Mis-Allocated Resources

Lest we forget, one of the reasons that the financial crisis is having such a deep impact on America's economy is the lack of underlying vigor in that very economy. Make no mistake, the immediate issues relate to growing government debt, sky-high consumer debt, and the breakdown of the financial system. But would we have piled up so much debt if economic growth had been greater? Would US trade have been so imbalanced if we had had goods and services to provide that the rest of the world wanted? Would we face such a low probability of ever paying American's debts (approaching zero now) if our economy were more competitive?

One of the issues brought to the fore by the present financial crisis is the extent to which America's productive capacity has been hollowed out. Now there is no doubt that the US cannot compete against the titans of East Asia.

The US needs to fix these problems, but how? Let's look at how we got into this mess. A lot of ink has been written on the immediate financial crisis, but there is more involved than that.

Bubble after bubble has resulted in wasting this country's productive effort on assets that it doesn't need. Houses, shopping malls, internet concept stocks -- all were bubbles that wasted billions of dollars that could have funded productive, forward-looking activities. And yet there was little competition for those dollars, because little thought went into preparing the US for the future. Even as we watched the world changing around us, economic issue after economic issue was ignored while the nation blindly stumbled its way into indebtedness and obsolescence.

Yes, we have idly watched the world changing around us. First, the bombed-out industries of Europe and Japan caught up and then surpassed the US in many areas. Then undeveloped countries like China and the former European colonies caught fire and started on the path to development. If the emerging markets are developing basic industries that produce the same goods that US can produce, but at a fraction of the input costs, you know that the US has a serious challenge. US industries tried to adapt, but eventually even high tech industries migrated overseas. Emerging economies out-competed the US in autos, textiles, electronics, and other industries on which we once depended.

Once, you would have expected the US to respond to a changing world by maturing its economy to another level, either undercutting its competitors in established markets or using its technological and educational resources to innovate and develop products and markets. After World War II the US had a tremendous lead in technology, industrial capacity, research and development, and education to serve as the basis innovation.

But the US let its supposedly enduring advantages erode away. Policy focused instead on keeping Americans happy and comfortable, and not on preparing for the future. In recognition of this new role for the citizenry, we decided to refer to ourselves as "consumers" rather than as "citizens". Consumers let themselves be lulled into a false sense of security. When economic challenges arose overseas, consumers responded to an eroding standard of living first with two-job families, and then by accumulating debt.

Divisive politics fanned fears and kept voters' attention focused away from the real challenges facing the country. Concerns with debt, both personal and national, were scorned as old-fashioned. Serious coordination of economic growth was viewed as too "socialist" for a country like America. Laissez-faire doctrine ran unchecked and landed us where we are today, the victims and perpetrators of a financial crisis.

Along the way, no serious thought was given to building a long-term foundation for a growing and competitive economy. Our industrial capabilities aged and dwindled. American innovations were exploited to the advantage of nations with nimbler businesses, cheaper labor, and access to capital markets that now serve the entire world. New US growth went into service industries that fed the consumer and left the US uncompetitive.

Now that the US is saddled with growing debt loads, an uncompetitive economy leaves few alternatives for responding to the crisis. Building a competitive nation takes a long time.
Of course, the thought of investing for the future is futile now, because we cannot afford the investment. Few can afford advanced education, and the technological lead is gradually moving more overseas. If the US is becoming a banana republic economically, it is also falling toward the lower tiers in science, engineering, education, and health -- all of the things we need to build up our human resources.

Beyond the obvious low interest rates that prompted all the borrowing and the asset bubbles, what kind of errors contributed to this situation? Some are on the front pages, but others are not. Let's see . . .

Students were motivated to study for MBA and became little managers. No one wanted to be a scientist or engineer. No one wanted to do real work. No one wanted to develop new knowledge or apply knowledge to innovate new products.

What about all of the effort devoted to building bigger and bigger houses? Who really needs all of that space? Prudence was left by the wayside when people engage in consumption arms races with their neighors. Vanity and lack of regard for the future drove people to live at the edge of affordability and risk going over the edge, which many eventually did.

What could we have done with all of the resources that went into building unneeded housing space? If we had spend the money on other activities, we could have bought infrastructure, an educated work force, research and development, or modern production systems. All would have made us more competitive and furthered future growth.

It wasn't just housing. A consumer society needs lots of stores, and retail companies waged their own arms race in expanding the available shopping space. Why did the US need so much more retail space than other countries need? Was it because the citizen needed to be distracted from political reality by a fantasy world? A recent New York Times article cites the book Retrofitting Suburbia that the US had 20 square feet per capita of retail space in 2003, while the next largest amount was 13 square feet for Canada. Sweden had only 3 square feet per capita. Did we really need so much retail space? Much of it is sitting vacant now. What if we had allocated the economic resources not to the unneeded houses and shops, but rather to the activites that I mentioned earlier -- infrastructure, an educated work force, research and development, or modern production systems? Maybe we would be more productive and able to pay our bills. All it would have taken was a little thought for the future and less political exploitation of the citizenry.

Many laissez-faire extremists say that Government has no role in making such decisions. Let the markets decide, they say, and you are a Communist if you disagree. Well, there are no historical data to support their extreme position, and we now see what lies those deluded extremists told. We see what hate they fomented to distract the electorate and hold onto their power. Sure, we need individual initiative in the economy, but it is now obvious that some government coordinating role is absolutely necessary. Unfortunately, whatever the way forward, it will be a long time before America digs itself out of the debt hole.

The Yuan Takes a Step Forward

It didn't make much of a ripple in the news at the time, but a couple of weeks ago Chinese regulators approved HSBC and Bank of East Asia as the first foreign banks to sell yuan-denominated bonds in Hong Kong.

A spokesman for HSBC China characterized sales of yuan bonds as provding a benchmark that other banks can use for yuan trade settlement, and a spokesman for Standard Chartered in Hong Kong said that the move will promote yuan liquidity. Benchmarks and liquidity will support China's goal to increase the use of the yuan for trade and investment, and to reduce risks of dependency on the US dollar.

As reported on Bloomberg, China announced a pilot project on April 8 to allow international trade settlement in the yuan in Shanghai and four cities in Guangdong province. Although Hong Kong's official currency is the Hong Kong dollar, bank deposits denominated in yuan have been accepted in the city since 2004.

If the process continues, China will eventually establish the enviable position of routinely settling international trades in yuan. Readily pricing trade goods in yuan would reduce China's need to maintain a narrow band on the exchange rate with the US dollar.

While the ability to sell yuan bonds in Hong Kong is hardly the same as making the yuan freely convertible to other currencies, it is a step in that direction. Given the rapid economic growth of China, it seems only a matter of time until the yuan is established as a major international currency. Such an event would be another step in the gradual but inexorable process of lessening the world's dependence on the US dollar as the common unit for pricing in international trade.

Over time, that will mean yet greater erosion in the premium that international banks and traders place on holding dollars -- i.e., more dollar weakness and a decline in American influence relative to developing countries like China.

Marc Faber's Latest Advice

It's always fun to read "Dr Doom" Marc Faber's investment thoughts, although it is not always clear if he is being serious or just trying to attract attention with extremely bearish views. Witness his recent Bloomberg interview in which he predicted that the US is doomed to hyperinflation on the order of Zimbabwe's.

Faber's most recent subscriber newsletter avoids mentioning the hyperinflationary extremes of Zimbabwe, but it is still negative on the US in the long term. In a story on FT.com/Alphaville, blogger Gwen Robinson summarized a few points from Faber's recent subscription newsletter.

After the recent rapid advance of stocks worlwide, Fabers sees them in the short term as either moving sideways or mildly correcting, although he does not expect the downside in the advanced markets to exceed the lows of last March, or the lows in emerging markets to exceed the lows of late last year. Although he likes neither the US dollar nor Treasury bonds long-term, in the short-term Faber sees both as oversold and due for a rebound. Both should rebound as safe-haven plays if the stock market corrects in the near term.

Faber hedged his short-term views of stocks, however. He cited insider selling and the net issuance of shares as reasons to avoid stocks right now, but because so many money managers have missed the spring stock rally, Faber believes that they “could lose their patience and their sudden rush into long positions could lead to another stock market upside explosion.”

Faber's longer-term views are less equivocal. Because he still sees the US fiscal deficit as posing a risk of accelerating inflation in the next few years, he advises as follows:

1. Shift from US dollars into Canadian and Asian currencies.


2. Keep accumulating precious metals.


3. Move out of US government bonds in favor of commodities, commodity-related companies, and hard assets in general.

This viewpoint (declining US, bond bear) is becoming more prevalent these days. You might think of that as a contrary indicator, but just because it is becoming more prevalent, doesn't mean it is wrong. Faber has been dismissed as "Dr Doom", but sometimes a bearish strategy is an appropriate stance. Is it a prudent course of action now, given the facts available to us?

SEC Sues Angelo Mozilo

The government is finally going after the most prominent of the senior executive fraudsters responsible for the subprime mortgage crisis. The SEC has filed a civil suit against former Countrywide CEO Angelo Mozilo, plus his former CFO and COO, for allegedly profiting personally while keeping the home lender’s deteriorating finances from the public as the subprime mortgage crisis unfolded.

Readers will remember that stockholders and employees suffered when Countrywide's finances and stock price deteriorated to the point that it had to be acquired by Bank of America. Pension funds, investment banks, and other holders of securitized mortgages originated by Countrywide also suffered when the risks of those mortgages became known. Everyone has suffered from the resulting credit crisis.

According to Bloomberg , the SEC said that while publicly reassuring investors about the quality of his loans, Mozilo issued “dire” internal warnings and engaged in insider trading accelerating stock sales, profiting by $140 million. Penalties sought by the SEC include fines and forfeiture of profits.

Everyone hates Mozilo for his arrogance, but there is apparently good evidence of his willful wrongdoing. An internal email described a “particularly profitable subprime product as ‘toxic.’” He also wrote that Countrywide was “flying blind” and had “no way” to determine the risks of some adjustable-rate mortgages, the SEC said. The SEC's suit plainly says: “Each of the defendants was aware, but failed to disclose, that Countrywide’s current business model was unsustainable.”

We can only hope that criminal charges are not far off.

Retail Sales Fell "Unexpectedly" in April

Retail sales are like other economic statistics in having too much variability to base conclusions on the month-to-month changes. In fact, thanks to financial deleveraging, the economy contracting is so strongly that the monthly numbers aren't even news.

Not to be daunted by the obvious, the media felt compelled to perform their mindless monthly ritual, adding no economic value to the data -- witness this pointless headline from Bloomberg today: U.S. Economy: Retail Sales Unexpectedly Fell in April.

Retail sales fell unexpectedly? On which planet? Who was expecting increased retail sales when more people lost their jobs in April? When more families lost their homes? When there are five unemployed people for every job opening? When Chrysler is in bankruptcy and GM is about to go bankrupt? Well, Bloomberg must believe it, because they repeated it in the body of the report:

Retail sales in the U.S. unexpectedly dropped in April for a second month, indicating that rising unemployment is prompting consumers to conserve cash.

Maybe Bloomberg just likes to emphasize the redundancy of this kind of non-news, because they contradicted themselves in the same report, admitting what everyone (including the "experts") already knows -- that consumer spending is dead and will remain that way for a long time:

Fewer jobs, falling home values and the biggest loss of household wealth on record may limit consumers’ ability to spend for years, analysts said.

If anyone has an income, he or she is saving as much of it as possible, because consumers have caught on that the bubble-induced good-old-days are gone. They have too much debt to deleverage, and their expectations for the future are greatly reduced. When the US returns to positive economic growth, it won't be at the rates that everyone came to take for granted. You can bet that consumer spending will be reduced "for years".

Too bad for the malls, because this nation is over-built with retail space that can't be supported any more. Look for retail occupancy rates to continue shrinking.

On the bright side, investors can think about which retailers will survive, how they will tighten their operations, and when they might start growing their businesses again. When economic activity has reached bottom, retailers will start to show positive year-over-year sales comparisons. If valuations are low enough then, maybe people will even start to think about buying the retail stocks ... that is, if would-be investors have saved enough money to afford more than putting food on their tables.

Why a Flu Pandemic Is Disruptive

As we have said in an earlier post, an influenza pandemic has the potential for disrupting the critical infrastructure of our society, such as health care, utilities, and public safety. Any disruption to these essential services can make everyday life more difficult, disrupt our businesses, create additional health risks, and reinforce the economic downturn.

Why would critical infrastructure be threatened? A pandemic could potentially be disruptive because it has the potential to sicken so many of the essential personnel responsible for our critical infrastructure -- as well as the rest of us. The Homeland Security Council has made it very plain that the effect on workplace absenteeism could be severe throughout society:

There will be up to 40% workplace absenteeism at the peak of the pandemic in any given community -- National Strategy for Pandemic Influenza

In our highly interconnected world, many factors will combine to keep people out of the workplace:

1. Up to 1/3 of the workforce can be expected to be sick over the course of the pandemic (which will come in waves); some will die


2. Some who are well will stay home to care for sick family members (most healthcare will be supportive care)


3. Government and workplace policies to control the spread of the disease will keep others home


4. As the pandemic worsens, fear will keep others home


5. Persons exposed to the disease may be quarantined, even if they are not sick


6. If schools are closed, some will stay home to care for children


7. Official disease containment measures could limit commerce further: Non-essential businesses may be closed, and non-essential workers furloughed


8. Border crossings could be limited, thus limiting the availability of parts and materials needed by industry, as well as limiting access to customers in other countries


9. Effects will multiply as supply chains are disrupted. One business's closure will have a domino effect on its customers, its customers' customers, etc.

In today's highly interconnected world, a worsening in any of these factors will act on other parts of society to create even greater friction to the normal working of society. With all these interactions, perhaps it is plausible that the cumulative effect could reach the 40% absenteeism estimated in the National Strategy for Pandemic Influenza. If that happens, we will all need to be very well prepared.