Saturday, January 5, 2008

Decade Of Deception

Decade Of Deception

By Martin Hutchinson | 4 January 2008

The Japanese public has dubbed 2007 the "Year of Deception". Expected Japanese GDP growth for the year has been revised down from 2.1% to 1.3% and the stock market has fallen by 10%. I’ll return to whether the Japanese are correct in their belief later, but the concept itself appears more generally applicable. There has in recent years been an excessively snake-oil-salesman quality to the policies and promises of politicians, monetary authorities and financial intermediaries.

In the United States for example, the country’s economic policymaking since 1995 has involved not just a "Year of Deception" but a decade of it. In examining the record, one is tempted to quote Mary McCarthy’s famous verdict on Lillian Hellman’s autobiography: "Every word she writes is a lie, including 'and' and 'the'."

Some examples:

In 1996, the Bureau of Labor Statistics adopted "hedonic pricing" by which price statistics were "corrected for improvements in quality." There were two problems with this. First, it counted quality improvement in the tech sector by raw processing power, which experience has shown to be wrong: functionality of tech equipment rises at best logarithmically with processing power. Second, it did not include the additional costs imposed on consumers by companies as a result of such innovations as automated telephone answering systems, which hugely increase the time and effort expended in conducting necessary consumer transactions. The result of hedonic pricing was to reduce consumer price increases by close to 1% per annum, producing an entirely spurious decline in reported inflation and a corresponding increase in "real" gross domestic product growth.

The second deception chronologically, though in many respects the most important, was Fed chairman Alan Greenspan’s "recognition" in 1997 that a 'new era of faster productivity growth' had 'dawned', so higher stock prices and lower interest rates were justified. Part of this "acceleration" was just random fluctuation (much of which was eliminated in later statistical revisions), part was the result of increasing capital intensiveness in the US economy, caused by lower real interest rates, and part was the effect of hedonic pricing, which artificially inflated GDP growth and hence productivity. The reality, when you look at the series over a long term, was that well over 100% of any rise in productivity in the late 1990s can be explained by these factors. The "miracle" was a mirage and lower interest rates and higher stock prices were wholly unjustified, inevitably leading to huge misallocations of capital.

As the bubble intensified, in 1999 - 2000, the Fed [[actually, just Allan Greenspan: normxxx]] moved to the pretense that it was impossible to know when a bubble was taking place, so monetary authorities [didn't dare] burst it. One may well ask, in that case, what is the point of having a monetary authority; an automatic system, whether a "Gold Standard" or a fixed monetary growth rule, would cause interest rates to rise in a bubble, thus deflating it automatically. Of course a monetary authority can deflate a bubble, as has happened many times; the Fed under Alan Greenspan and Ben Bernanke has however been a thoroughly political institution that doesn’t want to incur the temporary unpopularity from so doing [[No Paul Volckers they! : normxxx]].

Connected with the last point is the monetary authorities’ obfuscation of the monetary basis of their job, both domestic and international. From 1993, the Fed abandoned the entirely sound Paul Volcker-era practice of money supply targeting, which had successfully brought inflation down with only moderate pain. Allegedly, in this 'brave new world' of technology, monetary aggregates were no longer sufficiently accurate to steer policy. It is no coincidence that immediately after this change, the Fed embarked on its program of reckless expansion of M3 money supply, by almost 10% per annum for a decade when nominal GDP was growing at only 5-6%. The Bundesbank and initially the European Central Bank (ECB) resisted this laxity, but since Jean-Claude Trichet took over the ECB in November 2003 that too has been printing money supply, in its case using M2, as if its directors were paid by the banknote. Then in March 2006, the Fed compounded this error by the unparalleled arrogance of ceasing to report M3, presumably hoping that by this means its monetary misdeeds would go unnoticed.

In 1999 - 2000, Wall Street sold dot-com and telecom stocks to investors on the basis of non-existent earnings. They were aided in this by corporate top management, which proceeded to pay itself vast sums by means of stock options, while pretending these had no cost to shareholders. Again, utter deception.

In the political arena, one may note the "bait and switch" tactic of the George W. Bush administration in foreign policy. Bush came to office promising to pursue a "modest" foreign policy, avoiding expansionist Democrat "nation building." Needless to say, the 9/11 attacks, similar in kind albeit larger in scale to a myriad terrorist attacks in Europe, were used as an excuse for a 180-degree reversal of this, inaugurating a foreign policy that would have fulfilled Woodrow Wilson’s wildest power fantasies. The policy merits of this switch are still being determined (though at this stage one can be pardoned for having doubts); what is clear is that a single act by a small group of fanatics caused a complete reversal of the program on which Bush had been elected.

On public spending, too, the electorate can reasonably claim to have been sold a false bill of goods. The Republican Congresses elected after 1994 initially pursued an admirably tight fiscal policy. However, after Newt Gingrich was replaced as Speaker of the House of Representatives by Dennis Hastert in December 1998, Hastert and Tom DeLay proceeded to go hog-wild at the public trough, using it for innumerable corrupt pork-barrel schemes, to which Bush joined fatuous and counterproductive public spending boondoggles like the "No Child Left Behind Act" and his infamously expensive drug program, which was meant as a sop to ease the "privatization" of Medicare and Social Security. It is little wonder Hastert and DeLay were thrown out in 2006; the electorate reasonably feeling that if it wanted wasteful public spending and inventive new social programs, it could get them from the Democrats, traditionally far more expert in such matters.

After the stock market bubble burst, the Fed cut interest rates viciously, decimating the income of US savers and thereby causing a savings dearth and a huge balance of payments deficit. The Fed justified this by claiming to see a "deflation" for which there was no evidence whatever, as retail prices continued rising gently. Stock prices remained overvalued by historical standards and house prices began to soar— thanks in no little part to the inventive genius of Wall Street. Once again, deception was used to justify a mistaken monetary policy and incredibly risky loans were justified as 'statistically' safe, earning the highest of ratings (AAA) from befuddled rating agencies (who, in any case, were now in bed with the issuers of the loans).

In January 2004 and through June 2007, the Bush administration announced that a top priority would be to legalize the 12 million illegal immigrants who had mysteriously appeared in the country. No significant attempt was made to enforce immigration laws, either at the borders or, more importantly, among employers. The administration spent a huge effort claiming, entirely contrary to the evidence, that uncontrolled low-skill immigration had no effect on the earnings of domestic workers of modest attainments [[indeed, for all workers: normxxx]]. The reality was that, however useful the illegal immigrants in erecting millions of ugly, unnecessary houses for which there would soon be no market, by doubling or more the supply of unskilled labor, the illegal immigrant had the obvious economic effect of depressing low-skill wage rates to subsistence levels. Again, breathtaking and unjustifiable deception.

In housing itself, the modern housing finance market has been built on deception. Instead of assessing a credit risk and making a loan, the modern housing financier merely collects a fee and passes the risk off to some unknown and unsuspecting investor, preferably a foreign bank. Needless to say, this has resulted in a substantial percentage of housing loans being entirely fraudulent. It is increasingly becoming clear that a large proportion of modern finance rests on similar deceptions, with asset backed commercial paper, securitization in general, and much of the derivatives market resting solely on aggressive obfuscation of economic reality in pursuit of fees.

To return to the Fed (who may have been thinking I had finished with it), its recent activities have rested on two further deceptions. First, it pretends loudly that "core" inflation, stripping out food and energy, is all anyone needs to worry about. This is economically nonsense, and it knows it to be so— naturally when the economy is overheating food and energy prices are the first to rise, providing valuable signals of inflation in general. Second, the Fed and the ECB have now decided that the inevitable illiquidity in the interbank market following exposure of the banking system’s defalcations in housing and elsewhere can be cured by cutting interest rates aggressively and pumping $600 billion of taxpayer money into the banking system. Needless to say, such activities do not restore systemic confidence nor has proved itself justified; they simply prop up the stock market and cause an increase in inflationary pressure, pushing oil prices up over 30% in four months. Again, it’s quite literally a confidence trick, which will be exposed during 2008.

Turning now to Japan, whose people came up with the "year of deception" line, one is puzzled to find where the deception lies. Yes, economic growth in 2007 will be 1.3% compared with the 2.1% projected, but that is a modest difference, caused partly by the fiscal tightening in Japan’s 2007 budget, which was both essential to fiscal stability and in the long run economically beneficial as it reduces the burden of Japan’s excessive government debt.

There is a certain amount of deception in the monetary area. The Bank of Japan has kept its key interest rate at 0.5%, on the pretence that deflation is rampant. In reality, with energy and commodity prices having increased so rapidly, Japan is now suffering significant inflation as a result, so its short-term rates are negative in real terms. For the health of the economy, and above all the income of Japan’s numerous hard-saving retirees, Japan’s short-term interest rates should be increased to a more normal 2.5-3% as soon as possible. Nevertheless, it does not appear that the damage done by this mistake has yet been severe, so one can hope it will promptly be corrected.

A third example of alleged "deception" is the loss of 50 million pension records by the Japanese government. However, the responsible minister resigned, as is proper, and Britain shortly thereafter, by losing 25 million social security records of its own, proved that this was not a Japanese problem but a universal problem of placing excessive reliance on computer systems managed by incompetent government bureaucracies. One can also ask oneself where there is more risk of serious identity theft: in a country with almost no immigration and a well-established domestic criminal class that helpfully identifies itself by means of tattoos, or a country that has completely lost control of its borders and sold most of the prime real estate in its capital to the Russian mafia.

Naturally, a primary reason the Japanese investor class regards 2007 as a "year of deception" is that the Tokyo stock market has dropped 10%, the only large market to have done so. However, in a year of a major international financial crisis, in which several medium-sized banks have collapsed and at least $600 billion (by last count) in 'emergency' funds has been pumped into the interbank market, it may reasonably be questioned why any of the world’s stock markets should have risen.

It appears that the Tokyo stock market is currently the only major market in the world that is NOT ruled by deception!


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