No Exit

Not the financial Terminators, we hope

Mr Bernanke's Testimony. In Congressional testimony last week, Federal Reserve Chairman Ben Bernanke tried to put to rest the widespread concerns that the Fed has no "exit strategy" from the unprecedented degree of monetary easing and fiscal stimulus currently underway. Many commentators seem greatly relieved by the Chairman's testimony, which identified many of the monetary tightening mechanisms in the Fed's arsenal. Others were not impressed.

The Fed's Tightening Mechanisms. The Fed's inventory of assets includes short-term Treasury bills, which it can sell in order to soak up excess any excess liquidity in the hands of the public and thereby reduce inflationary pressures. The Fed can also encourage banks to hold excess funds (and not loan them to the public) by raising the interest rate that it offers member banks on overnight deposits. These kinds of tightening mechanisms are well known, and it is remarkable that so many observers seemed to be reassured by the Chairman's testimony.

Near-Term Deflationary Pressures. It is true that there is little apparent risk of inflation in the US in the near term. Deflationary forces are likely to persist for some months, or longer, for many reasons. Levels of debt are very high and money entering the financial system is being used for deleveraging and not for real economic activity. Overseas holders of US Treasuries are interested in supporting their own economies by keeping their currencies low relative to the dollar, so as to encourage exports. Debtors are defaulting in increasing numbers, and levels of economic activity are still declining.

Disciples of Bush asleep at the switch again!

Long-Term Debt Problems. Despite the near-term comfort, there are very real long-term risks. The off-balance sheet obligations of Medicare, Medicaid, Social Security, and other programs are huge and growing. The US shows little political will to prevent the train wreck that will occur when runaway promises threaten to turn into a runaway debt load.

Debt Reduction Problems. To make things worse, the economy may stay weak for years, making it even harder to pay for the financial bailouts, let alone pay for expensive social programs. What if the economy is still weak when the interest load starts to become unbearable for the US? Would the Fed defend the dollar by soaking up excess liquidity and risk sending the US into another depression? A depression is hardly the time to raise interest rates.

The Financial Terminator? California's current budget problems may be a forwarning of things to come for the US as a whole. There are clear imbalances in the state's long-term obligations and its ability to fund them. However, the state's supposed budget "solution" fails to cut costs or raise taxes enough to solve the long-term imbalances already built into the system.

The similarities to the growing budget burdens of the US are worrying for the US dollar. Like an army of financial Terminators, creditors do not treat spendthrift debtors kindly.

Closer to the Breaking Point?

Darius III encounters Alexander at the Battle of Gaugamela, detail from mosaic in the House of the Faun, Pompeii

The AP reported today that the administration's annual midsummer budget update — usually scheduled for mid-July — has been put off until the middle of next month, "giving rise to speculation the White House is delaying the bad news at least until Congress leaves town on its August 7 summer recess".

The delay is raising worries that the budget update will reveal what we already know -- "higher deficits and unemployment and slower growth than projected in President Barack Obama's budget in February and update in May". The AP story suggests that the release is being delayed because it could complicate his efforts to get his signature health care and global-warming proposals through Congress.

Investors need to worry about market implications.

More economic weakness would depress stock markets and drive hot money into dollars and Treasuries as safe harbors. That has been the usual play on news of economic weakness. But everyone already knows that the economy is weaker than the Obama administration forecasted.

Besides, the current meme is the continuing growth of China, accompanied by hot money flowing into speculative markets like commodities. Maybe the risks of a surprising budget update lie in a different direction.

Real news would be to reveal an even worse position than anticipated with the Federal budget. If worries arose about the ability to fund the deficit, investors would flee Treasuries, sell the dollar, and seek safety in the traditional safe haven -- gold.

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.