Black Holes & Revelations

Sean Corrigan is Chief Investment Strategist, Diapason Commodities Management, Lausanne & London.
“Glaciers melting in the dead of night/And the superstars sucked into the supermassive.”

Matthew Bellamy, Muse

“…If monetary policy has played a dominant role [in the recent benign financial conditions], the rise in inflation that has been observed recently in many countries and the likelihood of a further tightening of global monetary conditions suggest that the current episode of low interest rates and tight spreads could end quickly. This could have an adverse impact on interest rate sensitive sectors of the economy and lead to a withdrawal of liquidity from precisely those markets that have benefited the most from low interest rates.”

Malcolm Knight, BIS General Manager, June, 2007



To the casual observer, the recent behaviour of financial markets is surely a cause for wonder.

Trading volumes and M&A activity sets new records with every passing month; buy-out targets become more and more ambitious (and the leverage taken on to achieve them grows and grows); hedge funds proliferate and - no longer content to pick over such mundane assets as stocks and bonds - branch out into buying rare earth metals, art works, footballers and violins; emerging market equity indices trade on higher multiples than Western ones; US margin debt hits new records both outright and as a percentage of market cap despite a sputtering economy; equity mutual fund managers signal their endorsement of the view from the bucket shops by allowing liquid asset ratios to hit new lows.

Then there’s the increasingly bullet-proof mentality among risk takers who reacted to an emerging market fall in May 2006 by slashing positions so deeply across the board it took six months for some of them to recover the loss; who then responded to a mini-China crisis in February with not so much a flight- as a feint-to-quality that only took six weeks to shake off; and who then greeted the latest Shanghai shake-out with such a yawn that new highs had to wait less than six days from a sell off which lasted not a great deal more than six hours!

Finally, there’s the fact that emerging market and junk bond spreads, as well as CDS premiums, are hitting new lows even though the investment grade universe is tracking inexorably higher from the generationally low real and nominal yields set as recently as this year (e.g., in the case of the UK).

In fact, the key to understanding all these marvels – which are part of a wider phenomenon also made manifest in the record prices being set for drab Modernist daubings, French wines, Swiss watches, and all the other Hyper-Bling accoutrements of the nouveaux riches – and also the clue as to what may bring an end to this Bacchanalia is to be found in a careful re-reading of that last paragraph.

We say this because the great, gaudy merry-go-round to which we nowadays so precariously cling is powered by a vast surplus of credit which is being extended – not so much by banks who might, after all, be subject to some restraints on their lending activities, however notional - but by virtue of such exposures being floated off largely to an unregulated non-bank sector whose own liabilities the banks do fund, since they are theoretically fully-collateralized by the over-priced assets they have bought.

That the carousel spins so fast is because these non-bankers have also been instrumental in financing both the private equity boom and the knock-on flurry of acquisitions, spin-offs, and share buy-backs carried out by the nervous executives of vulnerable public companies. Their complicity has arisen both because the non-banks have participated actively in the LBO mania and because they have depressed yields and spreads in general (by writing ever cheaper insurance on ever more issued debt, if in no other way).

Like all good asset-collateral spirals, the volume of cash flooding into both institutional coffers and private pocket-books as a result of all this debt-based buying has left the recipients scratching around for places to re-invest their windfall and so - Hey Presto! – they have come to cultivate an avid taste for ‘alternative’ assets as replacements.

Apart from sounding impressively à la mode over the dinner table, this has meant in practice that they have rushed to buy stakes in the same private equity and hedge funds who initially relieved them of their former, more traditional holdings. Amazingly, this seems to take place in the expectation that the bought-out will enjoy greater future returns just because they have surrendered charge of their assets to the buyers-out (instead of exercising firmer shareholder control over the pre-existing management, in the first place), regardless of the damage wrought to the targets’ balance sheets and despite the eye-watering levels of fees involved in playing the game.

Thus refortified with ‘equity’ returned from those they have just borrowed to buy out, the non-banks can now go scoop up another fistful of assets, financing a hefty slice of the purchase with yet another slug of margin extended by their eager prime brokers.

Thus, the inflationary screw takes yet another turn to the cry of Come back, Signor Ponzi, all is forgiven!

To get a sense of the scale of but one aspect of all this, consider the findings of a recent Fitch Ratings survey which revealed that assets of ‘credit-oriented’ hedge fund had exceeded $300 billion as far back as 2005, since when CDS outstanding have doubled to $35 trillion, suggesting a substantial increase in the tally of those assets, too.

As the agency points out, even that sum represented a gross understatement of these funds’ influence since the typical financial leverage they employ is of the order of five to six. Moreover, on top of this figure of $1.8 trillion-and-counting, we must not forget to reckon with the extra economic leverage intrinsic to the fact that these funds also tend to concentrate their buying on the more risky tranches created much lower in the capital structure when loans are sliced, repackaged, and sold on by their originating banks.

Given that Fitch reckons that 60% of the trading volumes generated in the CDS market can be attributed to such funds, we can get a sense of the thinness of the ice upon which the whole bootstrapped edifice is being built.

But we mustn’t be too parochial here for, in addition to the internal distortions being wrought by the unholy alliance of hedge funds, LBO merchants, and prime brokers via securitization and through the use of structured products and derivatives, all of this has also brought about significant real world effects, far beyond the fairy tale realm of the financial markets themselves.

Though much of the world’s upsurge in economic activity (and the concomitant rise in commodity prices) these past five years has a genuine foundation in the modernisation of Asia and Eastern Europe, among others, there is also a large, if unquantifiable, overlay of that excessive or misplaced investment which has only arisen because the markets and the central bankers who oversee them have ensured that the real cost of financial capital has remained far too low for far too long.

Here it is that we see the first signs of danger, for, in a world which has come to define ‘risk’ as the avaricious angst that one could be missing out on a fabulous gain if one is not fully committed to the pot, the whole whirligig of financial speculation and industrial hyperactivity depends upon one thing and one thing only – non-threatening bond yields.

Here we must track back a little to set matters in context.

For well over eighteen months, it has been our view that the inflation genie has been fully let out of the bottle (taking ‘inflation’ in the misleading modern sense of a rise in a consumer price index which a central bank finds it hard to ignore) and that, as a result, we would see nominal short-term rates move successively higher, while real short-term rates lagged behind.

Then, we felt, there would be some weakness evident in some over-extended, interest-rate sensitive sector or other - and housing, thanks to the enormities of this cycle, was always a (sub) prime candidate to fulfil that role. Then, a pause for breath would ensue, that hiatus itself being taken as a sign that the next move in rates would inevitably be downwards, paradoxically setting the market up for another anticipatory move to the upside.

Absent a direct financial contagion from some parts of, e.g., the housing market (worries of which were certainly an accessory factor in the February wobble), we have also long contended that the heady mix of solid, secular and shaky, cyclical global growth would be sufficient to tide things over and would not let any material amount of slack back into the system - and that nor could it until the credit tap was further considerably tightened.

We have also argued that, due to the peculiarities of the energy market – a heady cocktail of the CB policy of ‘ex’-ing their price indices, the public ownership of oil & gas resources, and the politics of petrodollars – high fuel prices were acting as a monetary pump, not as a picket line to hobble output. Lo and behold, Brent crude is back at $70/bbl and we have been off to the races again, these past few months.

We further warned that the biofuel movement would have far-reaching effects, not just for commodity investors, but for the ordinary householder and – at length – for the central bankers anxious to keep his wards’ ‘inflation expectations contained’.

Finally, we thought that the balance of probabilities favoured a scenario where the move which broke the uneasy cease fire on rates would be up not down.

So far all of this has just about come true – though in a world riddled with self-installed vulnerabilities at every level, our fingers are still firmly crossed when we say so.

So far, the only thing missing is the next upward shift from the central banks which did go dormant, though New Zealand, for one, has gratified us. In Australia and Canada, we can see that the wider market (if not yet the monetary authority) has come round to our viewpoint, since futures are clearly pricing in such an imminent resumption. In the UK, Sweden, and the EU, too, where official rates have continued to rise, futures are, if anything marching further away from them as they do.

Ominously, too, the violent sell-off in Eurodollars has even begun to push the red months up above the funds rate and back towards a more normal premium which would signal the dispelling of the last lingering hopes of a cut. Additionally, the far end of the US curve is starting to resteepen with the differential between Fed funds and 10-year Libor, for example, moving from a negative 35bps in December (a six-year low) to an 11-month high of +48bps and, to cap it all, break-even inflation rates are also starting to move higher, not just Stateside, but in the EZ and the UK, too.

Finally, the sell-off has seen US T-notes at last break the downtrend which has capped the classic, long-term distribution built since the ’87 Crash, meaning Treasuries have joined the angry-looking charts for Bunds, Gilts, Canadas, Ozzies, et al.

Here, too, we could see another feedback come into operation – this time one far less helpful to the speculative herd – for rising long bond yields are likely to be viewed by central bankers as a sign that either their self-proclaimed anti-inflationary stance is being questioned or that the implied rate of return on capital has risen. Either way, bond yields could rise for fear of more CB tightening and the CBs could tighten more because bond yields are rising.

All it would need then would be for a little mortgage convexity to kick in, or for some other from of dynamic hedging on all that derivative product to take place, and we could see the asset-collateral spiral swirling rapidly into reverse.

If so, it is a matter of reasonable conjecture to suggest that, given the sheer mass of positioning involved – as well as the unfathomable interlinkages between its innumerable component parts - we could well see a good part of the present, self-supporting nebula of ‘liquidity’ rapidly vanish over the event horizon.

What price then the ‘global savings glut’ or the worldwide ‘asset shortage’ so beloved of US academia and how large a quota of disastrous malinvestment will be exposed once the impressive divide between the employment of means and the satisfaction of ends is no longer disguised by the anti-gravitational force of over-abundant credit?

(A version of this commentary originally appeared as part of the June monthly report for the Labarum fund)

Perpetual Cycle?

Edmund M. McCarthy is President and CEO of Financial Risk Management Advisors Company. This piece was originally published in his newsletter.

UNICYCLE, BICYCLE, CREDIT CYCLE OR PERPETUAL CYCLE?

The ridiculous starting phrase to this article above seems, to the author, in concert with the progression of what used to be known as, quite simply, the credit cycle. Put simply, business and consumers got frisky; the Fed raised rates/reserves, they got less frisky and the cycle restarted. We will refer to the bicycle as the point a couple of years ago when the Fed, consciously or unconsciously got the GSE’s in as augmentors of their interest rate cuts, liquidity expansions etc. Listening to (some) of the Fed, and (most) of the regulatory entities, it would now seem they yearn for something like the old Cycle. No Bicycle this time as the GSE’s are still mildly unable to find reliable numbers and some politicians actually think they should concentrate on median housing for those left out of the sub-prime bubble which was what they were created for in the first place.

How does a Perpetual cycle ensue if the Fed/Regulators etc. want a return to something new, but which brings about the result of the old cycle.? We have discarded the likelihood of the old cycle coming back to life after 17 Fed rate rises not only failed to stem the bubble, but a combination of either their amplification of money supply or

MORE LIKELY! A WHOLE NEW MONEY SUPPLY GENERATION CYCLIC MACHINERY INADVERTENTLY CREATED OUT OF THE U.S. PROPENSITY TO BORROW TO CONSUME FROM VIRTUALLY EVERY OTHER NATION ON EARTH.


If this is the case, there is a completely new set of players/machines at the helm! Even in the memory of some of the youngest is the parlous state of the rest of the world back in 1998. Now, in the aggregate, they have reserves over $5 Trillion. The Fed’s balance sheet of a paltry $1.8 Trillion shrinks in the shadow. The other new players, many of whom access greater or lesser parts of that $5 Trillions, the hedge funds at $1.3 Trillion (?) not including leverage, the private equity funds at much more than a trillion, depending on leverage and how you count or double count it, the mutual funds, still formidable at multi-trillions, even more if we throw in the money market funds, the investment banks having doubled into more than $3 Trillion.

All of these in the aggregate dwarf not only our fabled Fed but also the power of the rest of the central banks out there trying to realize they are operating in a different environment. (Remember though, those OTHER central banks are the guys with the $5 Trillion in reserves!). Talk about conundrum. Somewhere in here it is worth mentioning that the multiple needed to grow a dollar of GDP has moved from roughly 1-1 in the process to heading for $6 to 1 to produce the same dollar of GDP at the moment. Why and How? Credit Creation that is completely outside the traditional central bank/fractional reserve commercial bank/borrower mechanism that prevailed for such a long time.

Before getting into the details of how this phenomenon has come to pass, we would like to illustrate how fast this incredible world of non-bank credit creation is progressing. Yesterday, a financial executive I had mentioned CPDO’s to, e-mailed me asking what were CPPI’s. I had to profess ignorance and contacted a bunch of people smarter than me. I print below the amazing answer I received.

“Constant Proportion portfolio insurance (CPPI)”

Constant proportion portfolio insurance is a capital guarantee derivative security
that embeds a dynamic trading strategy in order to provide participation in the performance of a certain underlying asset. See also dynamic asset allocation. Note that the intuition behind the CPPI was adopted from the interest rate universe.

In order to be able to guarantee the capital investment, the option writer (option seller) needs to buy a zero coupon bond and use the proceeds to get the exposure he wants. While in the case of a bond + call case, the client would only get the remaining proceeds (or initial cushion) invested in an option, bought once and for all, the CPPI provides leverage through a multiplier. For example, say an investor has a $100 portfolio, a floor of $90 (price of the bond to guarantee his $100 at maturity) and a multiple of 5. Then on day 1, the writer will allocate 5 * ($100-90) = $50 to the risky asset and the remaining $50 to the riskless asset (The bond). The exposure will be changed as the asset performs and with leverage multiplied by 5 times the performance. (or vice versa). Same with the bond. These rules are predefined and agreed once and for all and for the life of the product. (All of the foregoing bad English from the writer of the definition not sender).

Two things stand out.
1. The CPPI is pretty much the same as the afore-mentioned CPDO except leverage can go up to 15x on the CPDO
2. The guys who re-invented the term portfolio insurance must have been in diapers (maybe still should be) in 1987 when portfolio insurance became a really dirty phrase!

All of this in aid of showing how complex the world of non-regulated credit creation has become. Another interesting statistic recently learned from a Financial Times article. Wall St/Hedge Funds etc. are proliferating Collateralized Debt Obligations or CDO’s. These are also fairly well known in the regulated Commercial/Investment Bank world inhabited by denizens like Citicorp. The regulated are in the Trillions. The Non-regulated-Private-Over the Counter- or basically opaque unknown CDO’s are also in the Trillions. Credit creation is truly beyond the ken of the world’s Central Banks.

How, in the opinion of the writer has all of this come to pass?
IF GIVEN THE OPPORTUNITY TO LEVERAGE WITH NO SKIN IN THE GAME (IF THE DEAL CRATERS, THE LENDER LOSES, YOU GO ON TO THE NEXT TRIUMPH/TRUMP?) AND INTEREST RATES GO TO A LEVEL WHERE THE MOST RAVENOUS OF LEVERAGE PLAERS (REAL ESTATE DEVELOPERS AND PRIVATE EQUITY, OR WHAT USED TO BE KNOWN AS LEVERAGED BUYOUT OPERATORS AFTER THEY ESCAPED THEIR PREVIOUS INVIDIOUS LABEL OF CONGLOMERATEURS) SLAVER AND DROOL , ENORMOUS AMOUNTS OF MONEY WILL BE BORROWED. THIS TIME, LOTS OF INGENIOUS DOCTORS OF PHILOSOPHY THOUGHT UP INCREDIBLE DEVICES TO BORROW OUTSIDE AS WELL AS INSIDE TRADITIONAL LENDING PARAMETERS!

When the now renowned Greenspan took interest rates to 0%, the horde was let loose. Pity the poor commercial banks and the GSE’s. They were in bad stead from the dot-com/telecom disaster and had to go into shipyard, opening the door for the Investment banks and the non-bank creations they had birthed to take off. The Brokers (Investment Banks) doubled and, as past readers know, the world of hedge funds, private equity funds, etf”s, venture capital and other non-regulated lending went wild. Since the successful, valiant effort of the hedge funds to face down the SEC on registration succeeded, there have only been estimations and gross numbers to give some idea of how much credit has been created out here in the unregulated world. In our previous missive, we came up with roughly 1½ times the amount to be found in the banking system or +/- $15 Trillion. That is only in the U.S. As we all know, numbers in much of the rest of the world are a flag of convenience rather than a certainty but that $5 Trillion in reserves from less than a trillion at the start of this run hints that the number must be at least the aggregate of the $25 Trillion combined in the U.S. before govt and agencies, if our hypotheses are anywhere in the ballpark.

All those who are research minded can go to the Bank for International Settlements website and get the numbers for the central banks scattered around the world. (Don’t put too much credence in the numbers of such worthies as Russia or China, much less Indonesia, but the sum total is truly dwarfed in any reasonable conclusion by the total non central bank balance sheets/credit out there in the non-regulated credit world. In terms of non-regulated U.S. credit (We are averse to using the word regulated even for the “commercial banks” in much of the rest of the planet) added to what we will, in the absence of the word “regulated” call “credit set loose by U.S. current account deficit,” in pools of Greed or ”CSLUSCAD” CREDIT, we have credit creation of humongous proportions. Recurrent rate raises by adventurous central banks in other parts of the world have had about the same effect in “CONTRACTING” money supply as has been the case so far in the U.S. That answer being slim to none and Slim went over the horizon.

To digress for a moment we look at the housing market in London. They raised rates there for a while and actually slightly slowed the housing bubble. Then they thought they had done enough. The creators of non-regulated credit are as ingenious (maybe more so) as the Wall St. creation machine and house prices began another precipitous ascent. They are raising rates again and house prices are going up even faster. CSLUSCAD credit is the answer to any pesky central bank that thinks it can get in the way of a Pool of Greed in full flight. Norway is sticking its neck out as the last unemployed Norwegian found two jobs and that Central bank actually thinks it should be responsible in monetary policy. Result so far, the Norwegian price index continues up led by housing prices.

A few weeks ago, we were privileged to hear a conference call by Larry Jeddlow of the TIS Group, Inc. that included slides he sent of the presentation. His thesis: “Investment Banks/Hedge Funds vs. Central Banks.” His conclusion: during the fall months, the central banks of the world were warning the CSLUSCAD crowd that they had gone too far in their headlong rush to lend; more recently (February/March) the warnings had gotten stronger. Therefore, credit/money (See the “Moneyness of Credit” by David Tice) growth was finally going to slow. There were actually a couple of mild warnings stuck in there by various Fed Presidents and Governors. Result, we have a Dow one day slide and Bernanke replays Greenspan’s 1987 performance (subtly), at least giving the CSLUSCAD crowd the “certainty” the Fed “PUT” is still in full force and effect. KKR is going to buy FirstData with no partners proving that those pesky investigators worried about collusion in the CSLUSCAD crowd are way off the mark. One possibility put forward in the aforementioned TIS Group presentation was “Property Derivatives.” While yet in their infancy, we actually found a four bank consortium writing a multi-hundred million play. Since the commercial property market dwarfs the commercial bond area that the CSLUSCAD players had run up to a reported $10 Trillion here in the U.S., the question we have been asking ourselves on where can a tens of trillions market be found to propagate the next bubble may have found an answer. Not at Sam Zell cap rates, however, as even the ridiculous spreads currently being accepted wouldn’t cut it in this proposed game. Who knows, this writer has been wrong before. If the private equity boys all go public, this kind of cash return on stocks is more the norm than the exception.

Continues at a frantic pace. The 4th Quarter Federal Reserve Z1 report is another clear indication that debt growth in the U.S continues at a frantic pace. Total Credit Market Borrowings running at an annualized rate of $3,567,000,000,000 (That is what it looks like in numbers instead of abbreviated Trillions. The admittedly slowing housing market cut back mortgage credit by several hundred billion but the U.S. CSLUSCAD more than made up the difference. (A decision on how to pronounce this newly created acronym is to leave the first S silent thus producing CLOOSCAD for anyone who wants to adopt it.)

What, if anything, will slow, halt or reverse this juggernaut (old name for battleship)? This observer, guided by mentors such as Doug Noland has resisted premature pronouncement of the end but is willing to hypothesize as such can always be dismissed as musings rather than predictions.

We are willing to agree with some rather astute financial analysts who have recently observed that the Credit Cycle (old version) has turned. The 1stData deal says the CSLUSCAD bunch are still at it. It is fairly evident from the slaughter in the world of sub-prime that the most egregious of “throughput” credit created by the alchemists on the Street has struck both the rock and the hard place. Early on the “throughput” crowd looked as though they might provide their own version of the Greenspan “Put” for this, their offspring but the wizened regulated banks seemed to have pulled that plug. Bubblevision or CNBC was just this morning babbling on about danger in the Alt A arena. M&T bank that thought it had found a niche there is looking at a New Century like hit for the day.

Another astute analyst we follow is fairly certain of a 2008 recession. Again, we are in agreement, at least for the United States. Happening to live in a state with the 2nd most ridiculous run-up in house prices over the last few years (California taking the crown in that race), we were perusing what goes for a local paper these days this morning. Even forewarned by our bear persuasion, we were still stunned by some data therein. Miami/Dade residents at the peak in 2005 extracted over 17% of their income from either home equity facilities or refinance/cashout mortgages. It was still running at 14.5% in the fourth quarter of 2006. While the average for the country peaked at about 10% in 2005 (Over $1 Trillion AND IS STILL HANGING IN THE 8.5% RANGE, ABOUT $900 BILLION+, THE PROFLIGACY IN south Florida has been amazing. With Chavez sending us floods of Venezuelans and the euro sending plenty of buyers from those countries, the real estate boom is lasting longer than anyone expected. Sign that the cycle has turned in the region, however, houses listed for sale doubled in the last year. One condo with 10 foot barbed wire fence ¾ of the way up 40 stories. Razor wire on top and dilapidated sign saying “All permits in place, for sale as is”. 48 cranes on the horizon in the Biscayne corridor. The ultimate end of the cycle will not be pretty.
Have an immediate relative who has found a nice business in the Florida keys. It isn’t worth it to an attorney in Key West to spend a day and 350 miles filing a chapter in Miami. Better to introduce the client to an attorney from Miami who can spend a day and file in a bunch. Business is booming. The papers are full of cruise ship ads offering deals. Like airlines, cruise ship guys have to order way in advance and capacity can quickly exceed demand. Even got an upgrade on a recent flight packed last year with spring-breakers. All this anecdotal.

Facts: C&I loan growth peaked at over 15% in mid 2006; now at 12.9%. Quarterly change in C&I loans March 2006-up $46 Billion, September $24 Billion. Mortgages in 2005, over $1.4 Trillion, 2006, just over $ 1 trillion. So, both consumer and C&I seem to have peaked. CRE is a subset of C&I and usually worse than C&I overall, both in the excesses and the whiplash when the cycle turns. Think about it; if the mortgage game based on refi/cashout and home equity lending really turns, a trillion could come out of income. Extreme to this generation’s thinkers but not beyond the realm of possibility. Home equity lending in the first quarter as measured by Asset Backed Securities issuance, is down some 35% so far this year. Conundrum: Year to date CDO issuance is running 38% ahead of last year.

WHAT ARE THEY PUTTING IN THESE THINGS AND WHO IS BUYING THEM AT THIS POINT IN THE CREDIT CYCLE? THE CSLUSCAD BOYS REALLY HAVE IMAGINATION!


All right, some data points which to this observer says the “old” credit cycle has turned. The conventional, regulated lenders are getting whatever mixed message the Fed less Bernanke seem to be sending out and the OCC is pretty clear that, particularly in CRE where they have been before, they want to dampen enthusiasm.

SO!THE ONE NECESSARY INGREDIENT FOR A CONTRACTION IN CREDIT(MONEY) CREATION IS STARTING TO HAPPEN IN THE REGULATED, CONVENTIONAL CREDIT CREATION MECHANISMS. !EXPLAIN THE 38% YEAR OVER YEAR GROWTH IN CDO’S! !EXPLAIN THE FIRST DATA ACQUISITION WITH THE CHUTZPAH TO GO IT ALONE ON KKR’S PART? THE ONE NECESSARY INGREDIENT THAT WE FORGOT TO MENTION ABOVE IS FEAR AND THAT IS OBVIOUSLY STARTING TO BUILD IN THE REGULATED, CONVENTIONAL CREDIT CREATORS BUT THE CSLUSCAD BOYS ARE APPARENTLY FEARLESS!

While our observations are agreeing with the TIS Group that the central banks around the globe and that the U.S. regulators (At least some of them) are starting to think that a dose of caution may need to be administered; is there a mechanism in place to enforce it with the CSLUSCAD gang?

At least so far in 2007, they seem to be ignoring any warnings. I am grateful to Doug Noland for having captured the following from the last week illustrating this.

1. Global debt issuance rose to $1.73 Trillion in the 1st quarter
2. Global mergers and acquisitions reached $1.130 Trillion, the busiest 1st quarter on record. The boom, driven by buy-out fever etc. rose 14% from the previous year’s record.
3. U.S. merger activity surged 21% in value year over year in the 1st quarter.
4. 1st quarter merger activity in the U.S. totaled $428 billion up from 2006’s record $352 billion.
5. U.S. companies sold $38.6 billion in high yield in the quarter, up from $29 billion the previous year.

NONE OF THE ABOVE SUGGESTS ANY FEAR OF CENTRAL BANKS IN THE CSLUSCAD GANG IN THE QUARTER AND, UNTIL SOMETHING OR SOME EVENT INSTILLS SOME FEAR INTO THIS TOTALLY FREE TO ROAM PARTY OF HIGH ROLLING DEAL MAKERS DRIVEN BY FEE INCOME AND BONUSES SUFFICIENT TO LEAD TO BELIEF IN INVINCIBILITY, LIQUIDITY/MONEY/WAMPUM OR WHATEVER THE ECONOMISTS WANT TO CALL IT WILL GROW AT THE 12% RATE IN THE U.S..; THE TEENS RATE IN EUROPE AND THE RIDICULOUS 20’S, 30’S AND EVEN 40 % RATES SEEN THROUGHOUT THE GLOBE.

Will inflation grow? According to John Williams of Shadow Government statistics, it already is in double figures. With rents being the owner equivalent rental income input for the Commerce Dept. it is even growing in the official statistics. Will the Fed raise rates to stop it? Who cares, we are funded in yen anyhow, so the long end of the curve is dependent on the Japanese Central Bank, a pillar of strength. Will a recession occur? Almost certainly and it will truly be a CONUNDRUM for Helicopter Ben as any cut while “Old Europe” continues to raise rates may avalanche the dollar. Sad to say, to use the Oriental sense of the word. “We live in interesting times!”

The Short Selling Bear...

Who Would Believe
by Doug Wakefield

Doug Wakefield is the president of Best Minds, Inc., a Registered Investment Advisor, and editor of the monthly newsletter The Investors Mind: Anticipating Trends through the Lens of History and author of Riders on the Storm: Short Selling in Contrary Winds. The following article was co-written with Ben Hill.


On January 2nd of 1900, the Dow Jones Industrial Average closed at 68. If you had told those living at that time that in one generation Americans would be driving automobiles and that the world would be looking back on a war in which the Allied Forces consumed 12,000 barrels of oil a day, who would have believed you? On September 3rd of 1929, the Dow closed at 381. If you had told those living at that time that on July 6th of 1932, the Dow would close at 44 – lower than its value on January 2nd of 1900 – who would have believed you?

After hitting 991 in January of 1966, thirteen years later, in August of 1979, the Dow closed at 885, and Business Week wrote a piece titled, “The Death of Equities.” If you had told those living at that time that the next generation would be surfing the web from their personal computers, who would have believed you? Who would have believed that median US home prices would go from $64,000, in 1979, to $257,000, in March of 2006?

On February 20th, 2007, the Dow closed at an all time high of 12,786. One week later, the Dow saw its worst one-day loss in 7 years (outside of 9/11). So, was February 27th a worldwide wakeup call for investors or just one more bump on the road to higher markets? While we wait to see what happens, we must contend with the fact that, collectively, we have a poor track record of foreseeing substantial changes in the future. Time and again, history shows the circumstances that have led to manias and the attendant aftermath of these episodes. In fact, the record is so replete, that we must consider how large of a role denial has played in financial history. The headlines and media coverage after Tuesday, February 27th, only serve to exemplify this trend.

In 2005, I dedicated five months to a topic that I think will be a historically significant in the near future and in generations to come. Though it has been around since the 1640s, little has been written on this topic. And, while many institutional players have had access to this tool through the hedge fund world, few people actually understand its value to investors. The topic? Short selling.

As recent events have caused some to consider the possibility that markets have a downside, I’ve decided to take this opportunity to revisit one of the managers that I interviewed for Riders on the Storm: Short Selling in Contrary Winds. As attested to by the Strunk Short Index, Robert B. Lang, Chairman and CEO of Lang Asset Management, is one of seven dedicated short-only managers in the US at this time.

I recently had the opportunity to ask Mr. Lang the following three questions:

Doug – Bob, dedicated short-sellers are extremely rare in our financial markets. Can you share some of your background and perhaps some of the experiences that led you to establish a short-only strategy?

Bob – I started in the business in 1959, have managed portfolios since 1964, and started my own firm in 1980.

I remember when the markets were bottoming in the mid 70s… I remember calling prospects and telling them P/E (price-to-earnings) ratios were down to 7 or 8, dividend yields were better than 6 percent, and that the market had likely bottomed so I thought it was a good time to start buying. There was absolutely no interest. Most people responded with something to the effect of, “I don’t want to touch the stock market. All its good for is losing people money.” Well, times have certainly changed.

Though, I have historically operated on the long side of the markets, during the latter part of the 1990s, I could tell that the activities on Wall Street were becoming much more speculative. Security analysts were no longer performing their traditional roles as independent thinkers. They would just take the information given to them by the companies they covered and parrot it. Also, since they had been given a boatload of options, many corporate executives were primarily interested in hyping their stock by making overly-optimistic predictions. To boost performances, mutual funds acted in ways that were not in the best interest of their fundholders. In short, Wall Street lost its way in a bullish tsunami. Since I had experienced multiple investment cycles and had witnessed how investors swing from greed to fear, it became apparent that a significant opportunity was developing for contrarians. That is, it was time to move to the short side of the markets.

Of course, since we are all products of our experience, and since most participants have only experienced stocks going up, a bearish view was, and is, extremely unpopular. Only a handful of investors understand the bigger picture. Stocks are subject to cycles.That is why long-term cycles occur.That is, one generation grows up with the understanding that stocks always rise. Finally, the market declines and a lot of people get hurt and the next generation look at stocks with contempt. So unless an individual investor is made aware of this pattern, they are inclined to go along with the current prevailing opinion. After the fact, that is once a decline unfolds, that decline becomes obvious in hindsight. But until then, most find it extremely difficult to “fight the crowd.”

Doug – Since most investors have no experience with short selling, can you give us some basic lessons on how short selling works?

Bob – Most investors buy stocks hoping that the price will rise.But short sellers, like Lang Asset Management, Inc, anticipate making a profit from declining prices.Expecting a drop in price, we sell the stock, and buy it back later at a lower price. The difference is our profit.
The natural question is: how can you sell a stock that you do not own?When you sell a stock short, the broker lends you the shares from a buyer, who previously approved such an arrangement.Later, when you buy the stock back (otherwise called covering), the broker returns the shares to the buyer, and all is settled.For example, you believe XYZ Corporation stock price is too high, so you instruct your broker to sell short 100 shares at $50. The broker borrows 100 shares from another account and “delivers” them to you, the short seller. As a short seller, you immediately sell the borrowed 100 shares at $50 per share, and $5,000, the proceeds from the sale, is credited to your account. If the stock were to fall to $30 a share, you might then decide to buy the 100 shares you borrowed back for a total of $3,000. You return the borrowed shares to the broker, and you make a $2,000 profit.

Of course the stock may go up instead of down. Suppose it goes to $60, and you decide to purchase in order to minimize your losses.You buy the shares back, and you have lost $1,000 ($5000-$6000). The net result is not all that different from a situation where you had bought the stock at $60 and watched it decline to $50.
Unless the broker “calls” the stock back because he must return the borrowed shares to the owner for some reason, there is no limit on the amount of time you may remain short. But, having a stock called away is a highly unusual situation which usually only occurs with stocks that have a low level of liquidity.There are a few stocks that the broker cannot obtain, and in such cases, you may not short that particular stock.

There are only a very few pure short sellers, probably measured in the single digits, versus many thousands of mutual funds and hedge funds.In my opinion, this endeavor requires a special aptitude, which is not easily transferable from the long side (without considerable experience).

Doug – How does the client benefit?

Bob – The same way one benefits if a stock rises. Most investors buy stocks hoping they will increase. The short seller makes a profit when the stock declines.When an overvalued market turns down, by definition most stocks decline, and portfolios that are short, increase in value. So, not only does the client not lose money, but by implementing this “hedging” strategy, he or she actually profits.Typically, as a measure of diversification, short selling is only done with a portion of a client's total assets.

Doug – Bob, I’d just like to thank you for taking the time to share your experience and knowledge with us today.
Unfortunately, millions of investors will never heed the words of Bob Lang or an article like this one. They continue to see warnings in their everyday lives, but take comfort in the fact that their friends and advisors are all doing the same thing. They ignore reality and trust theories that have worked well (for the last 3 decades) in an ever-expanding sea of credit. So why do most individuals, maybe even those reading this article, never take steps to protect their capital from a bear market?
In answering this question, I turn to a professor of geology at UCLA. As an evolutionary biologist, biogeographer, and Pulitzer Prize winning author, Dr. Jared Diamond addresses the “it can’t break” mindset in a story about individuals who live below a dam.

According to Diamond, attitude pollsters ask people who live downstream from the dam how concerned they are about the possibility of the dam bursting. Naturally, those that live further away from the dam are less concerned about the dam breaking that those that live closer to it. But shockingly, from a few miles below the dam, where one would assume the fear would be the greatest, as we approach the dam, the concern about the dam breaking falls off to zero. Why? Diamond notes that those that live closest to the dam, who are sure to drown if the dam breaks, must believe that the dam couldn’t break in order to preserve their own sanity. This ability to suppress or deny thoughts that cause us great pain is known as psychological denial. Diamond suggests that this behavior, common to individuals, could apply to groups as well.
The only way that investors will be able to take constructive financial steps before this credit cycle contracts, is to step outside of the powerful forces of the herd. From here, they can begin to address the unpleasant reality of that which is currently unfoldingand how we got here. Denial will only lead to unnecessary losses and increased pain.

Derivatives Bring Drama to Davos...

Derivatives bring drama to Davos
By Gillian Tett

Published: February 1 2007 02:00 | Last updated: February 1 2007 02:00

As Stephen Roach, chief economist at Morgan Stan-ley, moved around the debates on the world economy in Davos last week, he admitted that some of the discussions were distinctly bland. With the world economy growing steadily, de-bates about big economic themes lacked real drama.

However, in one area there was a raging debate: the role that the fast-growing derivatives sector may, or may not, be playing in distorting the cost of credit.

"We have just had a pretty lively discussion," Mr Roach said at a lunch to examine derivatives, attended by senior policy officials, economists and financiers. "In fact, this has probably been the fiercest argument I have had in Davos."

A cynic may suggest this reflects the fact that the global economy is so benign that policymakers now have the "luxury" of worrying about financial markets and esoteric instruments, as John Lipsky, the first managing director of the Internal Monetary Fund, put it.

Nevertheless, the focus on structured products does mark something of a departure for the Davos group, given that these issues have generally been ignored in previous years. The public and private meetings re-vealed sharp disagreement about three key points.

The first is whether regulators needed to worry about the fact that the structured finance and derivatives world is often opaque, particularly given the dominant role of unregulated hedge funds.

Optimists say this lack of transparency need not matter, since counterparties handling derivatives - such as investment banks - have a high incentive to monitor risks.

After all, as Andrew Crockett, now president of JPMorgan International and former head of the Bank for International Settlements, pointed out, investment banks do not want to suffer devastating losses.

However, pessimists poin-ted out that these banks were competing with one another to win business. Consequently, some banks "could be facing pressure to let their standards slip", as one regulator said.

Worse, the competitive climate may mean that banks lack the tools and the time correctly to monitor hedge funds - particularly since the instruments these funds are using can be opaque. That "makes it hard to see how much leverage is in the system", one policymaker said.

A second point of debate concerned the degree to which new products are dispersing risk across the financial system. In theory, senior officials pointed out, the proliferation of structured products should mean that credit risks were spread across a host of investors. Since this enabled investors to diversify their own risks, credit shocks could be absorbed easily.

But some policymakers suspect that banks might be re-acquiring risk via the back door because their investment arms are buying repackaged risk products or lending to hedge funds. "Banks have offloaded so many of their risks through hedge funds," said Michael Klein, co-head of investment banking at Citigroup. "But hedge funds have given some of this risk back."

While risk dispersal has helped the system weather shocks so far this decade, some policymakers fear that if a really big crisis were to hit, this dispersal might create a "contagion" effect. That could make a crisis worse, one regulator said.

But the third, related issue was how regulators should respond. Some observers said that policymakers needed to impose more oversight on hedge funds, private equity groups and over-the-counter markets. But others argued that this would be undesirable and impractical.

Meanwhile, the issue of legal authority poses a dilemma, as Stanley Fischer, governor of Israel's central bank, noted. For while banks such as the US Federal Reserve managed to quell the crisis at Long Term Capital Management in 1998, markets are now so international in scale that they cannot easily be controlled by any single authority. That made it hard to gather data in the short term but it also made unclear who had res-ponsibility for the system in a crisis, Mr Fischer said.

Policymakers are trying to deal with this in the Financial Stability Forum, a committee attached to the BIS.

"Every second month we meet in Basel and that is something which creates comfort for us," Jean- Claude Trichet, head of the European Central Bank, said.

One key point on which there was consensus was that more needed to be done.

Howard Davies, former head of the Financial Services Authority and now an academic, said: "We all know that the reality of the financial markets is that risk is being parcelled up and paced around. But international regulatory architecture is still organised as if the world had not changed. As a result, we have a regulatory architecture designed for a bygone age."

The Private Lives of Hedge Funds

The Private Lives of Hedge Funds
By JENNY ANDERSON
December 29, 2006

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

by Katy Delay

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

Katy Delay is a freelance columnist in economics and government, and maintains a blog at www.sybilstar.blogspot.com

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Melodramatic? Maybe. But only maybe.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Autumn Chills the Goldilocks Economy

Autumn Chills the Goldilocks Economy
by Max Fraad Wolff

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

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

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

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

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

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

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

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

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

China's Pegging - Mercantilism Plus

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

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

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

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

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

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

As described in this article at Breitbart:

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

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

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

The New World of Over-Demand and Under-Supply

Towards Energy Autarky

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

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

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

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

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

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

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

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

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

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

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

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

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

Is Japan’s Past Our Future?

Is Japan’s past our future?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Putting the Risk Back into Emerging Markets

Stephen Roach

A Monetary Policy Double Standard

Tim Iacono