Tuesday, December 30, 2008

Worse Than The Illness?

Is The Medicine Worse Than The Illness?

By James Grant | 20 December 2008

The world ran out of trust in 2008— but there is no shortage of money because the Fed is 'printing' like mad. It's the wrong approach, with potentially dire consequences, says James Grant.

It is a sorry place at which we Americans find ourselves this none-too-festive holiday season. The biggest names on Wall Street have gone to their rewards or into partnership with the U.S. Treasury. Foreigners stare wide-eyed from across the waters. A $50 billion Ponzi scheme (baited with, of all things in this age of excess, the promise of low, spuriously predictable returns)? Interest rates over which tiny Japanese rates fairly tower? Regulatory policy seemingly set by a weather vane? A Federal Reserve that can't make up its mind: Is it in the business of central banking or of central planning? And to think— our disappointed foreign friends mutter— all of these enormities taking place under a Republican administration.

Trust itself entered a bear market in 2008, complementing and perhaps surpassing the selloffs in stocks, mortgages and commodities. Never to be confused with angels, we humans seem to outdo ourselves when money is on the line. So it is that Bernard Madoff, supposed pillar of the community, stands accused of perpetrating one of the greatest hoaxes since John Law discovered the inflationary possibilities of paper money in the early 18th century.

Bundles of freshly printed bills at the Treasury Department.

Barely nudging Mr. Madoff out of the top of the news was the Federal Reserve's announcement last Tuesday that it intends to debase its own paper 'money'. The year just ending has been a time of confusion as much as it has been of loss. But here, at least, was the bright beam of clarity. Specifically, the Fed pledged to print dollars in unlimited volume and to trim its funds rate, if necessary, all the way to zero. Nor would it rest on its laurels even at an interest rate low enough to drive the creditor class back to work. It would, on the contrary, "continue to consider ways of using its balance sheet to further support credit markets and economic activity."

Wall Street that day did handsprings. Even government securities prices raced higher, as if, somehow, Treasury bonds were not denominated in the currency with which the Fed had announced its intention to paper the face of the earth. Economic commentators praised the central bank's determination to fight deflation— that is, to reinstate inflation. All hands, including President-elect Obama, seemed to agree that wholesale money-printing was the answer to the nation's prayers.

One market, only, registered a protest. The Fed's declaration of inflationary intent knocked the dollar for a loop against gold and foreign currencies. In many different languages and from many time zones came the question, "Tell me, again, now that the dollar yields so little, why do we own it?"

It was on Oct. 6, 1979, that then-Fed Chairman Paul A. Volcker vowed to print less money to bring down inflation. So doing, he closed one monetary era and opened another. With Tuesday's promise to print much more money, the Federal Reserve of Ben S. Bernanke has opened its own new era. Whether Mr. Bernanke's policy of debasement will lead to as happy an outcome as that which crowned the Volcker anti-inflation initiative is, however, doubtful. Whatever the road to riches might be paved with, it isn't little green pieces of paper stamped "legal tender."

Fed Chairman Ben Bernanke appears before Congress in Oct.

Our troubles, over which we will certainly prevail, stem from a basic contradiction. The dollar is the world's currency, yet the Fed is America's central bank. Mr. Bernanke's remit is to promote low inflation, high employment and solvent finance— in the 50 states. He wishes the Chinese well, of course, and the French and the Singaporeans and all the rest besides, but they don't pay his salary.

They do, however, buy the U.S. Treasury's bonds, which frames the emerging American dilemma. If the Fed is going to create boatloads of depreciating, non-yielding dollar bills, who will absorb them? Who will finance the Obama administration's looming titanic fiscal deficits? Who will finance America's annual surplus of consumption over production (after 25 more or less continuous years, almost a national trait)? Inflation is a kind of governmentally sanctioned white-collar crime. Every crime needs a dupe. Now that the Fed has announced its plan to deceive, where will it find its victims?

Mr. Bernanke has good reason to worry about the economy. We all do. In the boom, a superabundance of mispriced debt led countless people down innumerable blind investment alleys. E-Z credit financed bubbles in real estate, commodities, mortgage-backed securities and a myriad of other assets.

It punished saving and encouraged speculation. Imagine a man at the top of a stepladder. He is up on his toes reaching for something. Call that something "yield." Call the stepladder "leverage." Now kick the ladder away. The man falls, pieces of debt crashing to the floor around him.

The Fed, watching this preventable accident unfold, rushes to the scene too late. Not only did Bernanke et al. not see it coming, but they actually egged the man higher. You will recall the ultra-low interest rates of the early 2000s. The Fed imposed them to 'speed recovery' from an earlier accident, this one involving a man up on a stepladder reaching for technology stocks.

A money trader reacts to the falling price of the dollar on Dec. 12.

The underlying cause of these mishaps is the dollar and the central bank that manipulates it. In ages past, it was so simple. A central banker had one job only, and that was to assure that the currency under his care was exchangeable into gold at the lawfully stipulated rate. It was his office to make the public indifferent between currency or gold.

In a crisis, the banker's job description expanded to permit emergency lending against good collateral at a high rate of interest. But no self-respecting central banker did much more. Certainly, none arrogated to himself the job of steering the economy by fixing an interest rate. None, I believe, had an economist on the payroll.

None facilitated deficit spending by buying up his government's bonds. None cared about the 'average level of prices', which rose in wartime and sank in peacetime. It sank in peacetime because technological progress and the opening of new regions to agricultural production made merchandise and commodities cheaper and more abundant.

Not everyone agreed that these arrangements were heaven-sent. In comparison to the rigor of the gold standard, paper money seemed, to many, an intelligent and forgiving alternative. In 1878, a committee of the House of Representatives was formed to investigate the causes of the suffering of working people in the depression that was five years old and counting. Not a few witnesses pleaded for the creation of more greenbacks. They asked that the government not go through with its plan to return to the gold standard in 1879. But the nation did return to gold— it had financed the Civil War with paper money— and the depression ended in the very same year.

Gold is a hard master, and a capricious one, too, insofar as growth in the world's monetary base depends on the enterprise of mining engineers. But, as we have seen lately, there is no caprice like the caprice of sleep-deprived Mandarins improvising a monetary solution to a credit crisis (or, for that matter, of fully rested Mandarins setting interest rates by the lights of their econometric models). The times were hard in the 1870s and, for that matter, again in the 1890s.

But Americans repeatedly spurned the Populist cries for a dollar you didn't have to dig out of the ground but could rather print up by the job lot. "If the Government can create money," as a hard-money propagandist put it in an 1892 broadside entitled "Cheap Money," "why should not it create all that everybody wants? Why should anybody work for a living?" And— in a most prescient rhetorical question— he went on to ask, "Why should we have any limit put to the volume of our currency?"

A couple of panics later, the Federal Reserve came along— the year was 1913. Promoters of the legislation to establish America's new central bank protested that they wanted no soft currency. The dollar would continue to be exchangeable into gold at the customary rate of $20.67 an ounce. But, they added, under the Fed's 'enlightened' stewardship, the currency would become "expansive." Accordion-fashion, the number of dollars in circulation would 'expand or contract' according to 'the needs of' commerce and agriculture.

Elihu Root warned about 'easy money' in the early 1900s.

Elihu Root, Republican senator from New York, thought he smelled a rat. Anticipating the credit inflations of the future and recalling the disturbances of the past, Mr. Root attacked the bill in this fashion:
"Little by little, business is enlarged with easy money. With the exhaustless reservoir of the Government of the United States furnishing easy money, the sales increase, the businesses enlarge, more new enterprises are started, the spirit of optimism pervades the community.

"Bankers are not free from it,"
Mr. Root went on. "They are human. The members of the Federal Reserve board will not be free of it. They are human....Everyone is making money. Everyone is growing rich. It goes up and up, the margin between costs and sales continually growing smaller as a result of the operation of inevitable laws,
until finally someone whose judgment was bad, someone whose capacity for business was small, breaks; and as he falls he hits the next brick in the row, and then another, and then another, and down comes the whole structure.

"That, sir," Mr. Root concluded, "is no dream. That is the history of every movement of inflation since the world's business began, and it is the history of many a period in our own country. That is what happened to greater or less degree before the panic of 1837, of 1857, of 1873, of 1893 and of 1907. The precise formula which the students of economic movements have evolved to describe the reason for the crash following the universal process is that when credit exceeds the legitimate demands of the country the currency becomes suspected and gold leaves the country."

[[But, withall, we have not had a really serious inflation/deflation, or economic crash, since the Great Depression— the end of "hard" currency— not even since the end of any ties to "hard" currency and the beginning of the era of unlimited "fiat" money in 1971: normxxx]]

Little did Mr. Root suspect that the dollar would lose its gold backing altogether— that, starting in 1971, there would be nothing behind it more than the 'good intentions' of the U.S. government and (somewhat more substantively) the demonstrated strength of the U.S. economy. Still less could he have guessed that the world would nonetheless fall in love with that uncollateralized piece of paper or— even more astoundingly— that the United States would enjoy so great a reservoir of good will that it would be allowed to borrow its way to a net international investment position of minus $2.44 trillion ($17.64 trillion of foreign assets held by Americans vs. $20.08 trillion of American assets held by foreigners). "It goes up and up," Mr. Root said of the inflationary cycle, but just how high he could not have dreamt.

Knowledge of the precepts of classical central banking prepared no one to understand, much less to anticipate, the Fed's conduct in this credit crackup. The central bank is lending freely, all right, but not at the stipulated "high" interest rate. As a matter of fact, it is starting to lend at a rate below which there is no positive rate. The gold standard was objective.

Modern monetary management is subjective (under Alan Greenspan, it was intuitive). The gold standard was rules-based. The 21st century Fed goes with what works— or seems to work [[at least for now, and the devil take the next guy up! : normxxx]] What it hopes is going to work for the fellow who fell off the stepladder is more debt and more dollars.

Just how much of each can be found every Thursday evening on the Fed's own Web site. Open up form H4.1 and prepare to be amazed. Since Labor Day, the Fed's assets have zoomed to $2.31 trillion from $905.7 billion. And what is the significance of this stunning rate of asset growth? Simply this: The Fed pays for its assets with freshly made dollars. It conjures them into existence on a computer; "printing" is a figure of speech. [[An increasingly "quaint" figure of speech; there's probably not enough paper and printer's ink to produce the actual!: normxxx]]

In this crisis, the Fed's assets have grown much faster than its capital. The truth is that the Federal Reserve is itself a highly leveraged financial institution. The flagship branch of the 12-bank system, the Federal Reserve Bank of New York, shows assets of $1.3 trillion and capital of just $12.2 billion. Its leverage ratio, a mere 0.9%, is less than one-third of that prescribed for banks in the private sector.

Such a thin film of protection would present no special risk if the bank managed by Timothy F. Geithner, the Treasury secretary-designate, owned only short-dated Treasurys. However, the mystery meat acquired from Bear Stearns and AIG foots to $66.6 billion. A writedown of just 18.3% in the value of those risky portfolios would erase the New York Fed's capital account.

In congressional testimony eight years ago, Laurence Meyer, then a Fed governor, tried to allay any such concerns (which then must have seemed remote, indeed). "Creditors of central banks...are at no risk of a loss because the central bank can always create additional currency to meet any obligation denominated in that currency," he soothingly reminded his listeners. Yes, today's policy makers allow, there are risks to "creating" a trillion or so of new currency every few months, but that is tomorrow's worry. On today's agenda is a deflationary abyss. Frostbite victims tend not to dwell on the perils of heatstroke.

But the seasons of finance are unpredictable. Prescience is rare enough in the private sector. It is almost unheard of in Washington. The credit troubles took the Fed unawares. So, likely, will the outbreak of the next inflation. Already the stars are aligned for a doozy.

Not only the Fed, but also the other leading central banks are frantically ramping up money production. Simultaneously, miners and oil producers are ramping down commodity production— as is, for instance, is Rio Tinto, the heavily encumbered mining giant, which the other day disclosed 14,000 layoffs and a $5 billion cutback in capital expenditure. Come the economic recovery, resource producers will certainly increase output. But it is far less certain that, once the cycle turns, the central banks will punctually tighten. [[And, in any case, certainly not dramatically. : normxxx]]

The public has been slow to anger in this costliest and scariest of post World War II financial crises. Wall Street and the debt ratings agencies have come in for well-deserved castigation. But pointing fingers rarely find the Federal Reserve, whose low, low interest rates helped to set house prices levitating in the first place.

After Mr. Bernanke gets a good night's sleep, he should be called to account for once again cutting interest rates at the expense of the long-suffering (and possibly hungry) savers. He should be asked to explain how the central-banking methods of the paper-dollar era represent any improvement, either in practice or theory, over the rigor, elegance, simplicity and predictability of the gold standard. He should be directed to read aloud the text of critique by Elihu Root and explain where, if at all, the old gentleman went wrong. Finally, he should be directed to put himself into the shoes of a foreign holder of U.S. dollars. "Tell us, Mr. Bernanke," a congressman might consider asking him, "if you had the choice, would you hold dollars? And may I remind you, Mr. Chairman, that you are under oath?"

James Grant, the editor of Grant's Interest Rate Observer, is the author most recently of "Mr. Market Miscalculates."



The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

A 'Minsky Meltdown'?

A Minsky Meltdown?

By John Bogle | 30 December 2008

An old story— perhaps apocryphal— tells of the tailor who made his living selling fine silk shirts to the wealthy wizards of Wall Street. When the stock market crashed in 1929, he delighted in their demise. But within a year, his own business, bereft of customers, itself went bankrupt.

The failure of our financial system, as this sad example makes clear, often resonates throughout our entire economy. Today, we already see the profound weakness in our financial sector finding its way into the rest of our economy. [[And, at breakneck speed! : normxxx]] It will be hard for many of our citizens, far less well-to-do than our moneymen and moneywomen, to bear. In 2006, the wealthiest 20 percent of wage earners in Manhattan made some $350,000 a year on average, nearly 40 times the $8,800-a-year income earned by the poorest 20 percent.

In my long career in finance, going way back to 1951, I've now witnessed 10 bear markets (defined as a decline in the stock market of 20 percent or more). The current bear market has been off by more than 50 percent, slightly larger than the 1973–1974 and 2000–2001 crashes. But this decline is the first that I can recall in which the distress of the financial markets so profoundly [[and so quickly: normxxx]] impacted the real economy of goods and services, of ordinary people, especially of those who had no real way to participate in the boom that led to the bust, but who are, nevertheless, now paying the penalty for the market's excesses. [[And, around the world! : normxxx]]

What we are increasingly seeing is the verification of "the financial instability hypothesis" put forth by the economist Hyman P. Minsky (1919–1996). In 1992, Minsky warned that "capitalist economies exhibit ... debt deflations which ... spin out of control ... [as] the economic system's reactions to a movement of the economy amplify the movement ... . Government interventions aimed to contain the deterioration [are often] inept in … historical crises."

Minsky concluded that over long periods of prosperity, the economy transits from financial structures that make for a stable system to ones that make for an unstable system— i.e., that "stability leads to instability," largely through what he described as hedging, speculation and Ponzi finance. In that sense, Minsky was a prophet of [several] of today's economic crises.

Another insight was also prophetic: "Institutional complexity [read: today's collateralized debt obligations and credit default swaps] may result in several layers of intermediation between the ultimate owners of the communities' wealth, and the [business and individual] units that control and operate the communities' wealth." This separation between ownership and control has now come to pass. In a mere half-century, we have moved from an ownership society (92 percent of all stocks owned by individuals; 8 percent by institutions) to an 'agency' society (24 percent and 76 percent, respectively), a change I've described as "a pathological mutation in capitalism".

How has this separation contributed to the recent crisis? First, because these new agents— institutional money managers advising mutual funds and retirement plans— have far too often placed their own financial interests ahead of the interests of fund owners and retirement plan beneficiaries, ignoring the interests of their own principals. And second, because these agents have departed from their traditional investment principles focused on the wisdom of long-term investing to a 'new' approach that relies on the folly of short-term speculation.

How great a departure does this change in investment principles represent? An enormous change, however rarely noted. Today, turnover of stocks in the United States, which ran in a range of 20 to 40 percent during my first 30 years in the mutual fund field, will come to more than 300 percent in 2008— something like 10 times as large. [[But in line with, though still greatly exceeding, that of 1929. See also, "The Inevitable Dénoument" by Alan M. Newman, editor, Crosscurrents: normxxx]]

Yet it is not Wall Street, but the ordinary citizens of the United States who will foot the bill. "The government," as always, has no money of its own. So it is paying the financial sector for its gross excesses with our money. We may pay for part of this bailout with higher taxes, but given our flawed political system, the cost is more likely to be extracted from future generations with dollars that buy less. Inflation is just another form of taxation, albeit one that is sharply regressive. [[In other words, as usual, those who benefitted least will bear the greatest burdon.: normxxx]]

As the woes of our financial system resonate through our economy, it seems crystal clear that our current recession will intensify— a "Minsky Meltdown" of significant proportions. While I believe that something more serious— obviously, a depression— is unlikely, we can't be sure whether our plummeting stock market: (a) has yet to adequately anticipate the depth of the economic downturn; (b) has already anticipated it; or (c) has anticipated something much worse than what is likely to transpire.

I'm inclined to believe that the answer is somewhere between (b) and (c). Why? Because the market value of U.S. stocks has tumbled by 50 percent— from $18 trillion to $9 trillion, and I just can't imagine that the value of American enterprise is $9 trillion lower than it was at the market high last October. Further, let's not forget that today's lower stock prices translate into stronger fundamentals underlying future returns:
  • The dividend yield on the S&P 500— less than 2 percent in October 2007 and a skinny 1 percent in March 2000— is now 3.5 percent, a far larger contributor to future returns.

  • The price-earnings multiple, 32 times at the 2000 market high, is now about 12 to 15 times (depending on whether we look at operating or reported earnings).

  • The price of the S&P 500 Index is now about 1.8 times book value, a level not seen since 1990. (The price-book ratio reached the elevated level of 5.5 times in early 2000. [[for the significance of that, see "Valuing Wall Street: Protecting Wealth in Turbulent Markets" by Andrew Smithers and Stephen Wright: normxxx]])

As Benjamin Graham observed, in the short run, the market is a voting machine, but in the long run it is a weighing machine. Put another way, "The fundamental things apply as time goes by."



The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Thursday, December 25, 2008

Crisis Deepens; Asian Exports Plunge

For anyone who thinks the Credit Crisis has retired. The rest of the world seems now to be tanking worse than the US.

Crisis Deepens In Japan And China As Asian Exports Plunge
Japan's Exports Plunged 27% Last Month In The Steepest Fall For Half A Century.

By Ambrose Evans-Pritchard | 22 December 2008

The shock data came as the Japanese Cabinet Office warned that the world's second biggest economy is now deteriorating at an "exceptionally high pace". Shipments collapsed to almost all markets in North America, Europe, and Asia, following a pattern already set in recent days by South Korea, Taiwan, and China. Thailand on Monday said its exports fell 19% in Novermber. It is unclear to whether the violent drop is distorted by a "one-off" inventory shock as end companies slash stocks, or whether it is the start of a trade slump that threatens Asia's entire export strategy.

"We think this is very serious," said Stephen Jen, currency chief at Morgan Stanley. "These export surplus countries are super-leveraged to the West, and now we're seeing a multiplier effect (in reverse) as the intra-Asian trade model is stress-tested. What's incredible is that Japan has run a trade deficit for two months in a row despite the [huge] fall in oil prices. The next country to watch is going to be Germany," he said.

The Baltic Dry Index measuring freight rates for bulk goods has crashed by 94% since peaking in June. Container shipping for manufactured goods has been less volatile but that too has begun to buckle. Denmark's Maersk and China's COSCO have both cut container rates from Asia by a quarter.

Importers have been struggling to secure letters of credit, the lubricant of the trading system. Even large banks in Asia have had trouble obtaining dollars needed for shipping deals. Masaaki Shirakawa, the Bank of Japan's governor, said the central bank was preparing to buy corporate debt and commercial paper in an emergency move to unlock the credit market. It cut interest rates to 0.01% on Friday, tantamount to zero.

"It's an exceptional step," he conceded, insisting that the authorities were taking on private credit risk with great reluctance. The bank is boosting its purchase of governement bonds from ¥1.2 trillion to ¥1.4 trillion ($156bn) per month in a return to 'quantitative easing'. In China, the central bank cut rates for a fifth time since September to 5.31% and trimmed the reserve requirement for lenders. The Govenrmment is rushing through a $585bn fiscal stimulus package.

Beijing is alarmed by outbursts of civil unrest, both in the country's hinterland as 9m migrant workers return home after losing their jobs, and in the export hub of Guangdong where violence has been simmering for months. Some 3,600 toy factories have already closed this year. Premier Wen Jiabao said over the weekend that the key priority is to find jobs for migrants and some 6m fresh graduates— the two groups most feared as a political tinderbox.

"If you are worried, I am more worried than you," he told students. Japan's economy minister Kaoru Yosano said Tokyo is mulling a range of drastic measures to support the economy, including the outright purchase of equities held by banks in distress. "We're ready to do everything we can to break the cycle of deterioration in sentiment," he said.

The Cabinet Office warned that the surge in the yen against all major currencies was now tightening like a vise on Japan's economy. "The tempo of the economic downturn is getting substantially faster. What's worse is that there are many negative factors that can make a recession deeper and longer," it said.

The yen has appreciated by a third to ¥89 against the dollar since the credit crunch began. It has doubled in value against sterling. There has been a dramatic reversal of the "carry trade" as hedge funds close worldwide bets that were financed at near zero rates in Tokyo. Japanese investors began to repratriate their vast foreign holdings.

The surging yen has played havoc with the balance sheet of Japan's leading exporters. Every one yen appreciation against the dollar and euro shaves Toyota's profits by $450m. The company is now underwater, facing its first loss since 1938. The risk is that Japan could slide back into a deflationary crisis and renewed perma-slump. The country's `Lost Decade' never seems to end.


Protectionist Dominoes Are Beginning To Tumble Across The World
The Riots Have Begun. Civil Protest Is Breaking Out In Cities Across Russia, China, And Beyond.

By Ambrose Evans-Pritchard | 22 December 2008

Greece has been in turmoil for 11 days. The mood seems to have turned "pre-insurrectionary" in parts of Athens— to borrow from the Marxist handbook. This is a foretaste of what the world may face as the "crisis of capitalism"— another Marxist phase making a comeback— starts to turn two hundred million lives upside down.

We are advancing to the political stage of this global train wreck. Regimes are being tested. Those relying on perma-boom to mask a lack of democratic or ancestral legitimacy may try to gain time by the usual methods: trade barriers, sabre-rattling, and barbed wire. Dominique Strauss-Kahn, the head of the International Monetary Fund, is worried enough to ditch a half-century of IMF orthodoxy, calling for a fiscal boost worth 2% of world GDP to "prevent global depression".

"If we are not able to do that, then social unrest may happen in many countries, including advanced economies. We are facing an unprecedented decline in output. All around the planet, the people have reacted with feelings going from surprise to anger, and from anger to fear," he said.

Russia has begun to shut down trade as it adjusts to the shock of Urals oil below $40 a barrel. It has imposed import tariffs of 30% on cars, 15% on farm kit, and 95% on poultry (above quota levels). "It is possible during the financial crisis to support domestic producers by raising customs duties," said Premier Vladimir Putin. Russia is not alone. India and Vietnam have imposed steel tariffs. Indonesia is resorting to special "licences" to choke off imports.

The Kremlin is alarmed by a 13% fall in industrial output over the last five months. There have been street protests in Moscow, St Petersburg, Kaliningrad, Vladivostok and Barnaul. Police crushed "Dissent Marchers" holding copies of Russia's constitution above their heads in Moscow's Triumfalnaya Square. "Russia has not seen anything like these nationwide protests before," said Boris Kagarlitsky from Moscow's Globalization Institute.

The Duma is widening the treason law to catch most forms of political dissent, and unwelcome forms of journalism. Jury trials for state crimes are to be abolished. Yevgeny Kiseloyov at the Moscow Times said it feels eerily like 1 December 1934 when Stalin unveiled his "Enemies of the People" law, kicking off the Great Terror. The omens are not good in China either. Taxis are being bugged by state police. The great unknown is how Beijing will respond as its state-directed export strategy hits a brick wall, leaving exposed a vast eyesore of concrete and excess plant.

Exports fell 2.2% in November [alone]. Toy, textile, footwear, and furniture plants are being closed across Guangdong, now the riot hub of South China. Some 40m Chinese workers are expected to lose their jobs. Party officials have warned of "mass-scale social turmoil".

The Chinese Politburo is giving mixed signals. We don't yet know how much of the country's plan to boost domestic demand through a $586bn stimulus package is real, and how much is a wish-list sent to party bosses in the hinterland without funding. Shortly after President Hu Jintao said China is "losing competitive edge in the world market", we saw a move towards export subsidies for the steel industry and a dip in the yuan peg— even though China already has the world's biggest reserves ($2 trillion) and the biggest trade surplus ($40bn a month).

So is the Communist Party mulling a 1930s "beggar-thy-neighbour" strategy of devaluation to export its way out of trouble? Such raw mercantilism can only draw a sharp [response] from Washington and Brussels in this climate. "During a global slowdown, you can't have countries trying to take advantage of others by manipulating their currencies," said Frank Vargo from the US National Association of Manufacturers.

It is a view shared entirely by President-elect Barack Obama. "China must change its currency practices. Because it pegs its currency at an artificially low rate, China is running massive current account surpluses. This is not good for American firms and workers, not good for the world," he said in October. The new intake of radical Democrats on Capitol Hill will hold him to it.

There has been much talk lately of America's Smoot-Hawley Tariff Act, which set off the protectionist dominoes in 1930. It is usually invoked by free traders to make the wrong point. The relevant message of Smoot-Hawley is that America was then the big exporter, playing the China role. By resorting to tariffs, it set off retaliation, and was the biggest victim of its own folly.

Britain and the Dominions retreated into 'Imperial Preference'. Other countries joined. This became the "growth bloc" of the 1930s, free from the deflation constraints of the Gold Standard. High tariffs stopped the stimulus leaking out.

It was a successful strategy— given the awful alternatives— and was the key reason why Britain's economy contracted by just 5% during the Depression, against 15% for France, and 30% for the US. Could we see such a closed "growth bloc" emerging now, this time led by the US, entailing a massive rupture of world's trading system? Perhaps. This crisis has already brought us a monetary revolution as interest rates approach zero across the G10. It may overturn the "New World Order" as well, unless we move with great care in grim months ahead.

This is where events turn dangerous. The last great era of globalisation peaked just before 1914. You know the rest of that story.


The Federal Reserve Is Damned Either Way As It Battles Debt And Deflation
We Know What Causes A Recession To Metastasize Into A Slump. Irving Fisher, The Paramount US Economist Of The Inter-War Years, Wrote The Text In 1933: "Debt-Deflation Theory Of Great Depressions".

By Ambrose Evans-Pritchard | 18 December 2008

"Such a disaster is somewhat like the capsizing of a ship which, under ordinary conditions is always near stable equilibrium but which, after being tipped beyond a certain angle, has no longer this tendency to return to equilibrium, but [has, rather,] a tendency to depart further from it," he said. Today we call this "Gladwell's tipping point". Once you pass it, you can't get back up. This is why the Federal Reserve has resorted [so quickly] to emergency measures that seem mad at first sight.

It has not only cut rates to near zero for the first time in US history, it is also conjuring $2 trillion of stimulus out of thin air. This is 'Quantitative Easing', or just plain 'QE' in our brave new world. The key is the toxic mix of high debt and deflation. An economy can handle one at a time, but not both.

The reason why it "departs further" from equilibrium is more or less understood. The burden of debt increases as prices fall, creating a self-feeding spiral [[a 'negative feedback' effect: normxxx]]. This is what Fisher called the "swelling dollar" effect. Real debt costs rose by 40% from 1929 to early 1933 by his count. Debtors suffocated to death.

Brian Reading from Lombard Street Research has revived this neglected thesis and come up with some disturbing figures. US household debt is now $13.9 trillion, down just 1% from its peak last year. Meanwhile household wealth has fallen 14% as property crashes, a loss of $6.67 trillion [[even more, if we add in the losses in the stock and bond markets: normxxx]]. The debt-to-wealth ratio is rocketing.

Clearly the US is already in the grip of debt-deflation. "The obvious conclusion is that the Fed should print money to purchase private sector assets so as to drive up their price," he said. Fed chief Ben Bernanke does not need prompting. He made his name as a Princeton professor studying the "credit channel" causes of depressions. Now fate has put him in charge of the channel.

Under his guidance, the Fed has this week pledged to "employ all available tools" to stave off deflation— and damn the torpedoes. It will purchase "large quantities of agency debt and mortgage-backed securities." It will evaluate "the potential benefits of purchasing longer-term Treasury securities," i.e, 'printing' money to pay the Pentagon.

Put bluntly, the Fed is deliberately stoking inflation. At some point it will succeed. Then the risk flips quickly to spiralling inflation as the elastic snaps back. That will be a second point of danger.

By late 2009, if not before, the bond vigilantes may start to fret about the 'liquidity lake'. They will worry that the Fed may have to start feeding its holdings of debt back onto the market. The Fed's balance sheet has already risen from $800bn in September to $2.2 trillion this month. It will be $3 trillion by early next year.

"The bond markets could go into free fall," said Marc Ostwald from Monument Securities. "The Fed went into this with all guns blazing just as the Neo-cons went into Iraq thinking it was a great idea to get rid of Saddam, without planning an exit strategy. As soon as we get the first uptick in inflation, the markets are going to turn and say this is what we feared would happen all along. Then what?" he said.

New Star's Simon Ward said all three measures of the US broad money supply are flashing recovery. M2 has risen at annual rate of 17% over three months. "It has all changed since the Fed began buying commercial paper in October. If the money supply is booming at 20% in six months, inflation will become a concern. Given that public debt ratios are already on an explosive path, we risk a debt trap," he said.

For now, the bond markets are quiet. Futures contracts are pricing in five years of deflation in the US. Yields on 10-year US Treasuries have halved since early November to 2.09%, the lowest since the Fed's data began. Three-month dollar LIBOR has plummeted to 1.53%. [[And the dollar has plummeted in value.: normxxx]]

It is the same pattern across the world. 10-year yields have fallen to 1.27% in Japan, 3% in Germany, 3.2% in Britain, and 3.49% in France. The bond markets seem to be betting that emergency action by central banks will take a very long time to work, if it works at all. By cutting to zero, the Fed has come close to shutting down the US 'repo' market that plays a crucial role in providing liquidity.

It has caused havoc to the $3.5 trillion money markets— as the Bank of Japan, burned by experienced, had warned. It has become even harder for banks to raise money. Some argue that 'extreme' monetary policy is already doing more harm than good. Mr Bernanke is known for his "helicopter speech" in November 2002, when he nonchalantly talked of the Fed's "printing press" and said it was the easiest thing in the world to "reverse deflation".

Less known is his joint-paper in 2004— "Monetary Policy Alternatives At The Zero-Bound". By then doubts were creeping in. He admitted to "considerable uncertainty" as to whether 'extreme' tools would actually work. Liquidity could fail to gain traction. Put another way, the Fed is flying by the seat of its pants. It should never have let debt grow to such grotesque levels in the first place.


Fresh Credit Strains In Europe As Deutsche Bank Shocks Markets
Deutsche Bank Has Refused To Redeem A Bond Issue In An Unprecedented Move That Has Rattled Europe's Credit Markets And Cut Short The Relief Rally Following America's Dramatic Move To Zero Rates.

By Ambrose Evans-Pritchard | 17 December 2008

The news set off a fresh flight from European bank debt. Credit default swaps (CDS) on the iTraxx Financial index measuring stress in the sector saw the biggest jump since the Lehman Brothers crisis, rising 20 points to 226. Adding to the gloom, Standard & Poor's warned that a fifth of all lower-rated companies in Western Europe and the UK are likely to default over the next two years, greatly exceeding the scale of bankruptcies after the dotcom bust. The agency said up to 75 companies that issue debt in the capital markets would fail in 2009 as they struggle to roll over debt. Four have failed this year.

Deutsche Bank, Germany's top lender, said it had 'chosen not to exercise' a "call option" on a subordinated bond worth €1bn (£930bn), breaking an iron-fast 'code' in the credit markets. The bank's share price fell 7% in Frankfurt, and the default insurance on the it's debt surged. "This has never happened before," said Willem Sels, a credit strategist at Dresdner Kleinwort. "Banks have never wanted to do it because it upsets investors and could mean that future funding will be hit."

Deutsche Bank, run by Josef Ackerman, is within its legal rights. The contract lets the bank accept an automatic rise in interest costs after five years, or call the option and raise money on the open market. Ronald Weichert, the bank's spokesman, said it would have been "much more expensive" [[if not impossible: normxxx]] to secure fresh finance in the current climate. "The situation has changed, and we had to decide what to do in the appropriate interests of Deutsche Bank," he said.

The travails at Deutsche are the latest sign that credit stress is continuing to plague Europe's lenders, despite a blanket bail-out by EU governments in September. The European Central Bank warned in its Financial Stability Report this week that lenders are at risk from a deeper slowdown than expected. "Banks need to be especially vigilant in ensuring that they have adequate capital and liquidity buffers to cushion the risks that lie ahead," it said.

The European Central Bank (ECB) is coming under heavy pressure to follow the Federal Reserve and central banks of Canada, Britain, Switzerland and Sweden in slashing rates and exploring emergency options. Norway cut rates by 175 basis points to 3% on Wednesday. Eurozone prices fell 0.5% in November and may be flirting with deflation by the middle of next year.

The region is falling into deep recession. Berlin expects the economy to contract by 2% next year in the worst slump since World War Two, according to German press leaks. Italy is facing two years of contraction. Concerns are spilling over into the debt markets. Yields on Italy's 10-year bonds have risen to 132 basis points above German Bunds, partly on concerns that Italy may have trouble rolling over €200bn next year.

Jean-Claude Trichet, the ECB's president, this week hinted that the bank may hold rates at 2.5% in January. "Do we have a feeling there is a limit to the decrease in rates? At this stage certainly yes. We have to beware of being trapped at nominal rates that would be much too low."

ECB hawks have been warning that extreme rate cuts are 'unhealthy' and likely to lead to inflation down the road [[strongly reminiscent of Japan's (more or less successful) hawks in the early '90s: normxxx]], although there have been rumblings of discontent from the Dutch, Cypriot, Portuguese and Spanish members. There is now a stark divide in philosophy between the ECB and almost every other central bank. The result has been a sudden shift of funds into the euro over recent days, pushing it to $1.44 against the dollar and a record €1.0758 against sterling.

[ Normxxx Here:  Beware of a sudden surge in the dollar/euro exchange when the ECB finally caves.  ]


Sterling [The Dollar] Fall Is A Life-Saver For UK [US] Economy

By Ambrose Evans-Pritchard | 19 December 2008

The sharp slide in the pound has been a godsend for the UK economy and may have helped Britain avert a much more serious crisis, according to the German bank Dresdner Kleinwort. [[And the recent 'crash' of the dollar may just have similar effects for the US: normxxx]].

"If the currency had not gone down so far, think how much worse it could have been. A weaker sterling is just what you need in the current situation," said David Owen, the bank's chief economist for developed markets. He said exporters are taking advantage of the 20% fall in sterling [[or the over 10% slide of the dollar: normxxx]] to boost profit margins, giving them a vital cushion to help survive the collapse in lending. This is the same pattern seen after the ejection of the pound from Europe's Exchange Rate Mechanism in 1992.

"Export margins are going through the roof, and this helps not just manufacturing but also service exports. Profits are holding up surprisingly well. With banks threatening to cut off credit lines, these companies need all the help they can get," he said.

"We have been in a train-wreck since August 2007 and it is going on and on. Credit insurance [[think AIG: normxxx]] is drying up. We are hearing anecdotal evidence that banks are telling custormers not to rely on them for finance next year. If credit lines are cut off, even good companies will go into receivership," he said.

The concern is that there may be two more shoes to drop in this crisis. The wave of corporate defaults has hardly begun, and inventories are still too high for this stage of the cycle. [[In the US, we still have another wave of foreclosures due to ARMs mortgage rate resets and job losses, and expect more bank and other corporate failures. The government may bailout Citygroup and Detroit, but who else?: normxxx]]

"The good thing is that the authorities have thrown an awful lot of ammo at this problem. We're effectively moving towards zero interest rates in all the major economies. But we know from Japan that the central banks can pump liquidity into the system but that doesn't guarantee recovery if the banks won't lend," he said.

The risk [[for the UK: normxxx]] is that foreign investors stop buying Gilts and other forms of British debt, setting off a pound exodus that could spin out of control— as happened to Iceland's krona. UK bond auctions have held up well so far.

Mr Owen said newspaper columnists fretting about a sterling 'crisis' should remember what happened in the early 1930s when Britain was the first major economy to leave the Gold Standard and reflate through devaluation (and rate cuts). While the episode was humiliating at the time, it was a key reason why the UK economy contracted by just 5% during the Great Depresssion compared to 15% for France and 30% for the US.

Stephen Jen, currency chief at Morgan Stanley, said sterling is a "high-beta" currency, meaning that it is highly-geared to the global economic cycle. It shoots up during good times and plunges during bad times. It should return to health if and when the world emerges from economic winter..

The Bank of England's view is that sterling has served its purpose well in this crisis, acting as a shock-absorber.


Mr Bernanke Correctly Judged The Risk Of Deflation

By Ambrose Evans-Pritchard | 17 December 2008

US consumer prices are dropping at the fastest rate since January 1932 on a strict dollar for dollar basis. New house building fell by 18.9% in November to 625,000, the lowest since records began half a century ago. It is not yet clear whether America is sliding into a deflation trap but the risk is grave enough to justify radical measures as insurance against a potentially disastrous chain of events.

The sort of deflation now spreading across North America, Japan, and parts of Europe is not of the
[often relatively] benign variety of the late 19th century when prices slid gently for year after year. Debt levels are much higher today [[incredibly so; in the 19th century, hardly anyone carried any debt, except for arrears on payments due, or the priveleged few— the latter perhaps a few percent of the total population: normxxx]], so the deflation effect [[of increasing the real value of the debt with time: normxxx]] is that much more dangerous.

The danger is that of a self-feeding downward spiral [[a 'negative feedback' effect: normxxx]] as the
real burden of debt keeps rising into the slump, as Irving Fisher dissected in his great opus "The Debt-Deflation Theory of Great Depressions".

US inflation was minus 1.7% in November, and minus 1% in October. This entirely vindicates the brave decision by Ben Bernanke at the US Federal Reserve— and our our own Mervyn King at the Bank of England— to "look through" the oil spike earlier this year and keep his focus on the underlying forces at work in the global economy. While Mr Bernanke may have been caught flat-footed by the onset of the credit crisis in the summer of 2007, he has since moved with impressive speed. The string of emergency rate cuts this year have now brought America to the brink of zero.

They may prevent the current credit crash from metastasizing into a full-blown depression. We do not yet know for sure. It takes a year or so for the effects of monetary policy to feed through the economy even when the banking system is functioning. It will take even longer this time. But matters would undoubtedly be worse if the Fed’s backwoodsmen had succeeded in imposing a liquidation squeeze on the US economy, as they did from 1930 to 1932.

Mr Bernanke has not run out of ammunition yet. He has a nuclear arsenal, and has begun to use it. [[And means to use it!: normxxx]] The Fed is already buying mortgage debt. It has infinite means of injecting stimulus into the economy by `quantititive easing’, if needs be. It can ultimately print money and hang it on Christmas trees.

Mr Bernanke correctly judged the risk of deflation. His critics did not anticipate this current, sudden price collapse. The burden in now on them to explain why they are so sure that deflation can be safely left to run its malign course.


[The Germany Bully] Gets A Free Ride With Its Beggar-Thy-Neighbour Policy
For The First Time In My Life, I Am Starting To Feel Twinges Of Anti-German Sentiment.

By Ambrose Evans-Pritchard | 15 December 2008

This does not come naturally. My father insisted on German au pair girls during my childhood as his gesture towards post-War comity. I later did a stint at Mainz University dabbling in Kant (great) and Hegel (a fraud).

But even Teutophiles who think that Germany has played an enlightened role for 60 years are losing patience with the antics of the finance ministry and Bundesbank, and with the dictatorial turn in Berlin's EU strategy. Put bluntly, Germany is pursuing a beggar-thy-neighbour policy. It is not fulfilling its responsibilities as the world's top exporter and pivotal power of Europe's monetary union. It is leaching off global demand, even as it patronizes Anglo-Saxons, Latins, and Slavs.

No doubt binge debtors in the Anglosphere are much to blame for this crisis. But Germany rode the boom too. It made those Porsches and BMWs driven by the new rich. Its banks are among the most leveraged in the world.

Nor should we not forget that the European Central Bank set interest rates at recklessly low levels early this decade to help Germany out of a slump. Can this be separated from the property bubbles in Club Med, Holland, Ireland, Scandinavia, and Eastern Europe now causing such grief? Within the EMU, Germany has gained a competitive edge against France, Italy, and Spain for year after year by screwing down wages. In pre-euro days the North-South rift did not matter. The D-Mark revalued. Balance was restored. In the monetary union, it is toxic.

Germany now has a current account surplus of 7% of GDP. It is hollowing the industrial core of Latin Europe. Yes, Club Med needs to pull its socks up, but the flip side of the coin is that Germany is in breach of EMU's implicit contract.

The rules of the game are that surplus countries should boost demand. The Gold Standard collapsed in the early 1930s because they— then the US and France— refused to do so. The burden of adjustment fell on deficit states, who had to tighten yet harder. The downward spiral dragged everybody into depression.

Germany and China are today's violators. Their trade surpluses over the last 12 months have been $283bn and $279bn, respectively. They are exporting excess capacity.

Peer Steinbrück, Germany's finance minister, seems in no mood to yield. He prefers to mock the "crass Keynesianism" of the British. Nobel Laureate Paul Krugman was so disgusted that he broke away from his Stockholm banquet to pen The Economic Consequences of Herr Steinbrück.

"The world economy is in a terrifying nosedive, visible everywhere. The high degree of European economic integration gives Germany a special strategic role right now, and Mr Steinbrück is doing a remarkable amount of damage. There's a huge multiplier effect at work; it is multiplying the impact of German boneheadedness," he said.

Meanwhile, the Bundesbank has been doing its bit for depression. Germany's two ECB members— caught in a 1970s time-warp— orchestrated the mad rate rise in July. They are now trying to head off cuts in January, saying the ECB cannot risk using up its ammo. Even Switzerland's uber-hawks have ditched that doctrine.

Worst of all is Germany's [wicked] role in dredging up the EU Constitution (Lisbon Treaty) after it had been rejected by French and Dutch voters. Having made one blunder, they are now making another by refusing to accept the Irish verdict as well. Why are they so maniacal about this? Because the treaty establishes German primacy in the EU's voting structure. This is raw national interest— camouflaged, of course.

So Brian Cowen— already the most reviled Taoiseach [[the equivalent of a prime minister: normxxx]] since the creation of the Irish state— is bludgeoned into a second vote. This is what now passes for EU statecraft. A tactical case can be made, that fear will induce Irish voters to change their minds as GDP contracts by 4% next year. Even if that proves correct, will it convince anybody that the European Project is advancing with democratic assent?

What if the Irish vote 'No' again? Will Germany carry out its threat to "suspend" them from the EU, and thereby risk a final revulsion against Europe and the unravelling of the post-War order? One notes that Germany has acquired the taste for bullying small nations [[wrong; Germany and Germans have always had 'the taste for bullying small nations' and 'underdogs'— one had been led to expect that they had outgrown it— one was obviously wrong: normxxx]]. Mr Steinbrück threatened to "take a whip" to Switzerland. The sooner Germans take a whip to Mr Steinbrück and all he stands for, the better. Otherwise the rest of us will have to start examining our options.


Switzerland May Have To 'Print' Money To Stave Off Deflation
The Swiss National Bank Has Cut Interest Rates To 0.5% And Opened The Door For Emergency Stimulus, Becoming The First Country In Europe To Flirt With Zero Policy Rates.

By Ambrose Evans-Pritchard | 12 December 2008

South Korea cut to 3% and Taiwan cut to 2%, the lowest in 30 years. Both countries are facing a collapse in exports to China and traditional markets in the West. Thomas Jordan, a board member of the Swiss National Bank (SNB), said the bank was mulling 'extreme' measures to stabilise the financial system and cushion the economy as it falls into recession next year.

"We could engage in 'quantitative easing' and we could intervene in foreign exchange markets or we could buy up bonds and try to influence long-term interest rates. All these options are open and we're not limited in any way in choosing from among these instruments," he said. Quantitative easing is the tool pioneered by the Bank of Japan to stave off deflation. It is tantamount to just printing money.

David Bloom, currency chief at HSBC, said the shift in policy was breathtaking. "The SNB are the hard men of central banking; they are even harder than the European Central Bank. What they are saying is that inflation is no longer a problem, it's the solution. They want stimulus any way they can get it."

The banking sector makes up 20% of Swiss GDP, leaving the country extremely exposed to the credit crisis. The liabilities of Credit Suisse and UBS are equal to seven times national GDP. This has echoes of the situation in Iceland before the country collapsed, although Swiss banks have a much better mix of assets.

"The crucial difference is that the Swiss own half a trillion dollars of external assets. They have a current account surplus of 16% of GDP. This is their ace in the hole. If push ever comes to shove, the Swiss taxpayers have the money to pay," said Mr Bloom.

Switzerland, Sweden, Britain, and Canada are all now following the US Federal Reserve in taking revolutionary action to head off a slump next year, while the ECB has moved with much greater caution. It is unclear whether this reflects a rift in doctrinal policy, or whether the ECB is less able to respond to crises because of its treaty-bound institutional structure. The ECB's chief theorist, Lorenzo Bini-Smaghi, said it was hazardous for central banks 'to cut rates too low and risk using up ammunition'.


Asian Trade In 'Free Fall' As Exports To West Dry Up
The Economic Downturn In Asia Has Taken A Sharp Turn For The Worse As Japan Slides Into Deep Recession And Exports Contract In China, Korea, And Taiwan.

By Ambrose Evans-Pritchard | 10 December 2008

Asian trade in 'Free-Fall'

A blizzard of grim data this week points to a full-blown trade slump across Asia, confirming fears that the region's strategy of export-led growth would backfire once the West buckled. Flemming Nielsen, from Danske Bank, said exports from Korea and Taiwan both shrank by over 20% last month. "The numbers are terrible. Intra-Asian trade is in free-fall. Taiwan's exports to mainland China in November were down a whopping 42%."

The Baltic Dry Index measuring freight rates for bulk goods began to collapse in June, dropping 96% over the five months in the most dramatic fall in shipping fees ever recorded. It was a leading indicator of what we are now seeing in Asian trade. Fan Gang, a top adviser in Beijing, said China's exports would also show a decline when data is released this week. "Things are not good: industrial growth will be around 5% and export growth will be negative," he said. Economic expansion of 5% would be a major shock and entail recession in the Chinese context.

Japan's economy shrank 0.5% in the third quarter and risks sliding back into deflation and perma-slump. Exports fell 7.7% in October on crumbling demand for cars and machinery. Over 1,000 Japanese companies went bust last month as the high yen squeezed margins. Sony is laying off 16,000 staff.

Japan's industrial output is expected to fall by a post-War record of 8.6% in the fourth quarter. Tokyo is already planning "purchase vouchers" to kick-start spending in the world's second largest economy. A fresh stimulus package worth 20,000bn yen (£146bn) is being prepared for early next year.

"We need policies to keep the economy from falling apart," said economics minister Kaoru Yosano. "Japan will endure hardship next year." Zahra Ward-Murphy, from Dresdner Kleinwort, said Japan has slimmed down its bloated debt structure since its Lost Decade, but is still only half-reformed and over-reliant on exports. "It has not rebalanced the economy towards internal growth: now exports are tanking," she said.

Tokyo is once again running low on policy options. The Bank of Japan is wary of cutting rates below the current level of 0.3% for fear of damaging the money markets, a key lubricant of the credit system. [[It cut interest rates to 0.01% last Friday, tantamount to zero. : normxxx]] It may soon need to revert to emergency forms of monetary stimulus known as 'quantitative easing'.

Earlier rescue plans have already pushed Japan's national debt to 170% of GDP, the world's highest. Private savings have collapsed from 14% of GDP in the early 1990s to 2% today. Japan goes into this downturn without a cushion.


BIS Warns Of Collapse In Global Lending
The City Of London Has Suffered A Dramatic Collapse In Its Core Business As Global Lending Falls At The Steepest Rate Since Records Began, According To New Figures From The Bank For International Settlements (BIS).

By Ambrose Evans-Pritchard | 9 December 2008

Cross-border loans worldwide fell by $1.1 trillion (£740bn) in the first half of the year, reflecting the scramble by the financial industry to cut leverage by pulling credit lines and slashing risky exposure. Foreign lending by UK banks fell by a staggering $884bn, equal to 81% of the entire contraction in international lending. The City is facing a double blow since worldwide issuance of bonds and securities has also gone into freefall, plummeting 77% from over a trillion dollars to $247bn in the third quarter.

The City has been the epicentre of Europe's structured credit industry. The collapse in bond issuance reflects the near-total closure of the capital markets in the late summer as credit spreads surged. Bonds issued in euros dropped by 94% from $466bn to $28bn over the quarter.

The UK banking sector includes branches of US, European, Asian and Mid-East institutions. These banks tend to use London as a base for their global credit and investment operations. Though foreign, they make up a crucial part of the City nexus and are a mainstay for accounting firms, lawyers and the panoply of financial services that enrich the City.

In its quarterly report, the BIS warned the US Federal Reserve, the Bank of England and other central banks that near-zero interest rates and emergency monetary stimulus may come at a cost. By opening the cash spigot, the authorities risk displacing the money markets and may "discourage banks from lending to other banks". The money markets are a crucial lubricant for the financial system, but they cannot function if rates fall too low. The sector can wither away, as Japan discovered during its "Lost Decade".

The BIS also hinted that the European Central Bank and Sweden's Riksbank may have blundered by raising rates this year to contain the oil shock. It said short-term energy spikes have no lasting effect on inflation or wage deals. "Evidence suggests an absence of strong second-round effects on inflation. The temporary inflationary impulse will soon drop out," it said.


Deflation Virus Is Moving The Policy Test Beyond The 1930s Extremes
Debt Deflation Is Tightening Its Grip Over The Entire Global System. Interest Rates Are Creeping Towards Zero In Japan, America, And Now Across Most Of Europe. China Will Not Lift Us Out— They Are The Most Vulnerable Of All

By Ambrose Evans-Pritchard, Telegraph, UK | 9 December 2008

We are beyond the extremes of the 1930s. The frontiers of monetary policy are being pushed to limits that may now test the viability of paper currencies and modern central banking. You cannot drop below zero. So what next if the credit markets refuse to thaw? Yes, Japan visited and survived this policy Hell during its lost decade, but that was a local affair in an otherwise booming global economy. It tells us nothing.

This time we are all going down together. There is no deus ex machina to lift us out. Certainly not China, which is the most vulnerable of all.

As the risk grows, officials at the highest level of the British Government have begun to circulate a six-year-old speech by Ben Bernanke— at the time of its writing, a garrulous kid governor at the US Federal Reserve. Entitled Deflation: Making Sure It Doesn’t Happen Here, it is the manual of guerrilla tactics for defeating slumps by monetary means.

"The US government has a technology, called a printing press, that allows it to produce as many US dollars as it wishes at essentially no cost," he said.

Critics had great fun with this when Bernanke later became Fed chief. But the speech is best seen as a thought experiment by a Princeton professor thinking aloud during the deflation mini-scare of 2002. His point was that central banks never run out of ammunition. They have an inexhaustible arsenal. The world’s fate now hangs on whether he was right (which is probable), or wrong (which is possible).

As a scholar of the Great Depression, Bernanke does not think that sliding prices can safely be allowed to run their course. "Sustained deflation can be highly destructive to a modern economy," he said [[and Japan has most recently borne witness to: normxxx]]. Once the killer virus becomes lodged in the system, it leads to a self-reinforcing debt trap— the real burden of mortgages and other loans rises, inexorably, year after year; house prices fall, inexorably, year after year. The noose tightens until you choke. Subtly, it shifts wealth from workers to bondholders [[and like well heeled lenders: normxxx]]. It is reactionary poison. Ultimately, it leads to civic revolt. Democracies do not tolerate such social upheaval for long. They change the rules. [[And it was why Thos. Jefferson, for one, so sternly warned us against bankers in general and central banks in particular. And just perhaps why both Central banks in the US prior to the Fed were each ended by act of Congress in order to end a serious deflation, brought on by severe recession, panic, and hard money. Very hard, as the Fed of 1930 can attest to.: normxxx]]

Bernanke’s central claim is that the big guns of monetary policy were never properly deployed during the Depression, or during the early years of Japan’s bust, so no wonder the slumps dragged on. The Fed can create money out of thin air and mop up assets on the open market, like a sovereign sugar daddy. "Sufficient injections of money will ultimately always reverse a deflation." Bernanke said the Fed can "expand the menu of assets that it buys".

US Treasury bonds top the list, but it can equally purchase mortgage securities from US agencies such as Fannie, Freddie and Ginnie, or company bonds, or commercial paper. Any asset will do. The Fed can acquire houses, stocks, or a herd of Texas Longhorn cattle if it wants. It can even scatter $100 bills from helicopters. (Actually, Japan is about to do this with 'shopping' coupons!)

All the Fed needs is the 'emergency powers' under Article 13(3) of its code. This "unusual and exigent circumstances" clause was indeed invoked— very quietly— in March to 'save' the US investment bank Bear Stearns. There has been no looking back since. Last week the Fed began printing money to buy mortgage debt directly. The aim is to drive down the long-term interest rates used for most US home loans. The Bernanke speech is being put into practice, almost to the letter.

No doubt, such reflation a l’outrance can "work", but what is the exit strategy? The policy leaves behind a liquidity lake. The risk is that this will flood the system once the credit pipes are unblocked. The economy could flip abruptly from deflation to hyper-inflation.

Nobel Laureate Robert Mundell warned last week that America faces disaster unless the Bernanke policy is reversed immediately. This is a minority view, but one held by a disturbingly large number of theorists. History will judge.

Most central bankers suffer from a déformation professionnelle. Those shaped by the 1970s are haunted by ghosts of libertine excess. Those like Bernanke who were shaped by the 1930s live with their Depression poltergeists.

His original claim to fame was work on the "credit channel" causes of slumps. Bank failures can snowball out of control as the "financial accelerator" kicks in. The cardinal error of the 1930s was to let lending contract [[at least during the first half of 1930, in order to stave off the loss of gold, mostly to France: normxxx]].

This is why he went nuclear in January, ramming through the most dramatic rates cuts in Fed history. Events have so far borne him out. A case can be made that Bernanke’s pre-emptive blitz has greatly reduced the likelihood of catastrophe. It was no mean feat given that he had to face down a simmering revolt earlier this year from the Fed’s own regional banks.

The sooner the Bank of England tears up its rule books and prepares to follow the script in Bernanke’s manual, the more chance we too have of avoiding a [horrible end]. Monetary stimulus is a better option than the fiscal sprees that leave us saddled with public debt— the path that nearly wrecked Japan [[and who is not yet out of the woods: normxxx]].

Yes, I backed the Brown stimulus package— with a clothes-peg over my nose— but only as a 'one-off' emergency. Public spending should be a last resort, as Keynes always argued. Of course, Bernanke should not be let off the hook too lightly. Let us not forget that he was deeply complicit in creating the disaster we now face. He was a cheerleader of Alan Greenspan’s easy-money stupidities from 2003-2006. He egged on debt debauchery.

It was he who provided the theoretical underpinnings of the Greenspan doctrine that one could safely ignore housing and stock bubbles because the Fed could simply "clean up afterwards". Not so simply, it turns out.

As Bernanke said in that 2002 speech: "the best way to get out of trouble is not to get into it in the first place". Too late now.



The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Sunday, December 21, 2008

Stock Investors Lose Faith, WSJ

Stock Investors Lose Faith, Pull Out Record Amounts
Click here for a $$link to complete article:

By E.S. Browning, WSJ | 21 December 2008

One of the hallmarks of the long market downturns in the 1930s and the 1970s has returned: Rank-and-file investors are losing faith in stocks. In the grinding bear markets of the past, huge stock losses left individual investors feeling burned. Failures of once-trusted firms and institutions further sapped their confidence. Many disenchanted investors stayed away from the stock market, holding back gains for a decade or more.

Today's investors, too, are surveying a stock-market collapse and a wave of Wall Street failures and scandals. Many have headed for the exits: Investors pulled a record $72 billion from stock funds overall in October alone, according to the Investment Company Institute, a mutual-fund trade group. While more recent figures aren't available, mutual-fund companies say withdrawals have remained heavy.

If history is any guide, they may not return quickly.

Individual investors arguably form the bedrock of the market. It's difficult to pinpoint how much stock they hold, because they own shares through mutual funds, retirement accounts and other vehicles. But once retirement accounts are factored in, individuals likely account for half or more of all U.S. stock holdings, according to data from Birinyi Associates in Westport, Conn. Investors' discomfort with stocks has been growing for years, since just after the 2000 selloff of dotcom shares.

"I don't have any confidence in buying any new stocks," says David Herrenbruck, a 52-year-old New York photographer at the peak of his ability to save and invest. Mr. Herrenbruck was a big believer in stocks in the late 1990s, but he was burned by the tech-stock meltdown. He has since moved much of his money to real estate, and he has recently invested in bonds and certificates of deposit. "If I have some cash lying around, it is going to be in CDs," he says.

From 2002 through 2005, investors put an average of $62 billion a year into U.S. stock mutual funds, less than half the annual level of the previous decade. Since 2006, investors have been pulling money out of U.S. stock funds at a [net] rate of about $40 billion a year. Such skittishness already promises to put a brake on the stock market's recovery, which could make it harder for companies to raise capital and could squeeze financial firms' profits. That, in turn, could delay the economy's emergence from the severe recession that began last year.

Individuals aren't the only ones who have become skeptical of stocks. Many of the buyers who pushed indexes to record levels this decade— including private-equity firms and hedge funds— also appear to be increasingly looking beyond stocks. College endowments and hedge funds, for example, have in recent years funneled more money into alternative investments such as real estate, commodities, art, and even farms and timberland.

Lessons Learned

There's no way to know how long individuals could stay away from shares. Their confidence could be restored more quickly than in the past, optimists say, pointing to policymakers' efforts to avoid repeats of the 1930s and 1970s. Federal officials have sought to stabilize financial markets by injecting hundreds of billions of dollars, slashing target interest rates for overnight loans to nearly zero, and announcing plans to buy up mortgage-backed securities. Also, today's individual investors are different than those of past eras. In the 1930s and 1970s, stock investing was the province of a minority of rich Americans. Now, thanks to 401(k) programs and other retirement plans, nearly half of U.S. families have stock holdings.

Some of the biggest nest eggs belong to baby boomers who are reaching retirement age. The market could receive a boost if many sidelined boomers, whose retirements could span decades, decide it is safe to shift sharply back to stocks. But if these investors believe their money will be safer stashed elsewhere for upcoming years, it could slow a market recovery.

Four-Decade Cycles

Peter Lush is among those steering mostly clear of company shares. The 61-year-old retiree in Georgia built up his retirement plan by investing in a fund that owned midsize stocks. Until recently, he says, he had much of his savings in a bond fund, and after corporate bonds took a hit, he moved the money into CDs. "Maybe now would be a good time to buy" stock, says Mr. Lush. "But I am scared, to tell you the truth."

Enthusiasm for shares has waxed and waned in long cycles, with previous flights from stocks occurring eight and four decades ago. In 1932, the Dow Jones Industrial Average— in those days a speculative index of relatively young companies— had fallen 89% from its 1929 high. The 1930s brought [rapid Cyclical] bull markets followed by bears, taking back gains and sapping investor confidence. [[Typical of the Secular Bear we were in then and now, since 2000.: normxxx]] The sustained troubles of the 1930s exposed scandals in speculative instruments.

So-called investment trusts used investor money and borrowed funds to buy high-flying securities, sometimes buying stock in one another. Of the 1,183 investment trusts and other funds that existed from 1927 through 1936, more than half had failed by 1937, a government study showed. Goldman Sachs, which sponsored three prominent funds that lost most of their value, saw its reputation damaged for years.

The Dow didn't return to its 1929 high until 1954. New York University financial historian Richard Sylla recalls that even in the 1950s, some people were so spooked by the Depression that they were storing money in jars in the basement. The stock recovery of the 1940s and 1950s became a speculative boom in the 1960s, marked by the so-called Nifty Fifty stocks that brokers said would rise for years. They didn't.

In 1966, the Dow flirted with the 1000 level, then shed 25%. That bull-and-bear pattern would repeat for 16 years amid [fairly severe] inflation and soaring oil prices. Investor confidence was hammered again.

There was scandal, too, including the early 1970s collapse of Bernie Cornfeld's mutual-fund empire, Investors Overseas Services, which at one point had assets of more than $2 billion. Mutual-fund data from that period show investors reacted much as they have in recent years. After a market peak in 1968, people began putting less money than before into mutual funds, Investment Company Institute data show.

By 1971, they were pulling more money out than they were putting in. From May 1972 through March 1980, total dollars in stock funds fell 42%. Mutual-fund executives worried that the industry might not survive. [[Business Week famously declared The Death Of Equities in its August 13th, 1979 issue.: normxxx]] Money started flowing in again in the 1980s, after the government encouraged broad market participation through 401(k) plans and other retirement programs. Individuals gradually embraced the idea of 'buy-and-hold' investing, helping to usher in the stock boom of the 1990s.

Pax Americana

With the Cold War 'over' and investments flowing across the globe, people [everywhere] believed they were in a long-running Pax Americana of world-wide prosperity and rising productivity. During the 1990s, investors added $1 trillion to mutual funds. The Dow Jones Industrial Average surged above 11000 in 1999, up tenfold from 1982. Owning anything but stocks looked foolish.

That confidence has been shaken by two bad bear markets in less than a decade. Between 2000 and 2002, the Dow fell 38% and the Nasdaq Composite Index shed 78%. This year's market collapse knocked 47% off the Dow in just over 12 months, returning stocks to 1997 levels. As of Friday, the Dow still was 39% off its 2007 record.

"The question is whether this series of very strong bear markets will cause investors to retrench as they did in the '70s," says Brian Reid, chief economist at ICI. "I think there will be some of that," he says, although perhaps not as bad as it was then. People in the investment business hoped ordinary investors would return in large numbers when the market began recovering late in 2002. But this didn't happen.

In 2001, 53% of U.S. households held stock or stock funds, which turned out to be a peak. Now, about 46% of families own stocks, according to a report published last week by the ICI and the Securities Industry and Financial Markets Association. [But t]he disaffection appears to be deepening. By the end of October, amid the most recent market collapse, retirement savers tracked by consulting group Hewitt Associates were sending 58% of their contributions to stock funds. That was down from 75% at the beginning of this year.

The decade's second bear market also brought big failures and scandals— the end of venerable investment banks [indeed, of all of those banks, amid some very suspect accounting practices and activities reminiscent of Enron], an alleged $50 billion swindle by Wall Street stalwart Bernard Madoff— to add to the collapses of Enron, WorldCom, and others from earlier in the decade.

"For many investors, this has been a glimpse into the abyss," says Terrance Odean, a finance professor at the University of California, Berkeley, who has studied the behavior of individual investors. "They have been told that if you save regularly for retirement and buy and hold, you will be fine. Now, people see a possibility that this will not be the case."

Weak Hands

The market has given Karin Kuder a good ride over the past two decades, but now she's through. Starting in 1989, Ms. Kuder contributed as much as she could to her retirement fund, up to 15% of each paycheck. In the 1990s, she chose aggressive stock funds, moving to a more conservative mix after the 2001 terrorist attacks. Early this year, even after she retired as a nurse at a naval air station in Jacksonville, Fla., Ms. Kuder still held 60% stocks and 40% bonds.

In March, she trimmed her stock holdings to 50% of her portfolio. In October, with her account down $40,000, she ran out of confidence.
"It was the only money I had," Ms. Kuder says. "I wasn't sleeping." She phoned her financial adviser and said she wanted to put all her money in a safe place. The adviser persuaded her to leave 20% in stocks and bonds, but the rest went to a five-year fixed annuity, similar to a certificate of deposit, guaranteeing 5.1% a year.

"You put in all those years, and it is just falling right away from you," Ms. Kuder says. "I was so fearful that I was going to lose everything."

When market analysts talk about who's buying and who's selling in times like these, they sometimes speak of "weak hands" and "strong hands". Weak hands bail out when the market declines, seeking what they see as safer havens. 'Strong hands' are committed to the market for the long term, buying shares at what may turn out to be big discounts. Right now, the market is being driven by the exit of these 'weak hands'. Lasting recovery will come when some of these weak hands— or the next wave of younger investors— step back in.

There are signs that even younger investors are growing more fearful of stocks lately. Risk aversion has been on the rise this decade among all age groups, according to last week's report from the ICI and SIFMA. Although it will be long before young people need to tap their retirement savings, the losses they've seen in the current bear market could temper their enthusiasm for stocks for years to come.

Bright Future

Harris Cohen, a 25-year-old project manager with Amtrak in Washington, D.C., opened an individual retirement account in 2001, when he was 18, and filled it with stocks he thought had a bright future, including Apple Inc. and Garmin Ltd. He bought mutual funds that invest in alternative energy companies and utilities. He didn't bother with bonds.

"I had a real good track record over five or six years, with increases from 10% to 20% a year," Mr. Cohen says. His portfolio has fallen about 40% over the past 18 months, he says.

In September, he began pulling back from stocks. Now, he has shifted his retirement savings to corporate bonds, a money-market fund and a few utility funds. He says he doubts he ever will view stocks the same way.
"Even if the market were to rebound and the economy were to improve, I would be very loath to invest entirely in stocks," Mr. Cohen says.

While investor confidence is low, there are signs that it may have further to fall.

In 2001, people's hopes for stocks were extremely high. Only 5% of those surveyed expected average annual stock returns in the coming decade to be 5% or less, according to University of Oregon Prof. Paul Slovic, whose company, Decision Research, conducts the surveys. Today, nearly one-third of those surveyed expect such stock weakness, reflecting the decline in investor optimism.

But there is a surprising amount of optimism left. More than half of the small investors surveyed still expect annual gains of 10% or more over the next decade— at, or above, historical averages. At some point, these optimists may be right. [But i]nvestors who jumped into the market at the height of the last love affair with stocks are still hurting.

A $10,000 investment in 2000, into a fund tracking the S&P 500 with dividends reinvested, would [today] be worth about $7,000, according to Morningstar Inc. Those who put $10,000 into the same index in 1982, at the end of the last decade of disaffection, would have more than $150,000. But see also this article within the quote within the quote by Peter Bernstein
Two Little-Noted Features Of The Markets And The Economy; and this article Stock Dividend Yields vs. Interest Rates: An 80 Year History at the blog Seeking Alpha.

Click Here, or on the image, to see a larger, undistorted image.


The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.