than doubled from 1980 to 1984, but conditions then quickly improved. By the late 1980s, Britain was enjoying a boom, the economy was growing by 4% and unemployment had halved. In continental Europe, by contrast, unemployment has been stuck between 8% and 11% since 1991 and growth has reached 3% only once in those 14 years.”
Could the euro, therefore, suffer from the same sort of conflagration of discontent, as is now manifesting in the constitutional ratification process?
How would one re-establish national currencies, given that there exists no mechanism to re-establish them in lieu of the euro (at least none that have been publicly disseminated, for obvious reasons)? Indeed, France and Germany have only recently issued 50-year euro-denominated bonds. The euro itself is becoming an increasingly large component in the reserve portfolios of other central banks, particularly Asia. The prospect of chaos in the bond markets, and consequent severe economic dislocation, cannot be ruled out if this movement to restore national currencies were to gain sufficient political momentum on the back of this current outbreak of anti-EU populism.
What to do in that sort of context? In the past we have described the problems of the US economy ad nauseum. We have also highlighted the problems of the yen and the structural problems inherent in the existing European Monetary Union. Although the euro zone as a whole suffers less from the debt disease prevalent in both the US and Japan, it has largely “earned” its spurs on the foreign exchange markets as a consequence of being the least bad major paper currency alternative. Its acceptance has, until recently, continued unabated, largely by virtue of not being the dollar, as opposed to any intrinsic merits.
Generally speaking, most currency choices faced by market practitioners today are comparable to Keynes’s notion of market speculation: to paraphrase Keynes, one is not seeking to adjudge the most beautiful currency in absolute terms, but merely seeking to guess what the market’s will judge to have the best relative merits . In other words, paper currencies are only “relatively” attractive vis a vis each other and not genuinely attractive as ultimate stores of value. The current problems of the euro (as well as the longstanding problems of the dollar) illustrate that phenomenon.
This points the way toward a potential major paradigm shift in relation to gold, long viewed simply as another variant of the “anti-dollar” theme. Symptomatic of this shift in thinking is the Financial Times, a publication which has usually been viscerally hostile to gold as a legitimate reserve currency asset. In an editorial last April, however, the FT came to a fairly stunning conclusion:
“In truth, there are good reasons for selling all three of the world's main currencies. But could they all fall? Yes, against either gold or the Chinese renminbi. In recent years, gold has been a useful hedge against the dollar, but not against the euro or yen. Meanwhile, the U.S., Japan, and the EU would all like to see the renminbi revalue, but so far, the Chinese are not playing."
The current travails of the euro may change the perception of gold as a barbarous relic from a bygone era For the FT, which has been known as a very anti-gold publication, to come to this conclusion means that many people who have long viewed bullion as economically irrelevant are likely reassessing their viewpoint. This could well point the way forward for gold, notwithstanding the many travails its holders have experienced over the past two decades. Often, seismic shifts in thinking unfold in slow-motion, and are often masked by other “noisier” events, such as the French and Dutch referendums. The “noisier events”, however, could well be catalysing a far more profound change in financial thinking. The rejection of the EU’s constitution in France and the Netherlands, therefore, may well have initiated something well beyond the control of today’s paper currency custodians, much to their ultimate horror no doubt.
Saturday, May 21, 2005
Saturday, May 14, 2005
Saturday, May 07, 2005
Friday, April 29, 2005
Horror
Horror
I been to the lands of the Mountains, and the Rising and Setting Sun - oh, the horror, I see... I been to the lands of the Shining Seas, Eagles and Condors, and the horror, I see... I been to the land of the Bear, and oh, the horror, I see... I also been to the land of the Koala, and again, the horror, I see...
Oh yes, they all have their elite millionaires and billionaires, this is true enough, but the horror of their malnourished and starving children, is more than a soul can bear. They all have their under-country of misery and dispair...
My capitalism... my love, where are you? Are you in Africa, that once most beautiful of all the lands of free roaming animals, peoples and spirits? - How did you create this level of horror, my soul must see? Did you lose track of the lesser world's needs? Did you go to sleep at the wheel of excess, imbalanced profits? Can you awake?! Horror, oh horror - I honor you, to become the spirit of universal, balanced integrity... Rise up to your true calling and feed these poor, starving peoples and lands. - please, please, please!
L.A.Gillespie
I been to the lands of the Mountains, and the Rising and Setting Sun - oh, the horror, I see... I been to the lands of the Shining Seas, Eagles and Condors, and the horror, I see... I been to the land of the Bear, and oh, the horror, I see... I also been to the land of the Koala, and again, the horror, I see...
Oh yes, they all have their elite millionaires and billionaires, this is true enough, but the horror of their malnourished and starving children, is more than a soul can bear. They all have their under-country of misery and dispair...
My capitalism... my love, where are you? Are you in Africa, that once most beautiful of all the lands of free roaming animals, peoples and spirits? - How did you create this level of horror, my soul must see? Did you lose track of the lesser world's needs? Did you go to sleep at the wheel of excess, imbalanced profits? Can you awake?! Horror, oh horror - I honor you, to become the spirit of universal, balanced integrity... Rise up to your true calling and feed these poor, starving peoples and lands. - please, please, please!
L.A.Gillespie
Tuesday, April 26, 2005
Tuesday, April 19, 2005
'Global Conspiracy of Fools,' Perhaps?
Global Conspiracy of Fools
Also Stephen Roach - Tilt
Edmund M. McCarthy is President and CEO of Financial Risk Management Advisors Company. This piece was originally published in his January newsletter.
A detailed account, superbly researched and documented, of the Enron debacle under the title “A Conspiracy of Fools” by Kurt Eichenwald, recently read, is the inspiration for the question above. There is, at least, a workable hypothesis that the Enron rise and collapse is a possible microcosm of the global bubble ongoing, stoked by massive credit emanation currently believed to be the New Wave of Economic Growth. In it’s time, Enron was believed to be the new model of corporate growth, expanding exponentially more rapidly than prosaic forebears, incorporating marketing and financial genius, transforming industries and economies and enriching vast constituencies. It was, in fact, a gigantic scam and sham able to deceive with aplomb virtually all areas of expertise in understanding and analyzing risk and reward. A combination of fraud, greed, obliviousness, unbridled ego, unquestioned belief in growth, and fascinated obsession with financial innovation catalogues the “E” debacle. Virtually all these elements are in plentiful supply in global financial markets and the players therein as the world “reflates” with a vengeance in every nook and cranny having a medium of exchange and the means to exchange it.
There is no question of the criminality of many of the players in the Houston company’s demise, however, there is also clear proof that the complexities of modern finance are beyond the comprehension and understanding of many extremely intelligent and supposedly well informed “leaders” of the mammoth organizations now proliferating at excessively rapid growth rates across the global economy. In the abbreviated mini-downturn of 2000-2002, abruptly terminated by plummeting Fed rate cuts and massive liquidity injections (First in the $ Trillions from the GSE’s and latterly in the $ Trillions from the Primary dealer, hedge fund and bank lending arenas), there were quite a few Enron-like disasters such as the two currently in the trial headlines, Worldcom and Tyco. Again, there is criminality aplenty but also plentiful further evidence of inability of supposedly astute “leaders” and observers to unravel what seemingly are relatively complex but not insuperably difficult frauds and misuses. More recently, the burgeoning AIG scandal, the shocking GM cash flow reversal and the ongoing flow of announcements from the Citi’s and BofA’s confirm the following thesis:
MARKET AND CORPORATE GROWTH HAVE EXPANDED BEYOND THE ABILITY OF THOSE IN CHARGE TO BE AWARE OF AND COMPREHEND THE INCREDIBLY RAPIDLY GROWING RISKS, BOTH BUSINESS AND ETHICAL/INTEGRITY, ASSUMED IN THIS GROWTH!
This growth, unprecedented during the 1990’s, although marred by episodic blow-ups easily quelled by Fed/Central Bank/GSE liquidity emanation, has expanded exponentially globally since the Greenspan demotion of interest rates below 0%, inflation adjusted, in 2002 and the maintenance at that level until succeeded by, in effect, a guaranteed “contract” between the Fed and the Brobdingnagian financial colossus labeled the “Leveraged Speculative Community” by Doug Noland, of a “measured” policy enabling ongoing profitable speculation. The “policy/contract” even produced a “conundrum” for the redoubted Sir Alan when long rates fell as he “measuredly” raised the short end.
Some rational observers have noticed that a “guaranteed” spread, even when shrinking, is just as possibly profitable with a concomitant increase in leverage!
In the “carry trade” a massive increase in leverage is a massive increase in demand creating part of the Fedheads conundrum. He has had to actually mutter the “bogeyman” word (inflation) to try to, belatedly, stem the onrush into longer dated instruments by the “carry traders” and the vitiation of spreads out along the risk curve. (The rest of Greenie’s conundrum, if he would bother to look at the Fed Z1 report, is from what Anatole Kaletsky calls the three brain dead zombie fixed income investors, Asian central banks, Western pension and insurance funds and, most importantly, Japanese private investors. John Mauldin included a piece entitled “Of Bonds and Zombies” by Kaletsky in one of his recent fascinating “Outside the Box” efforts and more detail on the underlying support for long fixed income exacerbated by the hedgies playing the carry can be found at GaveKal.com.) The aforementioned zombies have provided the unlikely “ceiling” for longer U.S. rates in a seeming anomaly, permitting the continued chase for performance fees by the burgeoning hedge fund community using the carry trade as a significant part of their strategy. Foreign holders of Treasuries have accumulated $1,385 Trillion!
In a recent Credit Bubble Bulletin, Doug Noland summarized the credit sources available to the “Leveraged Speculators” just recently. The big 5 of Bear, Lehman, Goldman, Morgan Stanley and Merrill have expanded their borrowings 24% year over year to February and 44% over 2 years to a total of $2.60 Trillion. Bank credit is up $252 Billion so far in 2005 (a 19.4% annualized rate). In its infinite wisdom, the Fed Z1 report omits repos/reverse repos of $3.2 Trillion thereby vastly understating the blowout, in recent times, in credit available for speculation.
GROWTH RATES IN CREDIT IN THE HIGH TEENS/TWENTIES IN % OUTRUN BOTH CREDIT DETERIORATION AND THE ABILITY OF MANAGEMENT, NO MATTER HOW PRAISED AND SOPHISTICATED, TO COMPREHEND AND MASTER THE AFOREMENTIONED RISKS OF BOTH THE QUALITY OF THE BUSINESS BEING DONE AND THE ETHICS/INTEGRITY OF THOSE WRITING IT!
Layered on top of the “visible” credit expansion (balance sheet) and the aforementioned “repo” world of credit is a new game rapidly reaching prodigious proportions. CDS (Credit Default Swaps) is the fastest growing game in Speculation Town, the fastest growing gambling town in human financial history. A survey done by Fitch found the total under the purview of U.S. banking regulators at $3.1 Trillion by the end of 2004, having DOUBLED during the course of the preceding year. A recent look at the Bank for International Settlements year end derivatives numbers showed this category globally at $6.4Trillion and Bloomberg totals $8.4Trillion throughout all markets. By the way, the same annual compilation by the BIS showed total notional derivatives outstanding at the end of 2004 of $221 Trillion! The mind boggles.
Obviously, the bulk of this stuff is interest rate and foreign exchange, not to say that it is not potentially explosive in nature (Anybody remember Bankers Trust, Orange County, Gibson Greeting et al 1994?) and it is significantly obscure, given the willingness of the authorities to allow netting among the larger participants, but the credit default stuff is fuel for speculation and explosion where the notional category total in terms of “real” risk is not some computer derived tiny fraction but the actual amount at risk. “Financial Engineering, applauded by the eminent Alan, may disperse risk, thereby reducing it, or it may contain the seeds of greater risk an/or deals of questionable or even fraudulent provenance. Warren Buffett, of unquestioned integrity, is now caught up in the Greenberg/AIG deal, of which he knew. The fact that on March 29, Berkshire said in a statement repeated in the WSJ 3/30 that Mr. Buffett “WAS NOT BRIEFED ON HOW THE TRANSACTIONS WERE STRUCTURED OR ON ANY IMPROPER USE OR PURPOSE OF THE TRANSACTIONS.” Leaves two possibilities. 1) He is dissimilating or 2) the size of Berkshire and General Re, the complexity of financial engineering and some generalizations by a, presumably, trusted subordinate after a non-detail conversation with Greenberg previously, left Buffett feeling comfortable about a questionable transaction.
We are inclined towards 2 above and that makes the point of the thesis: The best, most honest, brightest of CEO’s cannot possibly stay on top of what goes on in these complicated financial megaliths. If the presumed honest, such as Buffett cannot, how can anybody believe that it is possible in the convoluted world of an AIG, driven by a CEO consumed by the company’s stock price (per statements by Wall St. analysts on the pressure from “Hank” for laudatory comments) and executives, motivated by excessive compensation for achievement of outlandish financial goals, that anyone within the company actually knows what is really going on. AIG is clearly out of control and only time will tell the order of magnitude. The question is how many other Financial Giants and BFB’s (Big Famous Banks) are in similar condition. The bonuses to the CEO’s are still given a la B of A where there is clear evidence the troops were out of control, based on a Board’s ridiculous excuses for “performance against goals” which obviously did not include having a spotless record in terms of regulatory, compliance or integrity to customers. Buffett himself has said that nobody can analyze entities such as Fannie Mae and he has likened derivatives to “financial weapons of mass destruction” but, nevertheless, finds himself beset within his own company. Jim Grant, of Grant’s Interest Rate Observer, an analyst truly worthy of respect, finds the FNM’s and JPM’s beyond analysis, as does this writer.
Speaking of Grant’s Interest Rate Observer (your writer is a “paid up subscriber” as Jim likes to refer to us and a member of a “small, perverse cult” as some commentators like to refer to such subscribers), in a recent issue, “deconvergence” was one of the articles. In it, a strategy is propounded. The concept is to use credit default swaps as a way to prosper if 1) credit analysis ever comes back into vogue and spreads go rational and 2) the euro gets into difficulty. Until reading this article, the writer was unaware of the current cost of obtaining credit protection on some of the various sovereign country European debt. Greece recently sold some 30 year paper at 4.45% or 26 basis points above the yield on German 30 year paper! As Jim says in the article: “Greece may be many things, but it is not 26 basis points removed from AAA quality.” We spent a couple of years lending to the country’s banks and we could not agree more. A Greek credit default swap for 10 years is available, according to the article and Bloomberg, at 14 basis points per year. The counterparty is not mentioned. The point is that if Greece were only to widen out by more than 14 bps, the deal goes into the money. Our point is that the counterparty is either some gigantic financial institution or a hedge fund. Likely, if a hedge fund, they are hedging the risk with a giant. Does anybody think Purcell, for instance, at Morgan Stanley, knows the details of the hundreds of billions of pieces of financial engineering being done. We happen to be a little more pro-euro than Grant but are still dubious on this bet. On the other hand, it is an example of the finest kind of credit default swap, a sovereign government which can actually print it’s way to payment. (They may elect to only print 30% a la Argentina) but at least the buyer of the swap won't get 100% probably of the face amount with 0% for the counterparty/swap seller. Citi managed to find $400 Million of sellers of CDS for Enron. Probably an example of the worst type of CDS back in 2002.
We wonder, in the halcyon days of of 4 ½ years of economic expansion, 2 ½ years of rising equity markets, falling unemployment and bad credit percentages and astronomically rising house prices, whether there may be some or a lot of deals being done in the CDS market which will provide the next “GREAT SURPRISE” for some CEO of one of these giants. In fact we like this bet as much as Grant’s bet against the CDS seller which we, not a GIANT institution, cannot participate in. It is about the only thing about CDS we like. Since all of this product is one-off, customized and “financially engineered,” our dim view of inherent risk and lack of understanding of such risk as it escalates continues to grow dimmer.
In a previous missive, we described the emergence of CDO SQUARED’S, debt obligations made up of synthetic CDO’s (CDS’s) leveraged into a higher yielding instrument. Now we have CDO CUBED’s, debt instruments leveraged another level filled with CDO SQUARED’s. We understand that at least one of the BFB’s is suffering significant problems with deterioration unexpected and premature in some of these. GM alone could cause such a problem, although we are unaware (as is virtually everybody) of the exact content of the CDO CUBED’s. As usual, total opacity in this over the counter, each issue unique world prevails. The March 31 WSJ has an article entitled “Amid Corporate-Bond Sell-Off, Risky Loan Market Chugs On. The presumption by the Journal is that this paper is favored over bonds because the loan “sits higher than bonds in a company’s capital structure” and mostly float in terms of interest rate. In passing, to this observer, if buying something for better bankruptcy protection, does it help to have rates cause an earlier possible bankruptcy? Leaving that aside, we posit that the real reason for the strength in this arena is the availability of such fodder for CDO’s and their combinations. Equally fascinating is the bailout of Krispy Kreme by CSFB and a hedge fund. Are we really to believe that this is a “relationship” deal or is the answer more fodder for a CDO. Anybody got a ready quote for a CDS on this one?
After many years of licking their wounds after the real estate disasters of the late ‘80’s and early 90’s, the Banking industry has really returned to the game with a vengeance. In the 1st 10 weeks of 2005, the industry grew real estate loans on an annualized basis of 19%. Home equity loans did even better at 21% year over year in the last report. Musing about the constant good health of the housing industry from the National Association of Realtors stating that the supply of homes for sale stays at lows of months of sale, we stumbled upon our old friend the numerator/denominator equation. Given that the 1980’s saw 400-500 thousand new homes sold per annum, the 1990’s some 800-900 thousand and recently, an annualized rate approaching 1,400,000, we are not surprised that the month’s sales number from the “unbiased” NAR stays low! Having been through a few housing busts, we know that this market doesn’t slow, it freezes. Say we have 700,000 supply at the moment, how much supply is there in terms of “month’s sales” at an annual sales rate of the 1980’s?
Recently, we have become aware of some statistics on the front end of this “market on fire”. 1.) Homes for sale, not yet started, have accelerated from a 1998 low of some 30M to in excess of 80M, exceeding the previous bubble number in 1991 of 70M. The rate of change recently growing over 60% yr over yr. 2) Homes not sold, still under construction has shot up from the 1993 low of 130M to over 260M, way over the previous bubble of 1989 of 220M. 3) Total New Homes for sale are headed for half a MILLION in a spike blowout 50% higher than anything previously seen. Admittedly, the extreme points of heat in this “market on fire” are concentrated geographically but so was the previous housing debacle that extinguished the S&L industry. Remember also, that the previous era did not have 0% down 5 yr I/O “financial engineering” to help it along. It also did not have the Trillions of $ of “financially engineered” mortgage backed securities.
The April 4 WSJ has an article on the OFHEO (Those nasty regulators of Fannie who doubted their accounting) that these persecutors are now looking at the “TRUSTS” used by Fannie to offload their guaranteed mortgages. Need we repeat our obvious theme that these indentures, created with exquisite “financial engineering” are complex, nearly innumerable at this point, and examined, if at all, on ratios and legality. Subsequent review after issue, is at best, perfunctory. Covenants on substitution in some we have seen are generally permissive and provide opportunities for Enron-like manipulation. Admittedly a “perverse cult” cynic, I cannot help but have the suspicion that a lot of these indentures are, upon close examination have everything from flaws to frauds contained therein. When that great denominator of housing sales slackens or, Heaven help and forfend, declines, the numerator may worsen by orders of magnitude more viciousness than the pedants of real estate currently foresee. The aforementioned article briefly hints at the possibility that some of these trusts, if flawed, may not flow back onto Fannie’s books but onto the banks that did the origination.
BAD ENOUGH THAT THE CURRENTLY WOEFULLY UNDERCAPITALIZED FANNIE MAY HAVE TO SWALLOW SOME OF THIS BUT WHAT A SHOCK TO THE MARKETS OF ANY WHOLESALE REPATRIATION OF THE TRILLIONS OF BANK INVOLVED BUT “OFF THE BALANCE SHEET” MORTGAGE CREDIT WOULD BE! ALL OF THIS, WE ADMIT, FROM A SINGLE DATA POINT/ARTICLE BUT NOT TO BE SHRUGGED OFF GIVEN THE OPACITY OF THE PROCESS.
Just to be totally ridiculous, let’s hypothesize that some number of these trusts are deemed flawed by OFHEO. Instead of, theoretically, flowing back onto Fannie’s balance sheet, they are deemed to be the obligation of the originator bank. Would it not be quite an irony for that bank to also hold the security as an asset!? Possible? Yes! What strange webs we mortal spin. The forgoing absurd soliloquy in aid of further demonstration of how complex this whole financial enterprise mechanism has become and further demonstration of how unlikely the risks are truly known, dimensioned and prepared/reserved for.
Throughout our experience, there have been two truly lagging indicators in the Financial Institution business 1.The Rating’s Agencies and 2 The Regulatory Agencies. Should we use Enron or AIG as the best example of the first category? How about the vintage 1983 Texas Commerce Bank, trumpeting itself in full page WSJ ads as one of two AAA banks not much before dropping a multi-hundred million clanger on the way to a distressed sale. “Nuff said.” Point is that the FDIC has just started to publish some cautionary commentary to it’s constituency and even the OCC seems to getting nerves/hives? The Fed doesn’t dare. All of this has been complicated by Sarbox and the SEC’s historic tendency to try and evaporate any “Unallocated” and therefore presumabllly “hidden earnings pocket” loan loss reserve just as the credit cycle turns. In the age of Enron, some financial institutions are not all that adverse to being “forced” to feed “excess” loan loss reserve into the earnings stream.
A reasonable observer of financial institutions might, at this point, have some reservations. One reasonable observer we are privileged to read, Charles Peabody of Portales Partners, the only “Street” analyst of Financial Institutions we respect, has lot’s of reservations. Cost of goods is going up, spreads are squeezed, there are lots of held to maturity assets which look to be in jeapoardy, branch expansion is rampant, competition on both price and credit standards is fierce and the economy just don’t seem to be hiring that many people. The Fed had to jigger the Z1 report in the last year by revaluing upward U.S. held “Non-Financial” assets(old bricks and mortar) by $900 billion to keep our net due foreigners below $5Trillion (It just exceeded that amount again)., and the current account deficit will accelerate as rates rise and what we have to pay accelerates. The domestic deficit is exploding and the consumer is sucking wind. If the market and/or the regulators slow the breakneck pace of credit creation previously detailed, the worst numerator (Bad Loans) is going to inexorably rise. Even if another $1.4-1.5 trillion in new mortgage credit plus corporations going berserk in capital spending were to be in the cards, there are ripplings of discontent in some of the zombie buyers in Asia. The Fed either has to keep raising rates or lose credibility and the famous “carry” will either require leverage even the prime brokers must be able to smell or will start to diminish. Two of the pillars of purchase of the four therefore look shaky. Three legged stools have a problem; two legged one’s collapse. When? Who knows? Whether-FOR CERTAIN.
The glorious days of burgeoning appraisals, magnificent cash-outs and “flipping” real estate for beginners are now turned over to home equity drawdown desperation, 0% down and no/low I/O mortgages, return to what is left of the credit card line and, finally, re-entry into lending on the most magnanimous basis by a banking system bereft of Fannie and Freddy.
The zombie buyers are not dead after all and are becoming restless. Brain death, if any is to be found, may be more domestic than foreign. All the Fed’s men and all the Fed’s horses (LIQUIDITY) have not resurrected Japan nor staved off EU recession. China and the U.S. are at the ends of their respective ropes.
CONCLUSION: OUR THESIS IS THAT THE GLOBAL FINANCIAL SYSTEM HAS UNWITTINGLY AND/OR GREEDILY GONE PAST ANY SAFE EXIT FROM A HUMONGOUS GLOBAL CREDIT BUBBLE. WHILE MALFEASANCE AND FRAUD WILL EMERGE IN THE AFTERMATH A LA LINCOLN SAVINGS AND PENN SQUARE; MUCH OF THE DAMAGE WILL HAVE BEEN DONE BY A CORPORATE/BANK/CENTRAL BANK LEADERSHIP OVERWHELMED BY A NEW, COMPLEX BREAKNECK, FINANCIALLY ENGINEERED CREDIT EXPLOSION A LA LTCM. HISTORY AND FORENSIC ACCOUNTING WILL JUDGE WHAT LEADERS WERE LARCENOUS, WHICH FRAUDULENT, WHOM WILLFULLY BLIND AND, FINALLY, THOSE OF THE EGO-DRIVEN OBLIVIOUS PERSUASION. THE COURTS AND PUBLIC OPINION WILL SORT THEM OUT!
Also Stephen Roach - Tilt
Edmund M. McCarthy is President and CEO of Financial Risk Management Advisors Company. This piece was originally published in his January newsletter.
A detailed account, superbly researched and documented, of the Enron debacle under the title “A Conspiracy of Fools” by Kurt Eichenwald, recently read, is the inspiration for the question above. There is, at least, a workable hypothesis that the Enron rise and collapse is a possible microcosm of the global bubble ongoing, stoked by massive credit emanation currently believed to be the New Wave of Economic Growth. In it’s time, Enron was believed to be the new model of corporate growth, expanding exponentially more rapidly than prosaic forebears, incorporating marketing and financial genius, transforming industries and economies and enriching vast constituencies. It was, in fact, a gigantic scam and sham able to deceive with aplomb virtually all areas of expertise in understanding and analyzing risk and reward. A combination of fraud, greed, obliviousness, unbridled ego, unquestioned belief in growth, and fascinated obsession with financial innovation catalogues the “E” debacle. Virtually all these elements are in plentiful supply in global financial markets and the players therein as the world “reflates” with a vengeance in every nook and cranny having a medium of exchange and the means to exchange it.
There is no question of the criminality of many of the players in the Houston company’s demise, however, there is also clear proof that the complexities of modern finance are beyond the comprehension and understanding of many extremely intelligent and supposedly well informed “leaders” of the mammoth organizations now proliferating at excessively rapid growth rates across the global economy. In the abbreviated mini-downturn of 2000-2002, abruptly terminated by plummeting Fed rate cuts and massive liquidity injections (First in the $ Trillions from the GSE’s and latterly in the $ Trillions from the Primary dealer, hedge fund and bank lending arenas), there were quite a few Enron-like disasters such as the two currently in the trial headlines, Worldcom and Tyco. Again, there is criminality aplenty but also plentiful further evidence of inability of supposedly astute “leaders” and observers to unravel what seemingly are relatively complex but not insuperably difficult frauds and misuses. More recently, the burgeoning AIG scandal, the shocking GM cash flow reversal and the ongoing flow of announcements from the Citi’s and BofA’s confirm the following thesis:
MARKET AND CORPORATE GROWTH HAVE EXPANDED BEYOND THE ABILITY OF THOSE IN CHARGE TO BE AWARE OF AND COMPREHEND THE INCREDIBLY RAPIDLY GROWING RISKS, BOTH BUSINESS AND ETHICAL/INTEGRITY, ASSUMED IN THIS GROWTH!
This growth, unprecedented during the 1990’s, although marred by episodic blow-ups easily quelled by Fed/Central Bank/GSE liquidity emanation, has expanded exponentially globally since the Greenspan demotion of interest rates below 0%, inflation adjusted, in 2002 and the maintenance at that level until succeeded by, in effect, a guaranteed “contract” between the Fed and the Brobdingnagian financial colossus labeled the “Leveraged Speculative Community” by Doug Noland, of a “measured” policy enabling ongoing profitable speculation. The “policy/contract” even produced a “conundrum” for the redoubted Sir Alan when long rates fell as he “measuredly” raised the short end.
Some rational observers have noticed that a “guaranteed” spread, even when shrinking, is just as possibly profitable with a concomitant increase in leverage!
In the “carry trade” a massive increase in leverage is a massive increase in demand creating part of the Fedheads conundrum. He has had to actually mutter the “bogeyman” word (inflation) to try to, belatedly, stem the onrush into longer dated instruments by the “carry traders” and the vitiation of spreads out along the risk curve. (The rest of Greenie’s conundrum, if he would bother to look at the Fed Z1 report, is from what Anatole Kaletsky calls the three brain dead zombie fixed income investors, Asian central banks, Western pension and insurance funds and, most importantly, Japanese private investors. John Mauldin included a piece entitled “Of Bonds and Zombies” by Kaletsky in one of his recent fascinating “Outside the Box” efforts and more detail on the underlying support for long fixed income exacerbated by the hedgies playing the carry can be found at GaveKal.com.) The aforementioned zombies have provided the unlikely “ceiling” for longer U.S. rates in a seeming anomaly, permitting the continued chase for performance fees by the burgeoning hedge fund community using the carry trade as a significant part of their strategy. Foreign holders of Treasuries have accumulated $1,385 Trillion!
In a recent Credit Bubble Bulletin, Doug Noland summarized the credit sources available to the “Leveraged Speculators” just recently. The big 5 of Bear, Lehman, Goldman, Morgan Stanley and Merrill have expanded their borrowings 24% year over year to February and 44% over 2 years to a total of $2.60 Trillion. Bank credit is up $252 Billion so far in 2005 (a 19.4% annualized rate). In its infinite wisdom, the Fed Z1 report omits repos/reverse repos of $3.2 Trillion thereby vastly understating the blowout, in recent times, in credit available for speculation.
GROWTH RATES IN CREDIT IN THE HIGH TEENS/TWENTIES IN % OUTRUN BOTH CREDIT DETERIORATION AND THE ABILITY OF MANAGEMENT, NO MATTER HOW PRAISED AND SOPHISTICATED, TO COMPREHEND AND MASTER THE AFOREMENTIONED RISKS OF BOTH THE QUALITY OF THE BUSINESS BEING DONE AND THE ETHICS/INTEGRITY OF THOSE WRITING IT!
Layered on top of the “visible” credit expansion (balance sheet) and the aforementioned “repo” world of credit is a new game rapidly reaching prodigious proportions. CDS (Credit Default Swaps) is the fastest growing game in Speculation Town, the fastest growing gambling town in human financial history. A survey done by Fitch found the total under the purview of U.S. banking regulators at $3.1 Trillion by the end of 2004, having DOUBLED during the course of the preceding year. A recent look at the Bank for International Settlements year end derivatives numbers showed this category globally at $6.4Trillion and Bloomberg totals $8.4Trillion throughout all markets. By the way, the same annual compilation by the BIS showed total notional derivatives outstanding at the end of 2004 of $221 Trillion! The mind boggles.
Obviously, the bulk of this stuff is interest rate and foreign exchange, not to say that it is not potentially explosive in nature (Anybody remember Bankers Trust, Orange County, Gibson Greeting et al 1994?) and it is significantly obscure, given the willingness of the authorities to allow netting among the larger participants, but the credit default stuff is fuel for speculation and explosion where the notional category total in terms of “real” risk is not some computer derived tiny fraction but the actual amount at risk. “Financial Engineering, applauded by the eminent Alan, may disperse risk, thereby reducing it, or it may contain the seeds of greater risk an/or deals of questionable or even fraudulent provenance. Warren Buffett, of unquestioned integrity, is now caught up in the Greenberg/AIG deal, of which he knew. The fact that on March 29, Berkshire said in a statement repeated in the WSJ 3/30 that Mr. Buffett “WAS NOT BRIEFED ON HOW THE TRANSACTIONS WERE STRUCTURED OR ON ANY IMPROPER USE OR PURPOSE OF THE TRANSACTIONS.” Leaves two possibilities. 1) He is dissimilating or 2) the size of Berkshire and General Re, the complexity of financial engineering and some generalizations by a, presumably, trusted subordinate after a non-detail conversation with Greenberg previously, left Buffett feeling comfortable about a questionable transaction.
We are inclined towards 2 above and that makes the point of the thesis: The best, most honest, brightest of CEO’s cannot possibly stay on top of what goes on in these complicated financial megaliths. If the presumed honest, such as Buffett cannot, how can anybody believe that it is possible in the convoluted world of an AIG, driven by a CEO consumed by the company’s stock price (per statements by Wall St. analysts on the pressure from “Hank” for laudatory comments) and executives, motivated by excessive compensation for achievement of outlandish financial goals, that anyone within the company actually knows what is really going on. AIG is clearly out of control and only time will tell the order of magnitude. The question is how many other Financial Giants and BFB’s (Big Famous Banks) are in similar condition. The bonuses to the CEO’s are still given a la B of A where there is clear evidence the troops were out of control, based on a Board’s ridiculous excuses for “performance against goals” which obviously did not include having a spotless record in terms of regulatory, compliance or integrity to customers. Buffett himself has said that nobody can analyze entities such as Fannie Mae and he has likened derivatives to “financial weapons of mass destruction” but, nevertheless, finds himself beset within his own company. Jim Grant, of Grant’s Interest Rate Observer, an analyst truly worthy of respect, finds the FNM’s and JPM’s beyond analysis, as does this writer.
Speaking of Grant’s Interest Rate Observer (your writer is a “paid up subscriber” as Jim likes to refer to us and a member of a “small, perverse cult” as some commentators like to refer to such subscribers), in a recent issue, “deconvergence” was one of the articles. In it, a strategy is propounded. The concept is to use credit default swaps as a way to prosper if 1) credit analysis ever comes back into vogue and spreads go rational and 2) the euro gets into difficulty. Until reading this article, the writer was unaware of the current cost of obtaining credit protection on some of the various sovereign country European debt. Greece recently sold some 30 year paper at 4.45% or 26 basis points above the yield on German 30 year paper! As Jim says in the article: “Greece may be many things, but it is not 26 basis points removed from AAA quality.” We spent a couple of years lending to the country’s banks and we could not agree more. A Greek credit default swap for 10 years is available, according to the article and Bloomberg, at 14 basis points per year. The counterparty is not mentioned. The point is that if Greece were only to widen out by more than 14 bps, the deal goes into the money. Our point is that the counterparty is either some gigantic financial institution or a hedge fund. Likely, if a hedge fund, they are hedging the risk with a giant. Does anybody think Purcell, for instance, at Morgan Stanley, knows the details of the hundreds of billions of pieces of financial engineering being done. We happen to be a little more pro-euro than Grant but are still dubious on this bet. On the other hand, it is an example of the finest kind of credit default swap, a sovereign government which can actually print it’s way to payment. (They may elect to only print 30% a la Argentina) but at least the buyer of the swap won't get 100% probably of the face amount with 0% for the counterparty/swap seller. Citi managed to find $400 Million of sellers of CDS for Enron. Probably an example of the worst type of CDS back in 2002.
We wonder, in the halcyon days of of 4 ½ years of economic expansion, 2 ½ years of rising equity markets, falling unemployment and bad credit percentages and astronomically rising house prices, whether there may be some or a lot of deals being done in the CDS market which will provide the next “GREAT SURPRISE” for some CEO of one of these giants. In fact we like this bet as much as Grant’s bet against the CDS seller which we, not a GIANT institution, cannot participate in. It is about the only thing about CDS we like. Since all of this product is one-off, customized and “financially engineered,” our dim view of inherent risk and lack of understanding of such risk as it escalates continues to grow dimmer.
In a previous missive, we described the emergence of CDO SQUARED’S, debt obligations made up of synthetic CDO’s (CDS’s) leveraged into a higher yielding instrument. Now we have CDO CUBED’s, debt instruments leveraged another level filled with CDO SQUARED’s. We understand that at least one of the BFB’s is suffering significant problems with deterioration unexpected and premature in some of these. GM alone could cause such a problem, although we are unaware (as is virtually everybody) of the exact content of the CDO CUBED’s. As usual, total opacity in this over the counter, each issue unique world prevails. The March 31 WSJ has an article entitled “Amid Corporate-Bond Sell-Off, Risky Loan Market Chugs On. The presumption by the Journal is that this paper is favored over bonds because the loan “sits higher than bonds in a company’s capital structure” and mostly float in terms of interest rate. In passing, to this observer, if buying something for better bankruptcy protection, does it help to have rates cause an earlier possible bankruptcy? Leaving that aside, we posit that the real reason for the strength in this arena is the availability of such fodder for CDO’s and their combinations. Equally fascinating is the bailout of Krispy Kreme by CSFB and a hedge fund. Are we really to believe that this is a “relationship” deal or is the answer more fodder for a CDO. Anybody got a ready quote for a CDS on this one?
After many years of licking their wounds after the real estate disasters of the late ‘80’s and early 90’s, the Banking industry has really returned to the game with a vengeance. In the 1st 10 weeks of 2005, the industry grew real estate loans on an annualized basis of 19%. Home equity loans did even better at 21% year over year in the last report. Musing about the constant good health of the housing industry from the National Association of Realtors stating that the supply of homes for sale stays at lows of months of sale, we stumbled upon our old friend the numerator/denominator equation. Given that the 1980’s saw 400-500 thousand new homes sold per annum, the 1990’s some 800-900 thousand and recently, an annualized rate approaching 1,400,000, we are not surprised that the month’s sales number from the “unbiased” NAR stays low! Having been through a few housing busts, we know that this market doesn’t slow, it freezes. Say we have 700,000 supply at the moment, how much supply is there in terms of “month’s sales” at an annual sales rate of the 1980’s?
Recently, we have become aware of some statistics on the front end of this “market on fire”. 1.) Homes for sale, not yet started, have accelerated from a 1998 low of some 30M to in excess of 80M, exceeding the previous bubble number in 1991 of 70M. The rate of change recently growing over 60% yr over yr. 2) Homes not sold, still under construction has shot up from the 1993 low of 130M to over 260M, way over the previous bubble of 1989 of 220M. 3) Total New Homes for sale are headed for half a MILLION in a spike blowout 50% higher than anything previously seen. Admittedly, the extreme points of heat in this “market on fire” are concentrated geographically but so was the previous housing debacle that extinguished the S&L industry. Remember also, that the previous era did not have 0% down 5 yr I/O “financial engineering” to help it along. It also did not have the Trillions of $ of “financially engineered” mortgage backed securities.
The April 4 WSJ has an article on the OFHEO (Those nasty regulators of Fannie who doubted their accounting) that these persecutors are now looking at the “TRUSTS” used by Fannie to offload their guaranteed mortgages. Need we repeat our obvious theme that these indentures, created with exquisite “financial engineering” are complex, nearly innumerable at this point, and examined, if at all, on ratios and legality. Subsequent review after issue, is at best, perfunctory. Covenants on substitution in some we have seen are generally permissive and provide opportunities for Enron-like manipulation. Admittedly a “perverse cult” cynic, I cannot help but have the suspicion that a lot of these indentures are, upon close examination have everything from flaws to frauds contained therein. When that great denominator of housing sales slackens or, Heaven help and forfend, declines, the numerator may worsen by orders of magnitude more viciousness than the pedants of real estate currently foresee. The aforementioned article briefly hints at the possibility that some of these trusts, if flawed, may not flow back onto Fannie’s books but onto the banks that did the origination.
BAD ENOUGH THAT THE CURRENTLY WOEFULLY UNDERCAPITALIZED FANNIE MAY HAVE TO SWALLOW SOME OF THIS BUT WHAT A SHOCK TO THE MARKETS OF ANY WHOLESALE REPATRIATION OF THE TRILLIONS OF BANK INVOLVED BUT “OFF THE BALANCE SHEET” MORTGAGE CREDIT WOULD BE! ALL OF THIS, WE ADMIT, FROM A SINGLE DATA POINT/ARTICLE BUT NOT TO BE SHRUGGED OFF GIVEN THE OPACITY OF THE PROCESS.
Just to be totally ridiculous, let’s hypothesize that some number of these trusts are deemed flawed by OFHEO. Instead of, theoretically, flowing back onto Fannie’s balance sheet, they are deemed to be the obligation of the originator bank. Would it not be quite an irony for that bank to also hold the security as an asset!? Possible? Yes! What strange webs we mortal spin. The forgoing absurd soliloquy in aid of further demonstration of how complex this whole financial enterprise mechanism has become and further demonstration of how unlikely the risks are truly known, dimensioned and prepared/reserved for.
Throughout our experience, there have been two truly lagging indicators in the Financial Institution business 1.The Rating’s Agencies and 2 The Regulatory Agencies. Should we use Enron or AIG as the best example of the first category? How about the vintage 1983 Texas Commerce Bank, trumpeting itself in full page WSJ ads as one of two AAA banks not much before dropping a multi-hundred million clanger on the way to a distressed sale. “Nuff said.” Point is that the FDIC has just started to publish some cautionary commentary to it’s constituency and even the OCC seems to getting nerves/hives? The Fed doesn’t dare. All of this has been complicated by Sarbox and the SEC’s historic tendency to try and evaporate any “Unallocated” and therefore presumabllly “hidden earnings pocket” loan loss reserve just as the credit cycle turns. In the age of Enron, some financial institutions are not all that adverse to being “forced” to feed “excess” loan loss reserve into the earnings stream.
A reasonable observer of financial institutions might, at this point, have some reservations. One reasonable observer we are privileged to read, Charles Peabody of Portales Partners, the only “Street” analyst of Financial Institutions we respect, has lot’s of reservations. Cost of goods is going up, spreads are squeezed, there are lots of held to maturity assets which look to be in jeapoardy, branch expansion is rampant, competition on both price and credit standards is fierce and the economy just don’t seem to be hiring that many people. The Fed had to jigger the Z1 report in the last year by revaluing upward U.S. held “Non-Financial” assets(old bricks and mortar) by $900 billion to keep our net due foreigners below $5Trillion (It just exceeded that amount again)., and the current account deficit will accelerate as rates rise and what we have to pay accelerates. The domestic deficit is exploding and the consumer is sucking wind. If the market and/or the regulators slow the breakneck pace of credit creation previously detailed, the worst numerator (Bad Loans) is going to inexorably rise. Even if another $1.4-1.5 trillion in new mortgage credit plus corporations going berserk in capital spending were to be in the cards, there are ripplings of discontent in some of the zombie buyers in Asia. The Fed either has to keep raising rates or lose credibility and the famous “carry” will either require leverage even the prime brokers must be able to smell or will start to diminish. Two of the pillars of purchase of the four therefore look shaky. Three legged stools have a problem; two legged one’s collapse. When? Who knows? Whether-FOR CERTAIN.
The glorious days of burgeoning appraisals, magnificent cash-outs and “flipping” real estate for beginners are now turned over to home equity drawdown desperation, 0% down and no/low I/O mortgages, return to what is left of the credit card line and, finally, re-entry into lending on the most magnanimous basis by a banking system bereft of Fannie and Freddy.
The zombie buyers are not dead after all and are becoming restless. Brain death, if any is to be found, may be more domestic than foreign. All the Fed’s men and all the Fed’s horses (LIQUIDITY) have not resurrected Japan nor staved off EU recession. China and the U.S. are at the ends of their respective ropes.
CONCLUSION: OUR THESIS IS THAT THE GLOBAL FINANCIAL SYSTEM HAS UNWITTINGLY AND/OR GREEDILY GONE PAST ANY SAFE EXIT FROM A HUMONGOUS GLOBAL CREDIT BUBBLE. WHILE MALFEASANCE AND FRAUD WILL EMERGE IN THE AFTERMATH A LA LINCOLN SAVINGS AND PENN SQUARE; MUCH OF THE DAMAGE WILL HAVE BEEN DONE BY A CORPORATE/BANK/CENTRAL BANK LEADERSHIP OVERWHELMED BY A NEW, COMPLEX BREAKNECK, FINANCIALLY ENGINEERED CREDIT EXPLOSION A LA LTCM. HISTORY AND FORENSIC ACCOUNTING WILL JUDGE WHAT LEADERS WERE LARCENOUS, WHICH FRAUDULENT, WHOM WILLFULLY BLIND AND, FINALLY, THOSE OF THE EGO-DRIVEN OBLIVIOUS PERSUASION. THE COURTS AND PUBLIC OPINION WILL SORT THEM OUT!
Friday, April 08, 2005
The Demise of The Dollar
MacroMouse
THE DEMISE OF THE DOLLAR [anonymous]
The Dollar was in a panic. He had lost a lot of weight and was suffering from teeth rattling chills. He called on its old friends the Yen and the Pound to hop into bed with him to warm him up, but they refused. Then he called his newest buddy, the Euro, who was putting on weight as if he were on steroids.
“Say buddy, how about climbing in bed with me so I can warm up,” pleaded the Dollar.
“Sorry, pal,” said the Euro, “You look like you’ve got some horrible disease and I make it a policy to keep out of sick beds. Why not try a hot water bottle?”
The Dollar concluded it was time to see a physician. The doctor prescribed moderation in his eating and drinking habits, for he was consuming far more than his system could tolerate, Then he handed the patient a prescription for a hefty daily dose of taxes. The Dollar ripped it up.
“Taxes, never! Dieting never!” After all, what was life for if not to be fat and happy and lord it over the rest of the world.
Soon there came a time when he could no longer stand on his own feet and begged his old buddies for help in keeping him up.
But they were afraid that when he fell, they would collapse with him and be crushed for he was much larger than they. The only one who could possibly keep him up was the Euro who would have been happy to give him ice in the winter.
Their universal refusal for help caused him to be placed in a nursing home for failing currencies. Yet even there, he refused to take tax pills and kept consuming more than he could pay for and he became a mere skeleton of his former self. Even his bones lost weight.
Thus ended the career of the almighty Dollar; sickly, confined to bed and powerless. And when he looked around, and saw what the other currencies were doing, he wept over his lost strength. However, he tried to keep his spirits up by finding new meaning to his life as wall paper and being recycled into toilet tissue. It didn’t make him very happy but as some consolation, he still had his memories.
THE DEMISE OF THE DOLLAR [anonymous]
The Dollar was in a panic. He had lost a lot of weight and was suffering from teeth rattling chills. He called on its old friends the Yen and the Pound to hop into bed with him to warm him up, but they refused. Then he called his newest buddy, the Euro, who was putting on weight as if he were on steroids.
“Say buddy, how about climbing in bed with me so I can warm up,” pleaded the Dollar.
“Sorry, pal,” said the Euro, “You look like you’ve got some horrible disease and I make it a policy to keep out of sick beds. Why not try a hot water bottle?”
The Dollar concluded it was time to see a physician. The doctor prescribed moderation in his eating and drinking habits, for he was consuming far more than his system could tolerate, Then he handed the patient a prescription for a hefty daily dose of taxes. The Dollar ripped it up.
“Taxes, never! Dieting never!” After all, what was life for if not to be fat and happy and lord it over the rest of the world.
Soon there came a time when he could no longer stand on his own feet and begged his old buddies for help in keeping him up.
But they were afraid that when he fell, they would collapse with him and be crushed for he was much larger than they. The only one who could possibly keep him up was the Euro who would have been happy to give him ice in the winter.
Their universal refusal for help caused him to be placed in a nursing home for failing currencies. Yet even there, he refused to take tax pills and kept consuming more than he could pay for and he became a mere skeleton of his former self. Even his bones lost weight.
Thus ended the career of the almighty Dollar; sickly, confined to bed and powerless. And when he looked around, and saw what the other currencies were doing, he wept over his lost strength. However, he tried to keep his spirits up by finding new meaning to his life as wall paper and being recycled into toilet tissue. It didn’t make him very happy but as some consolation, he still had his memories.
Monday, March 28, 2005
Wednesday, March 23, 2005
Waiting For The Big Wave!
Waiting for the big wave
Katy Delay is a freelance columnist in economics and government, and maintains a blog at Link.
By all logic, this nation should be in deep water right about now. In the 1980s, wise kahunas foretold a watery day of reckoning within the following two or three decades if nothing were done to counteract the scourge of chronic inflation that has proceeded unhampered since the early 20th Century.
We all note that indeed nothing has been done. On the contrary, the waves of increasing prices haven't let up for a moment, growing at a rate of at least 2-3% a year since 1900. So, since the dollar is now falling on the international marketplace, should we begin preparing for the crashing Big Wave as predicted? History says there will be retribution in the long run; but there are at least four elements of our modern economy that might explain the stealth with which it is approaching.
One of those is the extent of the recent technology boom. The discovery of electronics is the equivalent of the wheel in its significance to the economy. Computers and high-speed communications have brought productivity not only to an all time high, but frankly to another cosmic level; and through this factor alone, general prices should have decreased several points, just as they did back in the 1800s during the industrial revolution. (By the way, contrary to popular opinion, natural, gradual price deflation enriches everyone equitably and indiscriminately, by increasing our purchasing power. As prices decrease, relative or "real" wealth – i.e. our ability to raise our standard of living and save for the future – increases.)
Yet this hasn't happened. Why? Because the expected price decreases have been offset every year by a lowering of the dollar's value through "out of thin air" credit creation and currency inflating that camouflages improper price increases. Both the wasted cost devaluation and the parallel dollar debasement can remain invisible for years – at least until people wake up, as they are beginning to do.
But you will say, "Then why doesn't the CPI (consumer price index) reflect this inflating theft properly?" This is the second reason for our Big Wave's invisibility: economic statistics are misleading and inaccurate, to the point where one wonders just how naive economists must think we are. The dirty little secret is that they have always had difficulty measuring even something as "simple" as true output, or gross domestic product (GDP); and more complicated economic variables such as what I call "IEI," for "inflating embezzlement index" (the amount of hot-air credit in our economy) remain even more elusive. Believe it or not, the experts are just estimating the figures, hoping to possess the right data to start with (like the M1 and M2 aggregates you've heard of) and praying – or in some cases assuming with the hubris typical of far too many in the scientific community – that it is not garbage in, garbage out. IEI has proven to be particularly quixotic. No economist has come anywhere near accuracy, except perhaps Edward C. Harwood of the American Institute for Economic Research; and even AIER admits to having difficulty since the 1970s, given the arduous and all but impossible underlying statistics-gathering involved.
So let's have some fun conjecturing: How much purchasing power might we really be losing on an annual basis, above the 3% the Fed has already admitted to? If our measurement of GDP were more in tune with reality, we just might find that real national wealth should have increased by something on the order of – just to take a wild guess based on the contribution of new technologies in my personal life – some 7 to 10% per year since 1980. This should bring about a lowering of CPI (remember, lowering of prices is the equivalent of an increase of the populace's wealth) of at least a few percentage points a year, say 2%, to be modest. That, added to the 3% so-called "inflation" rate we are seeing in our CPI basket of prices, makes a total of 5% a year, or 100% of our wealth confiscated over a 20 year period, at the very minimum; and that's based on these GDP estimates alone. The punch line is that no one can certify that this is incorrect. Do you suppose this is one explanation why our dollar can't get no respect these days?
A third element that may be contributing to this exquisite prolongation of our Big Wave's dénouement is that the US is perceived as a bastion of economic strength compared to every other nation in the world. We're called the "world's tallest midget." Based on that, billions of our "good-as-gold" dollars, stocks, and US bonds and assets are being held as the safest investments. To top it off, the dollar is also used as a substitute money by foreign citizens of less financially secure countries. For example, no one is really certain just how many of our dollar bills are hidden in the coffers of the likes of Saddam Hussein, or held by Russian mafiosi, ready to pay for that chalet in the Swiss alps or a mansion on the Cote d'Azur. The money simply changes hands, never returning to its berth.
More recently, however, these dollars are buying less and less, and the bonds are decreasing in worth, so our fiscal rogues and central bankers are wont to diversify. By way of illustration, a recent Columbian street gang bust turned up a suitcase full of euros. Now, this alone does not constitute a direct challenge to the dollar's esteemed status (it may simply be a reflection of evolving European drug preferences); but one thing is certain: the dollar is no longer the only game in town.
If the drug lords and OPEC are already getting skittish, what will happen when the world's central bankers decide to act upon the realization that the dollar is not as good as gold, releasing a tidal wave of currency and bonds that will head home for lack of takers? The Fed will have to get the excess cash off the American streets in order to avoid pandemonium (imagine the scene: too many greenbacks chasing too few goods, and Greenspan in pursuit at the rear) they will also have to increase Fed rates further, which may slow the American economy and force prices to move erratically. But wait: the Fed has led us to believe that they have prices under control. They will be in a quandary. I wish I could be a fly on the wall of their boardroom when it happens.
But you can't be in two places at once, so I prefer to perch under this huge wave's crest, hoping to catch another good ride when the devil's plans play out. It's sad: if only all of humanity – not just the bankers, the US government and the smart speculators – could ride at the pinnacle of this technological progress that is holding us afloat today. Instead, the usual losers will remain clustered in herds along its flanks, trying to go about their business of competing sportsmanlike for the small swells, though increasingly unnerved by the moody seas and disrupting gulps of salt water. Like our Asian friends, their short memories will not allow them to conceive of the tsunami that may be about to bowl them ashore – or maybe even tumble us all asunder.
Katy Delay is a freelance columnist in economics and government, and maintains a blog at Link.
By all logic, this nation should be in deep water right about now. In the 1980s, wise kahunas foretold a watery day of reckoning within the following two or three decades if nothing were done to counteract the scourge of chronic inflation that has proceeded unhampered since the early 20th Century.
We all note that indeed nothing has been done. On the contrary, the waves of increasing prices haven't let up for a moment, growing at a rate of at least 2-3% a year since 1900. So, since the dollar is now falling on the international marketplace, should we begin preparing for the crashing Big Wave as predicted? History says there will be retribution in the long run; but there are at least four elements of our modern economy that might explain the stealth with which it is approaching.
One of those is the extent of the recent technology boom. The discovery of electronics is the equivalent of the wheel in its significance to the economy. Computers and high-speed communications have brought productivity not only to an all time high, but frankly to another cosmic level; and through this factor alone, general prices should have decreased several points, just as they did back in the 1800s during the industrial revolution. (By the way, contrary to popular opinion, natural, gradual price deflation enriches everyone equitably and indiscriminately, by increasing our purchasing power. As prices decrease, relative or "real" wealth – i.e. our ability to raise our standard of living and save for the future – increases.)
Yet this hasn't happened. Why? Because the expected price decreases have been offset every year by a lowering of the dollar's value through "out of thin air" credit creation and currency inflating that camouflages improper price increases. Both the wasted cost devaluation and the parallel dollar debasement can remain invisible for years – at least until people wake up, as they are beginning to do.
But you will say, "Then why doesn't the CPI (consumer price index) reflect this inflating theft properly?" This is the second reason for our Big Wave's invisibility: economic statistics are misleading and inaccurate, to the point where one wonders just how naive economists must think we are. The dirty little secret is that they have always had difficulty measuring even something as "simple" as true output, or gross domestic product (GDP); and more complicated economic variables such as what I call "IEI," for "inflating embezzlement index" (the amount of hot-air credit in our economy) remain even more elusive. Believe it or not, the experts are just estimating the figures, hoping to possess the right data to start with (like the M1 and M2 aggregates you've heard of) and praying – or in some cases assuming with the hubris typical of far too many in the scientific community – that it is not garbage in, garbage out. IEI has proven to be particularly quixotic. No economist has come anywhere near accuracy, except perhaps Edward C. Harwood of the American Institute for Economic Research; and even AIER admits to having difficulty since the 1970s, given the arduous and all but impossible underlying statistics-gathering involved.
So let's have some fun conjecturing: How much purchasing power might we really be losing on an annual basis, above the 3% the Fed has already admitted to? If our measurement of GDP were more in tune with reality, we just might find that real national wealth should have increased by something on the order of – just to take a wild guess based on the contribution of new technologies in my personal life – some 7 to 10% per year since 1980. This should bring about a lowering of CPI (remember, lowering of prices is the equivalent of an increase of the populace's wealth) of at least a few percentage points a year, say 2%, to be modest. That, added to the 3% so-called "inflation" rate we are seeing in our CPI basket of prices, makes a total of 5% a year, or 100% of our wealth confiscated over a 20 year period, at the very minimum; and that's based on these GDP estimates alone. The punch line is that no one can certify that this is incorrect. Do you suppose this is one explanation why our dollar can't get no respect these days?
A third element that may be contributing to this exquisite prolongation of our Big Wave's dénouement is that the US is perceived as a bastion of economic strength compared to every other nation in the world. We're called the "world's tallest midget." Based on that, billions of our "good-as-gold" dollars, stocks, and US bonds and assets are being held as the safest investments. To top it off, the dollar is also used as a substitute money by foreign citizens of less financially secure countries. For example, no one is really certain just how many of our dollar bills are hidden in the coffers of the likes of Saddam Hussein, or held by Russian mafiosi, ready to pay for that chalet in the Swiss alps or a mansion on the Cote d'Azur. The money simply changes hands, never returning to its berth.
More recently, however, these dollars are buying less and less, and the bonds are decreasing in worth, so our fiscal rogues and central bankers are wont to diversify. By way of illustration, a recent Columbian street gang bust turned up a suitcase full of euros. Now, this alone does not constitute a direct challenge to the dollar's esteemed status (it may simply be a reflection of evolving European drug preferences); but one thing is certain: the dollar is no longer the only game in town.
If the drug lords and OPEC are already getting skittish, what will happen when the world's central bankers decide to act upon the realization that the dollar is not as good as gold, releasing a tidal wave of currency and bonds that will head home for lack of takers? The Fed will have to get the excess cash off the American streets in order to avoid pandemonium (imagine the scene: too many greenbacks chasing too few goods, and Greenspan in pursuit at the rear) they will also have to increase Fed rates further, which may slow the American economy and force prices to move erratically. But wait: the Fed has led us to believe that they have prices under control. They will be in a quandary. I wish I could be a fly on the wall of their boardroom when it happens.
But you can't be in two places at once, so I prefer to perch under this huge wave's crest, hoping to catch another good ride when the devil's plans play out. It's sad: if only all of humanity – not just the bankers, the US government and the smart speculators – could ride at the pinnacle of this technological progress that is holding us afloat today. Instead, the usual losers will remain clustered in herds along its flanks, trying to go about their business of competing sportsmanlike for the small swells, though increasingly unnerved by the moody seas and disrupting gulps of salt water. Like our Asian friends, their short memories will not allow them to conceive of the tsunami that may be about to bowl them ashore – or maybe even tumble us all asunder.
Wednesday, March 16, 2005
"Throw the Book at China!"
Throw the Book at China - Kirchner:
The IIE's Fred Bergsten says it is time the IMF and US Treasury started enforcing the rule book on China's manipulation of its exchange rate:
Fred Bergsten even goes so far as to call for IMF counter-intervention in foreign exchange markets and the erection of trade barriers under WTO auspices. This is dangerous and unnecessary in my view. But if the IMF will not enforce its own rule book, we have to ask, what is it good for?"
The IIE's Fred Bergsten says it is time the IMF and US Treasury started enforcing the rule book on China's manipulation of its exchange rate:
key industrial countries and international institutions have done virtually nothing to counter these blatant market distortions. Despite their professed fealty to market principles, the US and European governments have limited themselves to ineffectual consultations with the perpetrators. Massive currency interventions by the Asian countries directly violate the charter of the International Monetary Fund, which calls on members to avoid manipulating exchange rates in order "to prevent effective balance of payments adjustment". The chief culprit is China, whose continued dollar peg has helped weaken its currency by more than 10 per cent since 2002.
The US and the Europeans, the IMF's leading shareholders, must insist the fund start implementing its rules. This calls for the managing director to send a consultation mission to each member country suspected of "manipulation" and, if resolution is not prompt, then to refer the problem to the fund's executive board. The list of target countries should start with China. In addition, the Treasury Department must start fulfilling its legislative requirement to label these countries, most notably China, as "currency manipulators" in its next semi-annual report to Congress on the topic due later this month.
Fred Bergsten even goes so far as to call for IMF counter-intervention in foreign exchange markets and the erection of trade barriers under WTO auspices. This is dangerous and unnecessary in my view. But if the IMF will not enforce its own rule book, we have to ask, what is it good for?"
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