Wednesday, December 26, 2007
Staying at the top
Mao and the art of management
Dec 19th 2007
Books on management tend to define success in the broadest possible terms—great product, happy employees, continuous improvement, gobs of profits, crushed competitors. Even when words such as “excellence” and “success” are omitted from the title, they are often implicit. A case in point is the book which many would say defined the genre, Alfred Sloan's “My Years with General Motors”, published in 1963 when GM was still an iconic company and Sloan correctly acknowledged as the architect of the well-run, decentralised, global corporation.
But focusing on how the best produce the best has its limits. Most managers, after all, do not stitch an industrial triumph from a vast bankrupt junkyard, as Sloan did. They do not delight their customer, crush competitors and create vast wealth. They struggle. They stumble.
Where is the book for them? Who can help the under-performing, over-compensated chief executive fighting to survive intrusive journalists, independent shareholders and ambitious vice-presidents who could do a better job? Where is the role model for the manager who really needs a role model most—the one who by any objective measure of performance cannot, and should not, manage at all?
An obvious candidate is Mao. Yes, he was head of a country, not a company. But he self-consciously carried a business-like title, “chairman”, while running China from 1949 until dying in office in 1976, having jailed, killed, or psychologically crushed a succession of likely replacements and therefore created the classic business problem: a succession void. He thought of himself as, in his own words, an “indefatigable teacher” and the famous “Little Red Book” drawn from his speeches is packed with managerial advice on training, motivation and evaluation of lower-level employees (cadres); innovation (“let a hundred flowers bloom”); competition (“fear no sacrifice”); and, of course, raising the game of the complacent manager (relentless self-criticism).
Mao still has at least a symbolic hold over the Chinese economy, even though it began to blossom only after death removed his suffocating hand. His portrait is emblazoned on China's currency, on bags, shirts, pins, watches and whatever else can be sold by the innumerable entrepreneurial capitalists that he ground beneath his heel when in power. No other recent leader of a viable country (outside North Korea, in other words) is so honoured—not even ones that did a good job.
It was not a nurturing management style that won Mao this adulation. According to Jung Chang's and Jon Halliday's “Mao, the Unknown Story”, admittedly an unsympathetic portrait, he was responsible for “70m deaths, more than any other 20th-century leader”. But why stop at the 20th century? In Chinese history, only Emperor Qin Shi Huang, who started building the Great Wall (in which each brick is said to have cost a life), was competition for Mao; and since the population was much smaller then, Mao is likely to have outdone him in absolute numbers.
Botched economic policies caused most of the carnage. Deng Xiaoping, Mao's successor, turned the policies, and eventually the economy, around. Yet he does not even merit an image on a coin.
The disparity between Mao's performance and his reputation is instructive, for behind it are four key ingredients which all bad managers could profitably employ.
• A powerful, mendacious slogan
Born a modestly well-off villager, Mao lived like an emperor, carried on litters by peasants, surrounded by concubines and placated by everyone. Yet his most famous slogan was “Serve the People”. This paradox illustrates one aspect of his brilliance: his ability to justify his actions, no matter how entirely self-serving, as being done for others.
Psychologists call this “cognitive dissonance”—the ability to make a compelling, heartfelt case for one thing while doing another. Being able to pull off this sort of trick is an essential skill in many professions. It allows sub-standard chief executives to rationalise huge pay packages while their underlings get peanuts (or rice).
But Mao did not just get a stamp from a compliant board and eye-rolling from employees. He convinced his countrymen of his value. That was partly because, even if his message bore no relation to his actions, it expressed precisely and succinctly what he should have been doing. Consider the truth and clarity of “serve the people” compared with the average company's mission statement, packed with a muddle of words and thoughts tied to stakeholders and CSR, that employees can barely read, let alone memorise.
Deng Xiaoping's slogan, which he used in his campaign to revive the economy, had similar virtues. “Truth from facts” is a sound-bite that Sloan would have loved and every manager should cherish, but you won't find it chiselled on a Chinese wall. It doesn't have the hypocritical idealism of Mao's version—nor was it pushed so hard.
• Ruthless media manipulation
Mao knew not just how to make a point but also how to get it out. Through posters, the “Little Red Book” and re-education circles, his message was constantly reinforced. “Where the broom does not reach”, he said, “the dust will not vanish of itself.” This process of self-aggrandisement is often dismissed as a “personality cult”, but is hard to distinguish from the modern business practice of building brand value.
Yet within China economic growth was pathetic and living conditions were wretched. So why did a vast list of Western political, military and academic leaders accept the value of Mao's brand at his own estimation? Even Stalin, no guileless observer, believed in and, to his later regret, protected Mao. The brand-building lesson is that a clear, utopian message, hammered home relentlessly, can obscure inconvenient facts. Great salesmen are born knowing this. Executives whose strategies are not delivering need to learn it.
Chief executives are not in a position to crush the media as Mao did. Nevertheless, his handling of them offers some lessons. He talked only to sycophantic journalists and his appeal in the West came mainly from hagiographies written by reporters whose careers were built on the access they had to him.
The law constrains the modern chief executive's ability to imitate Mao's PR strategy. Publicly listed companies have to publish information, rather than hand it out selectively. But many, within bounds, emulate Mao's media management; others, determined to control information about them, are delisting. Burrow beneath laudatory headlines on business and political leaders, and it becomes clear that the strategy works.
• Sacrifice of friends and colleagues
“Who are our friends? Who are our enemies? This is a question of first importance,” Mao wrote. Sloan agreed. He worried that favouritism would come at the expense of the single most valuable component of management: the objective evaluation of performance.
Mao had a different goal: he did not want people too close to him, and therefore to power; so being Mao's friend often proved more dangerous than being his enemy. One purge followed another. Promotions and demotions were zealously monitored. Bundles of incentives were given and withdrawn. Some demotions turned out well. Deng Xiaoping's exile in a tractor factory may have helped him understand business, and thus rebuild the economy, but that was an unintended benefit.
This approach makes sense. Close colleagues may want your job, and relationships with them may distract you. Mao's abandonment of friends and even wives and children seemed to be based on a calculation of which investments were worth maintaining and which should be regarded as sunk costs. Past favours were not returned. According to Ms Chang and Mr Halliday, a doctor who saved his life was left to die on a prison floor after being falsely accused of disloyalty. Mao let it happen: he had other doctors by then.
Enemies, conversely, can be useful. Mao often blamed battlefield losses on rivals who were made to suffer for these defeats. The names of modern victims of this tactic will be visible on the list of people sacked at an investment bank after a rough quarter; the practitioners are their superiors, or those who have taken their jobs.
• Activity substituting for achievement
Mao was quite willing to avoid tedious or uncomfortable meetings, particularly when he was likely to be criticised. But maybe that helped him avoid getting bogged down. From the Anti-Rightist Movement of the late 1950s to the Great Leap Forward, a failed agricultural and industrial experiment in the early 1960s, to the Cultural Revolution in the late 1960s, Mao was never short of a plan.
Under Mao, China didn't drift, it careened. The propellant came from the top. Policies were poor, execution dreadful and leadership misdirected, but each initiative seemed to create a centripetal force, as everyone looked toward Beijing to see how to march forward (or avoid being trampled). The business equivalent of this is restructuring, the broader the better. Perhaps for the struggling executive, this is the single most important lesson: if you can't do anything right, do a lot. The more you have going on, the longer it will take for its disastrous consequences to become clear. And think very big: for all his flaws, Mao was inspiring.
In the long run, of course, the facts will find you out. But who cares? We all know what we are in the long run.
Sunday, November 18, 2007
It's intriguing to read things from those who have been around in the markets long enough to comment on how the "good old days" differs from the "brave new world". John Mauldin is always very good at this, and he does it like a true straight-talking Texan who never tries to bedazzle an audience with unnecessary detail and technical language. There's a reason why poor people have been finding it harder and harder to survive in this country while official statistics continue to suggest nothing out of the ordinary. This article is fly, and it will teach you a thing or two about the obfuscation in government statistics (Inflation figures emphasized)... especially if you are contrarian, and perhaps by nature are disinclined to believe politics and politicians, then it will make you quite dandy, and gives you something to be politically incorrect with at dinner parties and cocktails.
That one paragrapher, about shifting from the fixed basket arithmetic calculation of CPI, to the variable basket geometric calculation--and the relationship between that decision and how much politicians wanted to lower social security and welfare payment burdens... sure seems to make sense!
How do You Spell Stagflation?
November 16, 2007
By John Mauldin
How do You Spell Stagflation?
I wrote this summer that it was likely that we would see inflation as reported in the Consumer Price Index rise dramatically in the fourth quarter. This is due to the very low year over year comparison numbers of last years fourth quarter. We got the CPI numbers yesterday, and we did indeed see a rather uncomfortable rise in inflation, just as I predicted. "Headline" inflation is at 3.5% over the last 12 months, well above anybody's comfort level, and "core" inflation (inflation without food and energy in the numbers) is at 2.1% over the same period.
It is likely to look worse in the coming months, at least in the statistics. To see why, let's go the table below from the Bureau of Labor Statistics who creates the CPI.
The monthly numbers are the index for inflation. Since the base is from 1982-84, we can see that sometime last year prices doubled over the last 25 years. But it certainly feels like it has been more. We will look at how those numbers are created in a minute, and whether we can attach much credulity to them.
Now, here is what to notice in the table. The number for December is the same as the number for October. Since the beginning of this year we have seen a steady rise almost every month. If you assume inflation is running at 2%, this would mean that the November number would yield a 3.8% inflation rate and would be closer yet to 4% for December.
If you extrapolate the inflation of the past two months for the next two months, that would take inflation slightly over 4% as we go into the next two Fed meetings. Yes, we all know the Fed prefers to look at core inflation, but at some point you do have to pay attention to the headline number.
Today, in a speech in New York, Federal Reserve Governor Randall Kroszner said policy makers probably won't need to reduce interest rates further to help the economy weather a "rough patch" in the coming year.
"The current stance of monetary policy should help the economy get through the rough patch during the next year, with growth then likely to return to its longer-run sustainable rate," Kroszner said. Data consistent with such growth "would not, by themselves, suggest to me that the current stance of monetary policy is inappropriate."
The risks are roughly balanced between inflation and growth in his opinion. However, futures prices still suggest that the market expects an 84% chance of a rate cut at the December 11 meeting.
Cooking the Inflation Books
Just for the record, I want to state that I know as does nearly everyone else who pays attention to the CPI statistics that they are bogus. They do not reflect the real world that you and I, gentle reader, live in. So, while it may look like I take them at face value, I do so only because the Fed pays attention to the number, (nod, nod, wink, wink) and makes policy based upon it. So, let's look at how the calculation of the CPI has been politicized and how much of a difference it makes, and then go on to the expectation for statistical inflation in the near future.
John Williams writes an excellent monthly letter on all types of government statistics called the Shadow Government Statistics at www.shadowstats.com. One of the things he points out that during the Clinton administration, the way the BLS calculates inflation was changed. He calculates his own inflation number using the old pre-Clinton inflation model. Using that methodology suggests that inflation is at 7%. And if you use other methods, inflation might even be substantially higher. Look at the chart below.
Since the CPI is used to calculate the increase in Social Security payments and a host of other items, calculating inflation is important. I the early 1990s the arguments in the press was that inflation was over-stated. Michael Boskin, chief economist in the first Bush administration and Alan Greenspan were among the chief proponents for a new methodology of accounting for inflation.
Quoting Williams: "Up until the Boskin/Greenspan agendum surfaced, the CPI was measured using the costs of a fixed basket of goods, a fairly simple and straightforward concept. The identical basket of goods would be priced at prevailing market costs for each period, and the period-to-period change in the cost of that market basket represented the rate of inflation in terms of maintaining a constant standard of living.
"The Boskin/Greenspan argument was that when steak got too expensive, the consumer would substitute hamburger for the steak, and that the inflation measure should reflect the costs tied to buying hamburger versus steak, instead of steak versus steak. Of course, replacing hamburger for steak in the calculations would reduce the inflation rate, but it represented the rate of inflation in terms of maintaining a declining standard of living. Cost of living was being replaced by the cost of survival. The old system told you how much you had to increase your income in order to keep buying steak. The new system promised you hamburger, and then dog food, perhaps, after that.
"The Boskin/Greenspan concept violated the intent and common usage of the inflation index. The CPI was considered sacrosanct within the Department of Labor, given the number of contractual relationships that were anchored to it. The CPI was one number that never was to be revised, given its widespread usage.
"Shortly after Clinton took control of the White House, however, attitudes changed. The BLS initially did not institute a new CPI measurement using a variable-basket of goods that allowed substitution of hamburger for steak, but rather tried to approximate the effect by changing the weighting of goods in the CPI fixed basket. Over a period of several years, straight arithmetic weighting of the CPI components was shifted to a geometric weighting. The Boskin/Greenspan benefit of a geometric weighting was that it automatically gave a lower weighting to CPI components that were rising in price, and a higher weighting to those items dropping in price.
"Once the system had been shifted fully to geometric weighting, the net effect was to reduce reported CPI on an annual, or year-over-year basis, by 2.7% from what it would have been based on the traditional weighting methodology. The results have been dramatic. The compounding effect since the early-1990s has reduced annual cost of living adjustments in social security by more than a third."
Then to confuse the process even more, the BLS uses something called hedonics, from the root word hedonism. Essentially, the adjust the price of an item based on the "pleasure" or increased value you get. Thus, they don't price automobiles based on the sticker price, but on what you get for your money. If the manufacturers load in more items like new electronics or anti-locking brakes that were not standard the year before that means you are getting more value for your dollar, so therefore the price in terms of inflation goes down even though you may be paying the same or even more to get out of the car show room.
The same is true for computers. We clearly get more power every year, so for the BLS the price of computers are going down, although it seems to me that the price I pay for a top of the line computer is about the same as it was five or ten years ago.
If the government mandates an additive to gasoline that costs 10 cents more, that is not included in the inflation numbers, because we get a new, improved gasoline that pollutes less. Supposedly the pleasure of breathing cleaner air reduces the costs to our pocket book, or something like that.
My health insurance costs have tripled over the last ten years, and I know that is the experience of many of my readers. Yet, the BLS has medical costs rising by less than 50% for the last ten years. Their data suggest the cost of housing has risen by about 30% over the last ten years. Again, that is not the experience of many of my readers.
Social Security expenses are $657 billion per year. If Williams is right (and I think he is) that under the old methodology that expenses would have risen by a third, then that means we are spending $200 billion a year less. Add $200 billion to the deficit. And then watch politicians panic.
I am not one to suggest conspiracy, but if the CPI reflected the real world, the US government would be spending far more money on Social Security and a host of other pension programs. The crisis we will be experiencing in about 8 years would have already hit us. Thus, there was an incentive for leaders to find economists who could argue for new, more "progressive" methods for calculating inflation. Notice that this was done by the BLS without any protest from Congress.
None of this was done behind closed doors. The BLS, to its credit, is extremely open about how it calculates CPI, and you can get an enormous amount of detail on their web site about prices of things like tomatoes in very part of the country going back for decades.
But the way we calculate the CPI is not going to change. No administration will want to go back and add in an extra 4-5% a year to Social Security and other government pension programs. So, let's return to the prospects for a rise in the CPI in the near future, which will have policy implications for the Fed.
Gaming the Producer Price Index
On Wednesday, we got the Producer Price Index. After the above notes on the CPI, it will probably not come as a surprise that there may be some problems with the PPI. The PPI rather oddly has the price of energy going down in October. PPI is important, as it is in indication of the trend of inflation in consumer prices in the future.
As friend Bill King notes:
"Since June, BLS has energy prices declining in all three PPI stages: finished, intermediate and crude. For June finished energy goods the index is 160.9, for October 159.5; the intermediate prices are 179.9 vs. 178; for crude it's 238 vs. 232.9. BLS has energy prices DOWN 3.64% since July!!
"Oil has rallied from ~$75 to the mid-90s since July 9. Over the same period, gasoline has rallied from $1.95 to $2.35; heating oil has rallied from $2.15 to $2.55; natural gas has fallen from $8.50 to $8.25."
That means that inflation in the PPI numbers may be less than the table below, which is bad enough. Notice the increase in the change of year over year inflation in the index over the last 8 months.
Another table shows "core" PPI, without energy and food, and you find that core PPI is flat. Again, we are seeing almost all of the real inflation in food and energy. But with a falling dollar, do we expect food and energy prices in the US to fall as well, since much of the price of food and energy is determined on international markets?
Consumer Spending is Up, but then Again, It May Be Down
Headline consumer spending came in up 5.2% year over year, which suggest a very respectable growing economy. But retail sales were only up 0.2% in October, which is below inflation. In other words, retail sales fell in October in real terms. But digging deeper into the numbers, we find a problem. Remember food and energy. As Greg Weldon points out, it is unlikely that US consumers bought 16% more gasoline than they did last year. The increase in spending for gasoline was all related to price. Ditto for food.
John Williams says the same analysts who want to use core inflation should also use core retail sales. And if you take out food and energy from retail sales, you find consumer spending to be flat in October. There were multiple categories like home furniture, music, electronic games, etc that were in outright declines. Most interestingly, online sales actually dropped last month. Annual sales growth dropped to its lowest number in years.
FedEx warned today that its earnings would be down due to fewer shipments and higher energy costs. The number of containers coming into the US is down. Retailers are expecting a very modest Christmas season.
So, we come to the question: Is the economy slowing and thus the Fed will cut, or is inflation rising which will force the Fed to sit tight?
A Two Dimensional Problem
I recently spent some time with the very brilliant Columbia Professor Graciella Chichilnisky (the economist whose work created the carbon credit markets, among other things). We got to talking about the problems the Fed is facing, and she gave me a very interesting insight from a paper she had written a few years back. I am going to try and re-create it, though I am sure I will take some of the potency away in trying to put it in my simple terms.
Assume that you have an individual living in a two dimensional world. For them there is only length and width, but no height. Then let's draw a line between two exactly opposite points above and below that two dimensional world and connect them with a line. At the precise point where the lines meet in the two dimensional world, to the individual in that world, it appears that both points are exactly the same. Two things which would clearly be opposite to anyone living in a three dimensional world would be equal in a two dimensional world.
The Fed faces a problem something like that. They are living in a two dimensional world, working with two dimensional tools (they can cut rates or raise them) but the problems they face are multi-dimensional.
If they cut rates, the dollar will fall and import prices rise, and it will also likely have negative effects on food and energy prices. If they do not cut rates, the markets will simply throw up as it will interpret that as a Fed which is not concerned about a slowing economy.
Not cutting rates risks an economy that could easily slip into recession due to a growing risk of a credit crisis turning into a credit crunch. Usually, that means that inflation will fall. Usually, but not always.
The Fed is faced with a problem I predicted four years ago in this letter and in Bull's Eye Investing, as the Fed dramatically eased monetary conditions in an effort to fight deflation. In a word, stagflation. That terrible moment in time when an economy slows (is stagnant) yet inflation is high, limiting the monetary authority's ability to act.
With a clearly slowing economy, a credit crisis, and rising inflation, they have no good and clear choices. Whatever they do is likely to create problems in a multi-dimensional real world. I still think they cut, as core inflation is still close to their comfort zone. But if core inflation starts to rise, they will have to act. Or at least should.
I usually avoid controversial matters, other than economics and finance, but I came across a story which I think deserves attention. It seems that a 19 year old young lady in Saudi Arabia was gang-raped by six armed men. They got between one and five years in prison. Because she was in a car with a man who was not related to her, she was given a sentence of 90 lashes. Because she appealed and a higher court ordered another trial, the court then more than doubled the sentence to 200 lashes.
"A court source told the English-language Arab News that the judges had decided to punish the woman further for 'her attempt to aggravate and influence the judiciary through the media.'" Her lawyer had his credentials removed for defending her. This is simply barbaric. It is an affront to any civilized thoughtful person. Where are the protests? Are we to believe that the Saudi royalty condones such acts?
I hope that other writers will use this in their letters.
New York, Toronto, Europe and Thanksgiving
This week I had to take a quick one day trip to Toronto. Changing my ticket ended up costing me six times the original round trip ticket. To add insult to injury, I got in a taxi at the Toronto Airport. It used to cost about $50 Canadian dollars to get a ride to downtown. The price has risen to $60 and then throw in a $10 tip. A few years ago, this would cost me about US$35. Today it was $70. I offered the taxi driver 3 twenty dollars bills and a tip, but he pointed out that the exchange rate made my US$60 only worth about Canadian $55. Sigh.
I am going to have to go to New York again in a few weeks to attend the Minyanville BBQ picnic and charity fundraiser. South African business partner Prieur du Plessis will be there, but I am going because his wife Isabel has demanded my attendance. And a European trip late in January is shaping up.
There will be no Thoughts from the Frontline letter next week, as it is Thanksgiving, and I am going to take the day off and spend it with the kids. They are all seven coming back home. I know that it will not be too far into the future when they are going to get scattered and having them all under one roof at the same time is something to be savored. I will make prime and smoke turkey, with mushrooms and all the fixings. I do so love Thanksgiving. Friends and family, food and Cowboys football, great wine and laughter. It just doesn't get any better.
I hope those of me readers in the US have a good Thanksgiving as well. Have a great week.
Your thinking about how the world will change analyst,
Friday, November 02, 2007
By Martin Hutchinson
October 29, 2007
Martin Hutchinson is the author of "Great Conservatives" (Academica
Press, 2005) -- details can be found on the Web site www.greatconservatives.com
There's a mystery on Wall Street. Merrill Lynch last week wrote off $8.4
billion in its subprime mortgage business, a figure revised up from $4.9
billion, yet Goldman Sachs reported an excellent quarter and didn't feel
the need for any write-offs. The real secret of the difference is likely
to be in the details of their accounting, and in particular in the murky
world, shortly to be revealed, of their "Level 3" asset portfolios.
Both Merrill and Goldman have Harvard chairmen - Merrill's Stan O'Neal
from Harvard Business School and Goldman's Lloyd Blankfein from Harvard
College and Harvard Law School. Thus it's pretty unlikely their
approaches to business are significantly different - or is a Harvard MBA
really worth minus $8.4 billion compared with a law degree? (The special
case of George W. Bush may be disregarded in answering that question!)
We may be about to find out. From November 15, we will have a new tool
for figuring out how much toxic waste is in investment banks' balance
sheets. The new accounting rule SFAS157 requires banks to divide their
tradable assets into three "levels" according to how easy it is to get a
market price for them. Level 1 assets have quoted prices in active
markets. At the other extreme Level 3 assets have only unobservable
inputs to measure value and are thus valued by reference to the banks'
Goldman Sachs has disclosed its Level 3 assets, two quarters before it
would be compelled to do so in the period ending February 29, 2008.
Their total was $72 billion, which at first sight looks reasonable
because it is only 8% of total assets. However the problem becomes more
serious when you realize that $72 billion is twice Goldman's capital of
$36 billion. In an extreme situation therefore, Goldman's entire
existence rests on the value of its Level 3 assets.
The same presumably applies to other major investment banks - since
they employ traders and risk managers with similar educations, operating
in a similar culture, they probably have Level 3 assets of around twice
capital. The former commercial banks Citigroup, J.P. Morgan Chase and
Bank of America may have less since their culture is different; before
1999 those institutions were pure commercial banks and a substantial
part of their business still lies in retail commercial banking, an area
in which the investment banks are not represented and Level 3 assets are
There has been no rush to disclose Level 3 assets in advance of the
first quarter in which it becomes compulsory, probably that ending in
February or March 2008. Figures that have been disclosed show Lehman
with $22 billion in Level 3 assets, 100% of capital, Bear Stearns with
$20 billion, 155% of capital and J.P. Morgan Chase with about $60
billion, 50% of capital. However those figures are almost certainly low;
the border between Level 2 and Level 3 is a fuzzy one and it is
unquestionably in the interest of banks to classify as many of their
assets as possible as Level 2, where analysts won't worry about them,
rather than Level 3, where analyst concern is likely.
The reason analysts should worry is that not only are Level 3 assets
subject to eccentric valuation by the institution holding them, but the
ability to write up their value in good times and get paid bonuses based
on their capital uplift brings a temptation that few on Wall Street
appear capable of resisting. Both Goldman Sachs and Merrill Lynch are
reported to have made profits of more than $1 billion on their holdings
of Level 3 assets in the first half of 2007, for example, profits on
which bonuses will no doubt be paid at the end of their fiscal years.
Given that we have had five good years on Wall Street, years in which
nobody has known the amount of Level 3 assets on banks' balance sheets,
and no significant media waves have been made questioning their
valuation methodologies, it would not be surprising if many banks' Level
3 assets had become seriously overstated, even without any downturn
When Nomura Securities sold its mortgage portfolio and exited the US
mortgage business in this quarter, it took a write-off of 28% of the
portfolio's value, slightly above the 27% of the portfolio that was
represented by subprime mortgage assets. Were Goldman Sachs's Level 3
assets similarly value-impaired, it would result in a $20 billion
write-off, more than half Goldman's capital, leaving the bank severely
damaged albeit probably still in existence.
Defenders of Goldman Sachs and the rest of Wall Street will insist that
less than 27% of their level 3 assets are represented by subprime
mortgages yet that is hardly the point. Subprime mortgages, estimated to
cause losses of $400-500 billion to the market as a whole, though only a
fraction of that to Wall Street, have been only the first of the Level 3
asset disasters to surface. There is huge potential for further losses
among assets whose value has never been solidly based. These would
include the following:
* Mortgages other than subprime mortgages. With the decline in
house prices accelerating, the assumptions on which even prime mortgages
were made are being exposed as fallacious. As house prices decline, debt
to equity ratios increase, and for mortgages with an original
loan-to-value ratio of 90% or more quickly pass the 100% at which a
mortgage becomes uncovered. If the value of conventional mortgages
decline many securities related to them, currently classed as Level 1 or
2 assets, will become un-marketable and descend into Level 3
* Securitized credit card obligations. $915 billion of credit card
debt is currently outstanding, the majority of it securitized, and its
default rate is likely to soar as the full effects of the home mortgage
market's crack-up spread to the credit card area. The risks in Level 3
portfolios derived from this asset class arise particularly in the areas
of complex derivatives and manufactured assets based on credit card debt
* Leveraged buyout bridge loans. After a hiccup in August, the
market in these has reopened recently, although around $250 billion of
them still remains on banks' balance sheets. The value of a leveraged
buyout bridge loan that has failed to find a pier to support the other
end of the bridge is very dubious indeed, even though these loans are
being carried in the books at or close to par. As the value of
underlying assets declines and the cash flow fails to match debt
payments, the deterioration in credit quality of these loans will
* Asset backed commercial paper. The amount of asset backed
commercial paper outstanding has dropped from $1.2 trillion to $900
billion in the last three months. This financing structure was always
unsound; it was basically a means of removing the assets backing the
commercial paper from bank balance sheets, and always faced the problem
of a severe mismatch between asset and liability duration. The $100
billion vehicle intended to rescue this market has found a mixed
reception to say the least. It is likely that as credit conditions
deteriorate, the assets underlying ABCP vehicles will increasingly find
themselves on bank balance sheets, where they will prove to be almost
* Complex derivatives contracts. Even simple interest rate swaps
and currency swaps caused large losses in the last significant credit
tightening in 1994, although most of those losses were suffered by Wall
Street's customers rather than Wall Street itself. The more complex
transactions that have been devised during the last twelve giddy years
are much more likely to prove impossible either to sell or to hedge.
Goldman Sachs reported that in the third quarter of 2007 its profits on
derivatives used for hedging more or less matched its losses on subprime
mortgages. It is likely in reality that the bulk of those profits were
incurred through model-based write-ups of value on contracts that were
within the Level 3 category - after all, Goldman's Level 3 assets
increased by a third during the quarter. It's not much good shorting to
match a long position you don't like if your hedging shorts prove to be
impossible to close out.
* Credit Default Swaps, the global outstanding value of which in
June 2007 was $2.4 trillion, according to the Bank for International
Settlements. These are a relatively new instrument, the efficacy of
which has not been tested in a downturn. It appears likely that the
value in banks' books of their Level 3 credit derivatives contracts
bears no relation whatever to reality. As discussed above, the
incentives have been all in favor of inflating it.
The capital underlying Wall Street, at the top, is not all that large -
a matter of a few hundred billion. Given the piling of risk upon risk
that has been engaged in over the last few years, and the size of the
losses in the mortgage market alone that seem probable - my own estimate
last spring of $980 billion looks increasingly likely to be somewhat
below the final figure - it appears almost inevitable that in a bear
market in which liquidity dries up and investors become skeptical, Wall
Street's capital will be wiped out. Only the commercial banks like
Wachovia and Bank of America whose investment banking ambitions have
been largely thwarted and portfolios of Level 3 rubbish are
correspondingly lower are less likely to disappear.
Given the size of the overall figures involved and the excessive
earnings that Wall Street's participants have enjoyed over the last
decade, a taxpayer-funded bailout of Wall Street's titans would seem
politically impossible, however loud the lobbyists scream for it.
In the long run, that is probably a blessing for the US and world
Wednesday, October 24, 2007
Therefore, it's always nice to read a refreshing piece or two that run counter to the overwhelmingly articulated arguments to own gold. I'm still pretty bullish on Gold myself--and still a believer in very inflationary times ahead, but these days I have been catching a few sneezes here and there curing my conviction hours--not because I don't think America and the American economy is going to be pretty gloomy in the next decade or so, but because of the sheer volume of liquidity that has been piling into gold, commodities, ect... THINKING IT'S AN ATTRACTIVE HEDGE/ALTERNATIVE TO THE MARKETS! The talks of a supercycle that is driven by demand from the likes of BRIC and other emerging markets seems old news, and is actually very accepted now among the investment community, maybe too fast too soon. So while you have the bulls calling for stock markets to be quite alright, you have the bears calling for a rush to safety in precious metals and secular growth commodities (secular only if China keeps up). In other words... everything is up! bulls and bears (shorts excluded) both party! unbelievable! And it's times like these, I get agnostic. There's simply too much money out there still!
Call me a party-pooper, but if (1) liquidity leaves this area--i.e. China slows down or (2) Bernanke grew balls and started targeting excess money supply at the expense of economic growth, then I think there could be a severe correction in not only asset prices, but also the things that are supposed to be "safe" havens for investors--Gold included. Bulks, basic metals, cyclicals, softs (maybe not this one, a story for another time) will do even worse.
The following article tells it well, with a specific focus on Gold. In a nut-shell, it's important to focus again on the Bernanke factor. If, again, he grew balls--ignored politicians and wall streeters like a central banker should in the first place, and raised rates and somehow manage to start a tradition of inflation-fighting, money supply targeting Fed, we will see some serious issues in the Gold call. The market is already pricing in that Bernanke isn't the type of guy that is serious about controlling inflation at the expense of offending wall street and the government (which might be a dangerous assumption since we arguably don't know much about his ultimate policy stance yet, outside the one time liquidity injection he gave that was necessary to prevent a complete banking crisis, and the snippets of being another Alan Greenspan--what investors want to believe). Nobody took Paul Volcker's words seriously at first when he said he's going to focus on fighting inflation (as you'll read about in the following article)... Bernanke said the same things along those same lines once or twice, but nobody is taking that seriously so far--so it's yet to be seen.
Meh... its too late at night. I don't even know sometimes why I focus on these macro things since everything that's ever made me money in my short and humble investing career has mostly been unsystematic, business specific, microeconomic positions. But hey, what can you do, I guess it's too interesting to avoid :D I can't wait until everything is cheap again.
Anyway, without further ado, here is that refreshing look on Gold
FORECASTS & TRENDS E-LETTER
Why I’m Taking Profits In Gold Now
IN THIS ISSUE:
1. My History With Precious Metals
2. The Precious Metals Crash Of January 1980
3. Why I’m Selling My Gold Coins Now
4. I’m Not Bearish On Gold
5. Pros And Cons Of Investing In Gold
6. Gold Exchange Traded Funds Revisited
As discussed last week, the response to our recent Reader Survey was much larger than we expected, and we received tons of comments and suggestions. Interestingly, many of you asked me to write about precious metals from time to time. The timing was excellent, since I sold most of my gold coins last week when gold prices topped $760.
The last time I made a sizable investment in gold coins was back in 1998 and 1999 when gold was around $300 per ounce. At that time, I purchased a large number of uncirculated American Gold Eagle coins. I also bought several bags of circulated silver coins, also known as “junk silver.” I have been sitting on them ever since, until now.
Obviously, gold and silver prices have risen substantially since 1998/99, especially in the last two years, and most especially in the last three months as prices spiked higher. Many analysts believe precious metals prices will rise much more in the months and years to come. There are plenty of predictions of $1,000 gold, and maybe they’re right. But in the pages that follow, I will tell you why I sold all but my core holdings of precious metals now. I’ll also tell you a little about my history with precious metals. I think you will find it an interesting discussion.
We will also revisit the subject of exchange traded funds in gold. There are currently two gold ETFs, and they have become a very popular way to participate in the movements in gold prices without having to own the physical metal.
My History With Precious Metals
After getting my Masters degree in 1975, I went to work for Continental Grain Company, one of the largest grain and agribusiness companies in the world. After less than a year, I became a broker in the company’s commodities futures division in their
In a relatively short period of time, I developed a large clientele which consisted mainly of grain elevators, commercial feedlots, cotton gins and many large farmers. Most of my clients were located in
I actually taught most of them how to do it. In 1977, I wrote a manual entitled “Hedging – Can You Afford Not To?” which explained in layman terms how the complicated process of hedging in the futures markets works. With all of these clients, I quickly became one of the largest producers in the company by the ripe old age of 25 or 26.
What does this have to do with precious metals, you’re probably asking. I’m getting there. It was also in 1977 that I was introduced to The Bank Credit Analyst. At that time, BCA was predicting that inflation was going to get out of control, and that precious metals prices, and tangible assets in general, were going to go through the roof in the next few years.
Of course, I was writing about BCA’s forecasts in my newsletter, even back in those days, and most of my clients agreed that inflation was going to be a big problem in the next few years. They wanted to know how they could make money from this trend. I had always urged my clients not to speculate in futures on the commodities they dealt in or produced. But in this case, we were talking about precious metals futures – gold, silver, platinum, etc.
In 1978, most of my clients loaded up on gold and silver futures at a time when gold was below $200 and silver was below $6. As most of us remember, inflation ran rampant in the last few years of the 1970s, and precious metals prices soared just as BCA had predicted. By late 1979, gold had reached $650, and silver had soared above $30.
My clients were making a killing, and I was a hero. As noted above, I had a lot of clients, and with all the market positions we had on - hedge positions and speculative positions - my daily printout of all accounts and all positions stretched the entire length of our large office suite.
But BCA Killed The Party In Late 1979
You may recall that Paul Volcker became Fed chairman in August of 1979, with a mandate to get inflation under control. Initially, there was a widespread consensus that Volcker was not going to take any significant actions to bring down inflation, what with Jimmy Carter in the White House. However, by late 1979, BCA thought otherwise.
Shortly after Volcker took over at the Fed, he talked about implementing a new monetary policy. Rather than targeting interest rates, as had been done for years, he was going to target the growth in the money supply. Volcker believed that if he squeezed the money supply, interest rates would rise and eventually choke off inflation. And he basically said he didn’t care how high interest rates had to go to get the job done.
As noted above, few believed Mr. Volcker’s words. But BCA did. In their November and December 1979 monthly reports, the BCA editors made it very clear that they believed Volcker was dead serious. They warned in chilling terms (at least for me) how they believed interest rates were going to soar, and how that could lead to a serious recession.
Most importantly they adamantly advised readers to liquidate all positions in precious metals, tangible assets and other inflation hedges immediately.
I was stunned to say the least! My clients and I were having so much fun, after all. And we were all very convinced that inflation would not be brought under control. I anguished for several days about what to do. My clients certainly didn’t want to get out of their inflation hedges. But in the end, I decided to take BCA’s advice, as much as I hated to. By the end of December 1979, I had sold out every single position in gold and silver for every client but one. That one client got so mad at me he transferred his account to another brokerage firm.
When I liquidated all of these large positions, gold was in the area of $650, and silver was around $35. Well, gold went on to soar to near $850 and silver to $50. I didn’t look so smart then, but no one complained that we got out a little early, especially after what happened in January 1980 – but I’m getting ahead of myself.
My branch manager was thrilled because of the huge volume of commissions this unloading of metals positions generated. A couple of days after the liquidation was done, my manager came into my office and asked, “When are you going to buy it all back?” I replied, “We’re not, we’re done.” He was shocked, once he realized I was serious.
In the ensuing days, the manager talked to me on several occasions, trying his best to get me to put all my clients back in these trades. I refused, even though the precious metals were still exploding on the upside. Growing weary of his efforts to get me to put my clients back in the market, I finally responded with something like the following (paraphrasing):
When I first got in to the commodities business, I heard an old saying that always made sense to me: ‘There’s some for the bulls, some for the bears, but there’s none for the hogs’. What a great saying! I repeated it to my commission-hungry manager, and he never asked me again. Good thing.
The Precious Metals Crash Of January 1980
After soaring to all-time record highs of $850 in gold and $50 in silver, the precious metals markets collapsed in the last half of January 1980. You may recall that the Hunt brothers of
Silver futures plunged from $50 to below $17 in less than a month! Silver futures were locked “limit down” for 21 consecutive days, meaning that no one could unload their positions. A move from $50 to $17 was a $33 swing, and on a 5,000-ounce silver futures contract, that move represented a $165,000 loss in value. Margin calls were huge, and several large brokerage firms were rumored to be in trouble.
At the same time, gold collapsed from around $850 to below $500 in less than a month. Gold was also limit down for a couple of weeks. To this day, that was the single most violent move in commodities that I have ever seen. Many speculators were wiped out. Fortunately, I got all of my clients out a month earlier. Talk about dodging a bullet! Perhaps this helps explain why I have valued BCA’s opinions for all these years.
Why I’m Taking Profits On My Gold Coins Now
As you probably know, precious metals prices have been on a tear for the last couple of years, and especially in the last few months. Gold has risen from below $450 in late 2005 to above $760 as this is written. Silver prices have soared from around $7 to above $14 per ounce in the last two years, although prices are slightly below $14 as this is written.
On Wednesday of last week, I decided to take profits on all but my core holdings of gold coins. For better or worse, I called the coin dealer I use (Camino Coin) and locked in the price on my Gold Eagles when spot gold was around $760. Gold prices have dropped back a bit since then, but it will not surprise me if gold prices continue to move higher for a while longer.
So why did I decide to sell last week? To begin with, I have been thinking about selling for a couple of months now, what with the sharp rise in gold prices just since August. Most analysts believe that precious metals prices are soaring due to expectations for a significant rise in inflation. Oil prices are at all-time record highs, and precious metals often track the price of oil to some extent. As noted above, there are analysts who now predict that gold will hit $1,000 per ounce on this move, and maybe they will be correct.
However, as I have discussed in recent E-Letters, the latest inflation numbers have been tame, even as oil prices have soared to record highs near $90 per barrel at one point last week. The Consumer Price Index (including food and energy) rose only 0.3% in September and was down 0.1% in August. For the last 12 months, the CPI is up 2.8%, and the trend is down. The “core” CPI is up only 2.1% over the last 12 months. That is hardly runaway inflation.
Meanwhile, BCA has maintained for several months that
In short, BCA expects overall inflation to surprise on the downside over the next year, despite soaring oil prices and the increases in food prices.
The tame inflation rates over the last few months are, in part, what led the Fed to cut interest rates on September 18, and it may do so again on October 31. I don’t think the Fed would be cutting rates if it believed that inflation is going to be a problem in the near-term.
I’m Not Bearish On Gold
For the gold bulls in our E-Letter audience, please note that my selling of my gold coins does not mean that I am bearish on gold, although I do believe it is overbought in the near-term. In fact, the long-term supply/demand fundamentals still look quite encouraging. Demand continues to rise, especially from
There are a number of other factors that have the potential to impact the price of gold in the future. I have discussed these factors in previous E-Letters, and have updated them below as they are just as relevant to the future price of gold as they were back then:
1. Gold is a good store of value during times of uncertainty, and there is definitely no shortage of uncertainty in the world today. In fact, you could call gold the “currency of global uncertainty,” in that, as a general rule, the greater the geopolitical tensions, the more investors tend to buy gold.
2. Gold is considered by many to be a hedge against inflation. I noted above that BCA does not feel that inflation will be a factor in the short-term. However, that doesn’t mean that inflation will never again be an issue. As Baby Boomers retire and the government is forced to borrow to fund Medicare and Social Security, both interest rates and inflation have the potential to rise in the long-term.
3. Although I do not believe that gold reacts to supply and demand in exactly the same way that many other commodities do (see #4 below for more about this), you cannot discount the fact that exploration was down during the period of low gold prices and gold mining companies have had to play catch-up in the last few years, and this has helped push up the price of gold.
4. As I have written before, another reason why gold does not always react to supply and demand forces the same way that many other commodities do is because gold has a hybrid nature. While it is a commodity used by many industries, it is also a currency maintained in large reserves by many countries, central banks and individual investors. As a result, the price of gold is often dictated more by its relative value to currencies rather than on a strict supply/demand basis.
Accordingly, the slide in the value of the US dollar over the last few years has been bullish for the price of gold. If the US dollar experiences a continued decline, this might provide additional upside potential for gold prices.
Obviously, these are not all of the reasons to be bullish on gold, but they are some of the major factors that I keep on my radar screen in relation to the yellow metal, in addition to the supply/demand fundamentals. The point is that there are several factors that are favorable for a continued increase in the price of gold. But you never know. What is clear is that gold prices are at a 28-year high, despite the fact that the US and global economies are slowing down.
Reasons To Be Cautious
Just as there are reasons to be bullish about the price of gold, there are equally valid reasons to be cautious about running headlong into a major gold investment at this point in time.
1. As noted above, gold prices in the
However, there have also been significant pullbacks in the price of gold, such as in 2006, and that’s another negative. Gold prices typically fall off a cliff after a sharp run-up, rather than gently trending downward. This extreme volatility can be disconcerting to many investors.
2. Most analysts believe that the US dollar will continue to fall for at least another year. That may well be true, but keep in mind that the dollar is already down apprx. 20%. If for any reason the dollar stabilizes, or begins to rise, that could take a lot of the wind out of gold’s sails.
3. Another thing to keep in mind is that the run-up in gold prices prior to late 2005 was largely a
More recently, however, it is important to note that gold has experienced a bull market even in other international currencies. Click on this LINK to see a chart of gold prices in various currencies since 2003.
4. Contrary Opinion. More often than not, I am a contrarian, meaning that I don’t like to buy when everyone else is buying (or short when everyone else is shorting). Right now, the bullish consensus on gold is very high, as evidenced by the stampede into the new gold ETFs over the last couple of years (more on this below).
5. As prices have continued to rise, gold producers have begun to ramp-up production. As noted above, they may be playing catch-up at present, but at some point increased supplies may adversely affect gold prices. It is also important to note that most of the gold that has ever been mined continues to exist. As prices rise, some of this gold will find its way to the markets. I’m sure you’ve seen the TV commercials for companies that will buy your gold watches, rings, etc. If enough of this “scrap” gold makes its way to the markets, it could help hold down the price.
6. As I have written in recent weeks, the
As the above pros and cons illustrate, there are many reasons to invest or not invest in gold. For those of you who do want to include gold as a part of your overall diversified portfolio, the question then becomes how to make the purchase.
Gold Exchange Traded Funds Revisited
As I discussed earlier, there are various obstacles to owning physical metals. Obviously, there is the storage issue – you must have a safe place to hold your precious metals, and this can be expensive. There is also the issue of insurance, which is not cheap. Then there is the shipping issue, unless you trade with a local dealer, which frequently will not have the best prices. Typically, you will need to ship your coins or bullion via registered mail, which I found has gone up substantially in the last 10 years.
I know there are some of you who will prefer to keep your gold in a safe deposit box at the bank. For others, however, there are relatively new gold Exchange Traded Funds (ETFs) that address many of the disadvantages of buying, storing and selling physical gold. If you want to participate in the movements in gold prices, I think ETFs are a good way to do it.
In late 2004, I discussed at length the then new gold exchange traded fund (ETF), StreetTracks Gold Trust (NYSE: GLD). Since then, we have seen the introduction of the iShares Comex Gold Trust (ASE: IAU), which is also an ETF. These funds have become very popular for those who wish to participate in movements in the gold market, either long or short.
There are advantages and disadvantages to trading these ETFs in gold. One of the most obvious advantages of the gold ETFs is that they solve the shipping, insurance and storage problems associated with investments in physical gold bullion or coins. Some of the other advantages of this new way to own gold are as follows:
1. Dealer markup is no longer a problem, in that there is no spread between bid and ask prices. There may be transaction costs associated with purchasing and selling these ETFs, but there is no premium to be paid.
2. The gold ETFs are listed on the New York Stock Exchange and the American Stock Exchange, so they are liquid and can be bought or sold any time the market is open and trading. In addition, the gold ETFs may be “shorted” if an investor believes the price of gold will fall.
3. In the past, many institutional investors were precluded from owning gold because of the costs related to buying, selling, and storing the physical gold. The gold ETFs allow these investors to have an undivided interest in gold, but without all the hassles.
4. Gold mining stocks, a popular way to play the gold market, are often significantly overvalued or undervalued, relative to the price of gold for various reasons, and are typically extremely volatile. Because the gold ETFs closely track the price of gold, they have become a popular alternative to gold mining stocks.
Unfortunately, there are still some disadvantages to investing in these gold ETFs. Perhaps the most obvious is that it is not physical gold. For those investors who want to own gold as a store of value in case of emergency, having an undivided interest in gold sitting in a London or Nova Scotia vault will provide little or no comfort. Those investors who want to run their fingers through their gold hoard will still have to buy physical gold, and deal with the storage, shipping and other hassles involved.
Other disadvantages of the new gold ETFs are:
1. As I have written a number of times, the price of gold is very volatile and can move suddenly and without warning. The gold ETFs do not change this characteristic of gold, but at least they offer a way to quickly trade out of a gold position without the hassles of selling physical coins or bars – on the days the markets are open, of course.
2. The success of the gold ETFs likely contributed to the rise in gold prices over the last few years. As large sums of money have flowed into these gold funds, the ETFs have had to buy more and more physical gold on the open market. This buying almost certainly contributed to the upward pressure on the price of gold, and may continue to do so as long as the demand for these ETFs continues to grow.
Of course, the reverse will also be true whenever gold prices start to decline and investors start to sell their shares in these gold ETFs. In that case, the funds will have to sell physical gold on the open market, and this could exacerbate price declines.
3. While shares in the gold ETFs are considered to be securities, the IRS classifies these shares as “collectibles” for tax purposes. This means that long-term gains will be taxed at a higher 28% rate reserved for collectibles, rather than the 15% rate for other types of investments.
The points above do not represent a complete discussion of the advantages and disadvantages of gold ETFs. Be sure to read the prospectus carefully before you invest. However, the gold ETFs can be a good way to participate in the price movements in gold without having to own physical precious metals.
Other ways to deal in precious metals are e-gold.com and e-bullion.com. Both of these are electronic Internet currency facilitators backed by gold or other precious metals. E-gold Ltd., a
Apparently, e-gold and e-bullion have become popular as a form of international payment, as well as an investment medium. How popular, I don’t know. I must emphasize that I have never used e-gold or e-bullion, so I cannot recommend these services.
There is an old saying in the commodities markets that “the solution to high prices is high prices.” This probably sounds strange but generally speaking, when commodities prices rise significantly, production increases and demand decreases. This combination usually results in lower prices at some point.
While I don’t profess to know what gold prices will do in either the short-term or the long-term, I simply decided to take some profits on my gold investment, based largely on how much prices have increased over the last two years, and especially in the last few months. So it will not surprise me if we see a pullback in gold prices just ahead.
And finally, while I have sold my speculative position in physical gold, I still maintain my core holdings in precious metals, and I still have exposure to gold via our futures funds and certain of our Absolute Return Portfolios.
Very best regards,
Gary D. Halbert
Monday, October 22, 2007
Enjoy, read, and absorb every bit. Hope you guys enjoy, I certainly did :D
A Subprime Outlook for the Global Economy
By Stephen S. Roach
After nearly five fat years, the global economy is headed for trouble. This will come as a surprise to policy makers and investors, alike-most of who were counting on boom times to continue.
At work is yet another post-bubble adjustment in the world's largest economy - this time, the bursting of America's massive property bubble. The subprime fiasco is the tip of a much larger iceberg - an asset-dependent American consumer who has gone on the biggest spending binge in the modern history of the global economy. Seven years ago, the bursting of the dot-com bubble triggered a collapse in business capital spending that took the US and global economy into a mild recession. This time, post-bubble adjustments seem likely to hit US consumption, which at 72% of GDP, is more than five times the share the capital spending sector was seven years ago. This is a much bigger problem - one that could have grave consequences for the US and the rest of the world.
There is far more to this story than a potential downturn in the global business cycle. Another post-bubble shakeout poses a serious challenge to the timeworn inflation-targeting approach of central banks. It also presents the body politic with a fundamental challenge to its tolerance and, in many cases, encouragement of a new asset-dependent strain of global economic growth. Subprime spillovers have only just begun to play out - as has the debate this crisis has spawned.
Game Over for the American Consumer
The American consumer has been the dominant engine on the demand side of the global economy for the past 11 years. With real consumption growth averaging nearly 4% over the 1996 to 2006 interval, US consumption expenditures currently total over $9.6 trillion, or 19% of world GDP (at market exchange rates).
Growth in US consumer demand is typically powered by two forces - income and wealth (see Figure 1). Since the mid-1990s, income support has lagged while wealth effects have emerged as increasingly powerful drivers of US consumption. That has been especially the case in the current economic expansion, which has faced the combined headwinds of subpar employment growth and relatively stagnant real wages. As a result, over the past 69 months, private sector compensation - the broadest measure of earned labor income in the US economy - has increased only 17% in real, or inflation adjusted, terms. That falls nearly $480 billion short of the 28% increase that had occurred, on average, over comparable periods of the past four US business cycle expansions.
Lacking in support from labor income, US consumers turned to wealth effects from rapidly appreciating assets - principally residential property - to fuel booming consumption. By Federal Reserve estimates, net equity extraction from residential property surged from 3% of disposable personal income in 2001 to nearly 9% by 2005 - more than sufficient to offset the shortfall in labor income generation and keep consumption on a rapid growth path. There was no stopping the asset-dependent American consumer.
That was then. Both income and wealth effects are now coming under increasingly intense pressure - leaving consumers with little choice other than to rein in excessive demand. The persistently subpar trend in labor income growth is about to be squeezed further by the pressures of a cyclical adjustment in production and employment. In August and September 2007, private sector nonfarm payrolls expanded, on average, by only 52,000 per month - literally one-third the average pace of 157,000 of the preceding 24 months. Moreover, this dramatic slowdown in the organic job creating capacity of the US economy is likely to be exacerbated by a sharp fall off in residential construction sector employment in the months ahead. Jobs in the homebuilding sector are currently down only about 5% from peak levels despite a 40% fall-off in housing starts; it is only a matter of time before jobs and activity move into closer alignment in this highly cyclical - and now very depressed - sector.
Moreover, the bursting of the property bubble has left the consumer wealth effect in tatters. After peaking at 13.6% in mid-2005, nation-wide house price appreciation slowed precipitously to 3.2% in mid-2007. Given the outsize overhang of excess supply of unsold homes, I suspect that overall US home prices could actually decline in both 2008 and 2009 - an unprecedented development in the modern-day experience of the US economy. Mirroring this trend, net equity extraction has already tumbled - falling to less than 5.5% of disposable personal income in 2Q07 and retracing more than half the run-up that began in 2001. Subprime contagion can only reinforce this trend - putting pressure on home mortgage refinancing and thereby further inhibiting equity extraction by US homeowners.
With both income and wealth effects under pressure, I don't see any way saving-short, overly-indebted American consumers can maintain excessive consumption growth. For a US economy that has drawn disproportionate support from a record 72% share of personal consumption (see Figure 2), a consumer-led capitulation spells high and rising recession risk. Unfortunately, the same prognosis is likely for a still US-centric global economy.
Don't Count on Global Decoupling
A capitulation of the American consumer spells considerable difficulty for the global economy. This conclusion is, of course, very much at odds with notion of "global decoupling" - an increasingly popular belief that depicts a world economy that has finally weaned itself from the ups and downs of the US economy.
The global decoupling thesis is premised on a major contradiction: In an increasingly globalized world, cross border linkages have become even more important - making globalization and decoupling inherently inconsistent. True, the recent data flow raises some questions about this contention. After all, the world seems to have held up reasonably well in the face of the slowing of US GDP growth that has unfolded over the past year. But that's because the downshift in US growth has been almost exclusively concentrated in residential building activity - one of the least global sectors of the US economy. If I am right, and consumption now starts to slow, such a downshift will affect one of the most global sectors of the US. And I fully suspect a downshift in America's most global sector will have considerably greater repercussions for the world at large than has been the case so far.
That's an especially likely outcome in Asia - the world's most rapidly growing region and one widely suspected to be a leading candidate for global decoupling. However, as Figure 3 clearly indicates, the macro structure of Developing Asia remains very much skewed toward an export-led growth dynamic. For the region as a whole, the export share has more than doubled over the past 25 years - surging from less than 20% in 1980 to more than 45% today. Similarly, the share going to internal private consumption - the sector that would have to drive Asian decoupling - has fallen from 67% to less than 50% over the same period.
Nor can there be any mistake as to the dominant external market for export-led Asian economies. The United States wins the race hands down - underscored by a 21% share of Chinese exports currently going to America. Yes, there has been a sharp acceleration of intra-regional trade in recent years, adding to the hopes and dreams of Asian decoupling. But a good portion of that integration reflects the development of a China-centric pan-Asian supply chain that continues to be focused on sourcing end-market demand for American consumers. That means if the US consumer now slows, as I suspect, Asia will be hit hard - with cross-border supply chain linkages exposing a long-standing vulnerability that will draw the global decoupling thesis into serious question. A downshift of US consumption growth will affect Asia unevenly. A rapidly growing Chinese economy has an ample cushion to withstand such a blow. Chinese GDP growth might slow from 11% to around 8% - hardly a disaster for any economy and actually consistent with what Beijing has tried to accomplish with its cooling-off campaign of the past several years. Other Asian economies, however, lack the hyper-growth cushion that China enjoys. As such, a US-led slowdown of external demand could hurt them a good deal more. That's especially the case for Japan, whose 2% growth economy could be in serious trouble in the event of a US demand shock that also takes a toll on Japanese exports into the Chinese supply chain. While less vulnerable than Japan, Taiwan and South Korea could also be squeezed by the double whammy of US and China slowdowns. For the rest of Asia - especially India and the ASEAN economies - underlying growth appears strong enough to withstand a shortfall in US consumer demand. But there can be no mistaking the endgame: Contrary to the widespread optimism of investors and policy markers, the Asian growth dynamic is actually quite vulnerable to a meaningful slowdown in US consumption growth.
A Subprime Dollar
This constellation of forces could prove especially vexing for the US dollar. Currencies are, first and foremost, relative prices - in essence, measures of the intrinsic value of one economy versus another. On that basis, the world has had no compunction in writing down the value of the United States over the past several years. A broad dollar index, which measures the US currency relative to those of most of America's trading partners, is off about 20% from its early 2002 peak. Recently, it has hit new lows against the euro and a high-flying Canadian currency, likely a harbinger of more weakness to come.
Sadly, this depreciation of the US currency is not surprising. Because Americans haven't been saving in sufficient amounts for a long time, the United States must import surplus savings from abroad in order to grow. And it has to run record balance of payments and trade deficits in order to attract that foreign capital. The United States current account deficit - the broadest gauge of America's imbalance in relation to the rest of the world - hit a record 6.2% of gross domestic product in 2006 before receding slightly in the first half of this year. America must still attract some $3 billion of foreign capital each business day in order to keep its economy growing.
Economic theory is very clear on the implications of such huge imbalances: Foreign lenders need to be compensated for sending scarce capital to any country with a deficit. The bigger the deficit, the greater the required compensation. The currency of the deficit nation usually bears the brunt of that compensation. It then follows that as long as the United States fails to address its saving problem, its large balance of payments deficit will persist and the dollar will keep dropping.
The only silver lining so far has been that these adjustments to the US currency have been orderly - declines in the broad dollar index averaging a little less than 4% per year since early 2002. Now, however, the possibility of a disorderly correction is rising - with potentially grave consequences for the American and global economy.
A key reason is the mounting risk of a recession in America. As noted above, the bursting of the subprime mortgage bubble - strikingly reminiscent of the dot-com excesses of the 1990s - could well be a tipping point. In both cases, financial markets and policy makers were steeped in denial over the risks. But the lessons of post-bubble adjustments are clear. Just ask economically stagnant Japan. And of course, the United States lapsed into its own post-bubble recession in 2000 and '01. Sadly, the endgame could be considerably more treacherous for the United States than it was seven years ago. In large part, that's because the American consumer is now at risk. Consumption expenditures currently account for a record 72% of the gross domestic product - a number unmatched in the annals of modern history for any nation.
This buying binge has been increasingly supported by housing and lending bubbles. Yet, as also stressed above, both of these bubbles are now in the process of bursting - an outcome which could put US consumer demand under considerable pressure. That will make it exceedingly difficult for the United States to avoid a recession.
Fearful of that possibility and the additional Fed easing it implies, foreign investors are becoming increasingly skittish over buying dollar-based assets. The spillover effects of the subprime crisis into other asset markets - especially mortgage- backed securities and asset-backed commercial paper - underscore these concerns. As a result, foreign appetite for America's complex and opaque financial instruments is likely to be sharply reduced for years to come. That would choke off an important avenue of capital inflows, putting more downward pressure on the dollar.
The political winds are also blowing against the dollar. In Washington, China-bashing is the bipartisan sport du jour. New legislation is likely that would impose trade sanctions on China unless it makes a major adjustment in its currency. Not only would this be an egregious policy blunder - attempting to fix a multilateral deficit with more than 40 nations by forcing an exchange rate adjustment with one country - but it would also amount to Washington taxing one of America's major foreign lenders.
That would undoubtedly reduce China's desire for United States assets, and unless another foreign buyer stepped up, the dollar would come under even more pressure. Finally, the more the Fed under Ben Bernanke follows the easymoney, market-friendly Alan Greenspan script, the greater the risk to the dollar.
Why worry about a weaker dollar? The United States imported $2.2 trillion of goods and services in 2006. A sharp drop in the dollar makes those items considerably more expensive - the functional equivalent of a tax hike on consumers. It could also stoke fears of inflation - driving up long-term interest rates and putting more pressure on financial markets and the economy, exacerbating recession risks. Optimists may draw comfort from the vision of an export-led renewal arising from a more competitive dollar. Yet history is clear: No nation has ever devalued its way into prosperity.
So far, the dollar's weakness has not been a big deal. That may now be about to change. Relative to the rest of the world, the United States looks painfully subprime. So does its currency.
The Failure of Central Banking
The recent chain of events is not an isolated development. In fact, for the second time in seven years, the bursting of a major asset bubble has inflicted great damage on world financial markets. In both cases - the equity bubble in 2000 and the credit bubble in 2007 - central banks were asleep at the switch. The lack of monetary discipline has become a hallmark of an unfettered globalization. Central banks have failed to provide a stable underpinning to world financial markets and to an increasingly asset-dependent global economy.
This sorry state of affairs can be traced to developments that all started a decade ago. Basking in the warm glow of a successful battle against inflation, central banks decided that easy money was the world's just reward.
America's IT-enabled productivity resurgence in the late 1990s was the siren song for the Greenspan-led Federal Reserve - convincing the US central bank that it need not stand in the way of either rapid economic growth or excess liquidity creation. In retrospect, that was the "original sin" of bubble-world - a Fed that condoned the equity bubble of the late 1990s and the asset-dependent US economy it spawned. That set in motion a chain of events that has allowed one bubble to beget another - from equities to housing to credit.
Yet bubbles always burst. And when that happened to the equity bubble in 2000, central banks threw all caution to the wind and injected massive liquidity into world financial markets in order to avoid a dangerous deflation. With globalization restraining inflation and real economies recovering only sluggishly in the early 2000s, that excess liquidity went directly into asset markets.
Aided and abetted by the explosion of new financial instruments - especially what is now over $440 trillion of derivatives worldwide - the world embraced a new culture of debt and leverage. Yield-hungry investors, fixated on the retirement imperatives of aging households, acted as if they had nothing to fear. Risk was not a concern in an era of open-ended monetary accommodation cushioned by a profusion of derivativesbased shock absorbers.
As always, the cycle of risk and greed went to excess. Just as dot-com was the canary in the coalmine seven years ago, subprime was the warning shot this time. Denial in both cases has eerie similarities - as do the spillovers that inevitably occur when major asset bubbles pop. When the dot-com bubble burst in early 2000, the optimists said not to worry - after all, Internet stocks accounted for only about 6% of total US equity market capitalization at the end of 1999. Unfortunately, the broad S&P 500 index tumbled some 49% over the ensuing two and a half years and an over-extended Corporate America led the US and global economy into recession. Similarly, today's optimists are preaching the same gospel: Why worry, they say, if subprime is only about 14% of total US securitized mortgage debt? Yet the unwinding of the far broader credit cycle, to say nothing of the extraordinary freezing up of key short-term financing markets, gives good reason to worry - especially for over-extended American consumers and a still US-centric global economy.
Central banks have now been forced into making emergency liquidity injections - including a rare intra-meeting cut in the Fed's discount rate that was then followed by a 50 basis point reduction in the overnight lending rate. The jury is out on whether these efforts will succeed in stemming the current rout in still overvalued credit markets. While tactically expedient, these actions may be strategically flawed in that they fail to address the moral hazard dilemma that continues to underpin asset-dependent economies. Is this any way to run a modern-day world economy?
The answer is an unequivocal "no." As always, politicians are quick to grandstand and blame financial fiduciaries for problems afflicting uneducated, unqualified borrowers. Yet the markets are being painfully effective in punishing these parties. Instead, the body politic needs to take a look in the mirror - especially at the behavior of its policy-making proxies and regulators, the world's major central banks.
It is high time for monetary authorities to adopt new procedures - namely, taking the state of asset markets into explicit consideration when framing policy options. Like it or not, we now live in an asset-dependent world. As the increasing prevalence of bubbles indicates, a failure to recognize the interplay between the state of asset markets and the real economy is an egregious policy error.
That doesn't mean central banks should target asset markets. It does mean, however, that they need to break their one dimensional fixation on CPI-based inflation and also pay careful consideration to the extremes of asset values. This is not that difficult a task. When equity markets go to excess and distort asset-dependent economies as they did in the late 1990s, central banks should run tighter monetary policies than a narrow inflation target would dictate. Similarly, when housing markets go to excess, when subprime borrowers join the fray, or when corporate credit becomes freely available at ridiculously low "spreads," central banks should lean against the wind. The current financial crisis is a wake-up call for modern-day central banking. The world can't afford to keep lurching from one bubble to another. The cost of neglect is an ever-mounting systemic risk that could pose a grave threat to an increasingly integrated global economy. It could also spur the imprudent intervention of politicians, undermining the all-important political independence of central banks. The art and science of central banking is in desperate need of a major overhaul.
The Political Economy of Asset Bubbles
There may be a deeper meaning to all this. It is far-fetched to argue that central banks have consciously opted to inflate a series of asset bubbles - and then simply deal with the aftershocks once they burst. At work, instead, are the unintended consequences of a new and powerful asset-led global growth dynamic that is very much an outgrowth of the political economy of growth and prosperity.
This outcome reflects the confluence of three mega-trends - globalization, the IT revolution, and the provision of retirement income for aging workers. Globalization has injected a powerful new impetus to the disinflation of the past quarter century - facilitating a cross-border arbitrage of costs and prices that has put unrelenting pressure on the pricing of goods and many services, alike. At the same time, IT-enabled productivity enhancement - initially in the United States but now increasingly evident in other economies - has convinced central banks that there has been a meaningful increase in the non-inflationary growth potential in their respective economies. Finally, rapidly aging populations in Japan, Europe, and the United States are putting pressure on plan sponsors - public and private, alike - to boost investment yields in order to fund a growing profusion of unfunded pension and retirement schemes.
A key result of the interplay between the first two of these mega-trends - the globalization of disinflation and IT-enabled productivity enhancement - has been a sharp reduction in nominal interest rates on sovereign fixed income instruments for short- and long-term maturities, alike. Lacking in the yield to fund retirement programs from such riskless assets, investors and their fiduciaries have ventured into increasingly riskier assets to square the circle. That, in conjunction with the ample provision of liquidity from inflation- relaxed central banks, has driven down yield spreads in a variety of risky assets - from emerging-market and highyield corporate debt to mortgage-backed securities and a host of other complex structured products. In an era of spread compression and search for yield, the rising tide of ample liquidity covered up a profusion of jagged and dangerous rocks. As the tide now goes out, the rocks now get uncovered. The subprime crisis is a classic example of what can be unmasked at low tide.
The same set of forces has had an equally profound impact on the investment strategies of individual investors. Lacking in traditional yield from saving deposits and government bonds, families have opted, instead, to seek enhanced investment income from equities and, more recently, from residential property. This has created a natural demand for these asset classes that then took on a life of its own - with price increases begetting more price increases and speculative bubbles arising as a result. As long as inflation-targeting central banks remained fixated on their well-behaved narrow CPIs, there was little to stand in the way of a powerful liquidity cycle that has given rise to a multi-bubble syndrome.
In the end, it is up to the body politic to judge the wisdom of this arrangement - essentially, whether the inherent instability of increasingly asset-dependent and bubble-prone economies is worth the risk. Lacking a clear feedback mechanism to render such a verdict, it falls to the world's central banks - the stewards of economic and financial stability - to act as proxies in resolving this problem. This is where the problem gets particularly thorny. It takes a truly independent central bank to take a principled stand against the systemic risks that may arise from the pro-growth mindset of the body politic and act to "take the punchbowl away just when the party is getting good" - to paraphrase the sage advice of one of America's legendary central bankers, William McChesney Martin. Yet as recently retired Fed Chairman Alan Greenspan concedes, "I regret to say that Federal Reserve independence is not set in stone."
Greenspan's confession underscores the important distinction between two models of the central banker - those who are truly politically independent and those who are more politically compliant. The United States has had both types. I would certainly put Paul Volcker in the former category; amid howls of protest, his determined assault against the ravages of double-digit inflation was conducted at great political risk. Yet in the end, he held to a monetary policy that was fiercely independent of political pressures. By contrast, Arthur Burns, who I worked for in the 1970s, was highly politicized in his decisions to avoid the wrenching monetary tightening that a cure for inflation would eventually require. The market-friendly stance of Alan Greenspan - and the asset-dependent US economy it spawned - was more consistent with the model of the complaint central banker who was very much in sync with the pro-growth mindset of the body politic. Greenspan's memoirs are as much about politics as economics - underscoring his much stronger sense of the interplay between these two forces than a more independent central banker might otherwise perceive.
Yet Greenspan's basic point is well taken: It is not easy for any central banker to do unpopular things - especially if he happens to be a political animal operating in a highly charged political climate. But that's where I would draw the line. With all due respect to Alan Greenspan, the truly independent central banker was never supposed to win political popularity contests. I would be the first to concede, however, that it will take great political courage to forge the new approach toward monetary policy that I am advocating. But it can be done - as exemplified by the legacy of Paul Volcker.
In the end, it will undoubtedly take a crisis to provide central banks with the political cover they believe they need to broaden out their mandate from the narrow dictums of CPI-based price stability. Who knows if such a crisis is now in the offing? But with the credit cycle unwinding at the same time that Washington is turning protectionist and the overly-indebted American consumer is in trouble, the wisdom of condoning asset-dependent, bubble-prone economies may finally be drawn into serious question.
A Subprime Prognosis
How all this plays out in the global economy in the years immediately ahead is anyone's guess. I have long framed the tensions shaping the outlook in the context of "global rebalancing" - the need of a lopsided world economy to wean itself from a US-centric growth dynamic. A partial rebalancing now appears to be at hand - likely to be led by the coming consolidation of the American consumer. That is painful but good news for those of us who have long worried about the destabilizing risks of a massive US current account deficit. But a more complete global rebalancing is a shared responsibility - one that must also be accompanied by an increase in domestic demand from surplus-saving economies elsewhere in the world. To the extent that doesn't happen - and, as underscored above, that remains my view - then a asymmetrical rebalancing dominated by slowdown in US consumer demand should take a meaningful toll on global growth.
For a world economy that has been on close to a 5% growth path for nearly five years, that points to nothing but downside over the next 1-2 years. It's always hard to pinpoint the magnitude of such a shortfall with any precision, but I would not be surprised to see world GDP growth slip down into the 3.5% to 4% range at some point in 2008. Interestingly enough, such a downshift would only take global growth back to its post-1970s trend (3.7%). While that's hardly a disaster, it would still represent approximately a 25% slowing from the world's recent heady growth pace. Such an outcome could prove especially troublesome for the earnings optimism still embedded in global equity markets. The silver lining of such a prognosis would be likely cyclical relief on the inflation front - providing support for sovereign bonds.
But, as I have attempted to underscore above, the issues shaping the medium-term prognosis for the global economy go far beyond a standard call on the business cycle. America's asset-dependent growth paradigm is finally at risk. And with those risks comes the potential for collateral damage elsewhere in a still US-centric global economy. Dollar risks are especially problematic but so, too, is the collective wisdom - or lack thereof - of central bankers and politicians who have allowed the world to come to this precarious point. Policymaking and politics remain driven purely by local considerations. Yet the stresses and strains of a globalized world demand a much broader perspective. A new approach is needed - before it's too late.