Grantham

Jeremy Grantham can be a bit of a perma-bear, but there's a point in his most recent letter that rings especialy true to me:

China’s ability to sustain rapid growth and avoid a
serious stumble has become an article of faith that
I was buying into without much skepticism. But
why? No sooner do we fi nish wallowing in the idea
of Soviet incompetence than we start to believe that
Chinese central planners can wonderfully manage
a complicated economy, growing unprecedentedly
fast and transforming overnight from a rural society
to a capital-intensive industrial wonder using half of
some of the world’s resources. Economic logic and
history suggest that their governmental interferences
will be sub-optimal, and that China’s current level
of investment will turn out to be dangerously high,
encouraging waste. They continue to build basic
capacity on automatic pilot even as they encounter
dangerous times for their export-led economy, since
we are all facing the rising probability of a global
slowdown in economic growth and trade. China also
has to deal with rising energy costs in their particularly
energy ineffi cient economy. Surely they will stumble.
And if we are all unlucky, they will stumble right into
the global credit crisis.

Magical Mystery Accounting

As usual, Barry Ritholtz has some good points:

Just when you think there is a glimmer of hope that some of these ne'er do well, lying, cheating, sniveling, cowardly bank CEOs might finally be forced to step up to the confessional and tell all, this comes along: FASB Postpones Off-Balance-Sheet Rule for a Year.

There will eventually be a financial sector recovery, and some smart people will make loads of money off of it, but I'm afraid they will be smarter or luckier (or simply better connected) than I. Right now though, I can only imagine investing in some special case that I can actually understand, and I'm setting the understanding bar (understandably, given the eternal litany of writedowns) pretty high.

Question: How can anyone value a financial company if they cannot tell what are on their balance sheets?

Answer: You cannot. If you buy a financial under these conditions, you are flying blind.

Investment Thesis: Ritholtz Rule #1: Know What You Own.
Whoever buys Financials under these circumstances loses the right to whine down the road about companies not being forthcoming. If you own them, don't complain when you get what you deserve.

Google Lobbies

I recently wrote about this in a more reflective mood, but it's worth revisiting in the sobriety of the office: Google spent $730,000 to lobby in second quarter.

US Socialism

I like this one:

Two major related threats loom over the world economy: credit crises and rising inflation. What do these two menaces have in common? Bankers, hedge-fund managers, speculators and capitalism in general have been taking the hit for the economic turmoil, both for credit risk and inflation. But the looming collapse of Fannie Mae and Freddie Macin the United States should help change the focus a little. We are now getting down to the heart of the matter, which turns out not to be rampant capitalism but out of control back-door socialism.

- Terence Corcoran, The culprits behind credit, inflation risks

Learning about markets

Despite its academic cachet and theoretical appeal, I've never been much of a believer in the idea that markets are truly efficient. Free and open markets are a pretty good tool in a wide variety of circumstances. They are an equilibrium tending process both theoretically and (usually) in practice. However, they consist of monkeys buying and selling stuff (capitalism is an animal behavior pattern after all) and they occasionally suffer from the flaws associated with this status. I've never believed markets were completely efficient, because if they were, I wouldn't have a job and companies would in general not have profits, both of which predictions are verifiably false.

What I don't understand about the current market crisis is all the people who claim we have recently learned something fundamentally new about markets. Even a cursory knowledge a financial history extending beyond the last 10 years will show you that a boom-bust credit cycle tied to over-investment in real estate is the most often repeated error in all of capitalism. We've got literally two centuries of examples of this phenomenon, from all over the world, with all different kinds of economic backdrops, states of technological development, and monetary conditions. We've got an entire century of data about how this phenomena occurs even when there is a lender o last resort. The current situation is the most predictable, least surprising economic fact I can think of. We have run this experiment literally hundreds of times; we know how it ends.

So, when someone like Paul De Grauwe in the linked article, claims that we have now had a cherished myth about markets destroyed, that only now it has become apparent that unregulated financial markets are not perfect, I go nuts. On two levels.

First, I can't possible see how this is surprising. All the fancy econo-physical models about risk and volatility and rational expectations and whatnot were obviously and transparently wrong right from the beginning. Anybody who has spent any time at all actually looking at how a business or a stockmarket works knows this immediately and intuitively -- the only way to make money is precisely to avoid the places where there is an eficient market. Make whatever model you want, but don't ask me to be shocked when it turns out that assuming the cow is a point in space isn't good enough to turn you into a dairy farmer.

Second, stop coming to conclusions about how markets have failed us when in reality all that has happened is that the reality of these markets hasn't corresponded to the toy model you made of them. It reminds me of the idiocy of people in the 90's saying that the USSR collapse somehow proved that "communism doesn't work". The truth is that you can't come to any conclusions about "markets" from the current experience, because the financial system doesn't even come close to resembling a free, open, and transparent market. The problem here is that there are three definitions of "market" involved in this discussion -- the economist's efficient market, real functioning markets (of which they are many concrete examples called 'commodities businesses' which no one is very excited about owning in general, the current euphoria for this sector aside), and the most common type of market, which is not at all free, but a system which whole going under the name of the 'free' market is actually rigged by the biggest players to their own advantage via the political system. The implosion of Freddie and Fannie has absolutely nothing to do with the first two definitions of the market because these companies never ever operated in a truly free market. They have always been the classic example of a government sponsored private monopoly -- the precise opposite of what a market is supposed to be.

This is why it drives me so nuts when the opportunistic moralists come out of the wood-work to proclaim that "unregulated markets have failed". Because there is no such thing as an unregulated market -- it's a complete oxymoron. The only unregulated market is the one where we go around hitting each other over the head with sticks and dragging women back to our caves by their hair. All real markets are regulated extensively with legal systems defining and enforcing property rights, contracts, etc ... There can be no market without regulation. The question is whether the regulation puts everyone who wants to play the game on the same foot, or whether it unfairly advantages the biggest players in the game. The current crisis is a failure of regulation -- that regulation failed to create the conditions of a free market because (among other things) it let people who knew they would be bailed out by the government gamble with other people's money. The current crisis is not a failure of anything resembling a "market" -- but it is a dramatic failure of something vaguely resembling a government.

The Banana Republic Club

Yves Smith has inaugurated the Banana Republic Club, which aims to commemorate respectable folks comparing the US to a Banana Republic. Given that the first members are William Buiter of the FT, and Mohamed El-Erian of PIMCO and Harvard Endowment fame, the company looks good, and I would like to sign up for a front-row seat at the next event. Maybe we can all get together at Burning Man?

Have you got rocks?

I no longer remember which year it was, but I do recall Warren Buffett's discussion of the Hadrocks and the Gotrocks in one of his annual letters (2005 it turns out). His point was simply that unlike in Lake Woebegone, not everyone can be above average or beat the market, and that if we all pay hedge fund 'helpers' 2-and-20 in an attempt to do this, we are simply collectively transferring our wealth to the helpers. The appropriate physical analogy is indeed friction -- financial industry profits are the frictional drag on our economic system.

I was reflecting on this this morning, and on the current financial meltdown, and realized that Buffett is right when it comes to beating the stock market, but not quite right about the financial sector in general -- some financial profits can come from creating a non-zero sum game. If I have capital and you have a business idea, neither of us is going anywhere fast unless we can meet and form a partnership. Someone who introduced us would actually generate economic value, and could capture (some of) this value without us being worse off. In fact, I think one of the big problems with the emerging markets is their lack of this non-zero sum game infrastructure, which is every bit as important as roads and schools.

I started wondering how one might measure what percentage of financial profits are real, in the sense of generating economic value, and what percentage are frictional. A tough question, but FT Alphaville has a post today suggesting one simplistic but plausible way of doing this. Barring some radical new-age-of-finance argument, there's nothing to suggest that finance has become dramatically more non-zero sum in the last decade. Hence, the sector's profits as a percentage of GDP ought to be about the same as it was a decade ago. If you check out the graphs in the post, you'll see graphically that financial profits have soared with respect to GDP, and you will find a measure of the excess profits generated over the last ten years -- $1 trillion dollars of light and heat, smoke and mirrors, friction at its most fricative and explicative. Fuckers.

Now, should we really be surprised that some of this excess may have been invested politically in making sure there was no mean reversion? Should we really be surprised that we have to bail these guys out.

Agency Issues

Brad Sester has a (slightly) less polemic and more data driven follow-up on Roubini's idea. It turns out that foreign official holdings of agency debt (Freddie, Fannie, Ginnie) are roughly 20% of the total $5 trillion agency debt outstanding. Looked at from the other side, he also estimates that between teh agency debt and the (explicit) treasuries they hold, China is sitting on a US government obligation position that equates to 25% of their GDP. Canned disclaimer on comparing stock numbers and flow numbers here. No matter how you look at it though, this is an extraodinarily large position for either side.

The basic take-away from this is that China is simply going to have to suck up the inflation that results from pegging to the US economy in this way, and the US is simply going to have to wallow through several years of stagflation. The other options -- letting the renminbi appreciate, or diversifying away from dollars, seem less and less viable every time I think about this. Sester has some interesting reflections on the irony of all this:

In some sense, it is remarkable that the system for channeling the emerging world’s savings into the US housing market - a system that relied on governments every step of the way, whether the state banks in China, that took in RMB deposits from Chinese savers and lent those funds to China’s central bank which then bought dollars and dollar-denominated Agency bonds, or the Agencies ability to use their implicit guarantee to turn US mortgages into a fairly liquid reserve assets — hasn’t broken down after the “subprime” crisis. The expectation that the US government would stand behind the Agencies is a big reason why.

That allowed the US government to turn to the Agencies to backstop the mortgage market once the “private” market for securitized mortgages dried up, as emerging market governments continued to buy huge quantities of Agencies.

And it now seems that this game will break down on the US end before it breaks on the emerging market end. The Agencies will run out of equity before central banks lose their willingness to buy Agency paper.

History, it is said, rhymes rather than repeats. Bretton Woods 1 broke down because some key governments weren’t willing to import inflation from the US. Bretton woods 2 has survived — even intensified — the subprime crisis because many emerging market governments have preferred importing inflation to currency appreciation. China seems more worried about textile job losses than inflation, negative real returns on household deposits or the risk of financial losses on its (large) holdings of Agencies.

Smart idea

Now, here's a smart idea from Nouriel Roubini (via Naked Capitalism). Instead of the government nationalizing Freddie and Fannie, why don't we just magically say that all of their obligations par value has been reduced by 5%. After all, what's really going on today is that the US is defaulting. We borrowed a lot of money from the Chinese and spent it on McMansions and color televisions, and now we can't pay it back. Fortunately for us, we have the reserve currency and the nukes, so the rest of the world is just going to have to resign themselves to having lost money on the deal. This is the sort of things that happens when somebody goes bankrupt -- you restructure their debt and life continues on.

First, notice that the hit that bondholders will take will be limited in the absence of their bailout. With a debt/liabilities of about $5 trillion and expected insolvency – as of now and in the worst scenario of $200 to $300 billion – the necessary haircut is relatively modest: either a reduction in the face value of the claims of the order of 5% (if the mid-point hole is $250 billion) or – for unchanged face value – a very modest reduction in the interest rate on their debt after it has been forcibly restructured.

Second, a 5% haircut is much smaller than the 75% haircut that the holders of Argentine sovereign bonds suffered in 2001-2005, much smaller than the haircuts that holders or Russian and Ecuadorean debt suffered after those sovereign defaults, and much smaller than the 30% haircut that holders of corporate bonds suffer on average when a corporation goes into Chapter 11 and its debt is restructured. So why should Uncle Sam – i.e. eventually the U.S. taxpayer – pay that $250 billion bill when investors in the U.S. and around the world can afford it? The same investors are getting a fat subsidy of $50 billion a year (whose NPV is much bigger than $250 billion) for holding claims that now provide a 100bps spread above Treasuries and are under the implicit guarantee of a full bailout.

Third, of the two options we need to pick one: either we formally guarantee those claims and start paying the Treasury yield on that debt saving the tax payer that $50 billion subsidy; or if we maintain the subsidy a credit event in the form of a small haircut because of insolvency would be the fair cost that such investors pay for earning the extra spread over Treasuries.

Fourth, while the haircut would reduce the market value of such agency debt and inflict mark to market losses to investors such losses are already priced by the fact that the widening of the agency debt spread relative to Treasuries – from 10bps to about 100bps – has reduced the mark to market value of such agency debt. So, in the current legal limbo of insolvent GSEs whose debt is however not formally guaranteed the persistence of the spread would lead to those $250 billion mark-to-market losses regardless of a formal default, restructuring and haircut on that debt. We may as well resolve that insolvency and restore the positive net worth of the GSEs by doing the haircut.

Giant elephant in room

Why is it that we never read anything anywhere any more about to defense budget? This is the first thing that occurred to me when I saw this post about the new for brainwashing ... errr ... educating students on the dangers of social security.

Public Agenda said this week it will get a $500,000 grant to roll out a mini-curriculum at up to 500 colleges and universities focusing on the nation’s deteriorating financial situation. The National Academy of Public Administration and PETLab will get $325,000 to develop a game for college students focusing on “difficult fiscal issues like unsustainable entitlement programs, rising health care costs, and financing investments in alternative energy sources.”

Why is there no game educating students about the danger of electing a monkey as President and letting him appoint most of corporate America to his cabinet?

Socialized Capitalism is called Fascism

Fannie, Freddie, blah blah blah -- you don't need me to repeat what you've already read about their fates, and the fact that you sir, Mr. Taxpayer, will have to bail them out. Nor will I repeat the moaning moral outrage of those like Robert Reich who are shocked shocked to find that the government has loaded the capitalist dice in favor of the house, when in fact as the former Labor secretary he was involved in the process.

Marc Thoma however, seems to be a pretty smart and reasonable guy, and he expresses an opinion you can find in many places now, probably even in the mouths of your very own smart and reasonable friends.

On the too big to fail issue, my view hasn't changed. If failure of these firms endangers the broader economy, and hence threatens to impose large costs on people who had nothing to do with creating the problems, then policymakers need to step in and do what they can to prevent a downward economic economic spiral. In addition, they need to change the rules and regulations that allowed the problem to emerge in the first place, and add new rules and regulations as needed to lower the moral hazard worries going forward.

This stuff absolutely works me into a lather when I read it from someone I know means it seriously and with the best of intentions. Because well ... WHAT THE FUCK DO YOU THINK WE HAVE BEEN DOING FOR THE LAST CENTURY!!! Not to put to fine a point on it, but if any strategy has been absolutely, repeatedly and scientifically proven to be utterly, completely and totally doomed to failure it is the procedure recommended here. Please, I beg you, consider thinking about a different way of dealing with this.

Lost Decades

Some reflections from Yves and Ronnie Chan on the economies of the next decade. While I'm not sure I would call it a 'crisis of capitalism' I do think that the next decade may prove that the last one was an unsustainable pattern of growth. Essentially, real per capita economic growth is driven by increasing productivity -- and productivity is a difficult thing to sustainably increase at a very rapid rate because it depends on a whole host of factors. It depends factories and industrialization, but also on political and financial institutions and technological innovations that overcomes commodity bottlenecks. It strikes me that these institutions are some of the slowest things to change, and that when they become bottlenecks in the process, you can see extended periods of slow growth.

What has happened in the last decade is unsustainable precisely because a lot of the emerging world, and particularly China, hasn't even tried to develop these institutions -- they've been borrowing the more developed ones from the US and Europe. Export led growth in China implies more than simply rapid industrialization that takes workers out of the rice paddy and puts them in a factory stamping out plastic golf cups. That process can move quickly, as fast as you can build the factories and fill them with workers and ship the stuff to someone ready to buy it. The gains are dramatic precisely because you've reduced the equation of growth to just one factor, pinning everything the dramatic difference between subsistence agriculture and factory production. But that's not sustainable unless you also develop some way to sell the stuff, some way to manage the reinvestment of the profits, some way to control the rapid urbanization and industrialization. The Chinese have outsourced this to the US just as the US let the Chinese become their producer of last resort.

This symbiotic relationship is unstable, but sustainable at least for a while by the US accepting the role of consumer of last resort and allowing itself to go deeper and deeper into debt. The US already had the consumer and financial infrastructure in place to be able to grow its consumption at any given pace -- it was just a matter of printing more money and getting people to go out and spend it. The bottleneck was in how fast China could produce more stuff. This cycle has now ended because there is simply a limit to how in debt the rest of the world is willing to let you go. Now the bottleneck in growth shifts to how quickly you can get new raw materials -- commodity investment and new technology -- but also to developing consumer and financial infrastructure in other places. The first one has gotten a lot of press, but in fact is the easier part to deal with. Commodities have always been cyclical and always will be. Increasing production there happens on a relatively quick time scale though, something like 3-5 years. Changing institutions, as the post points out, is not at all so easy or so quick. Building democracies, financial systems, physical infrastructure, etc ... is much harder than building a factory. There is a whole global social machine that has become saturated, and that is what may take a decade to cure. The capitalist axiomatic rides again.

Reorganization

Came across some earlier notes today which hold up remarkably well.

2/16/08
The GS report from Credit Suisse talks about a liquidity crisis with lots of liquidity. Where did all of this liquity come from and where is it going to? Certainly, to know that there is lots of cash sitting in hedge funds and private equity funds makes you wonder just how bad this can all really get. The stock market at least, hardly seems overvalued, and the bargain hunting has already begun. I wonder, however, whether there aren't two time-scales to this particular cycle. First, a rapid one defined by hedge funds finding bargains in companies that have written off debt and putting their cash to work. Second, a slow time-scale based on the actual economic fall-out of the bad housing debts. Bad mortgages can be marked to market in an instant but people don't stop paying on them for years. In addition, you can mark to market (especially an illiquid market) with all kinds of assumptions, but who knows what the economic reality of these instruments will be -- i.e. how far housing will fall. This gap in time scales, assuming the worst for the economic consequences of housing dropping (say, 50% in real terms according to Shiller's index) may lead to a quick apparent recovery as people's fear's ease and they go back into the market, and then a much longer and more grinding slide down as the real economic consequences become gradually apparent. Which is to say, look for a big bounce within a few months followed by a long, slow unwinding.
The next question is where does all this liquidity in the middle of a liquidity crisis come from? I think the relatively simple answer to this is foreign central banks supporting the dollar and thus pumping money into our credit markets. There's no way to bet on how long they will go on doing this, because it's a political rather than an explicitly economic calculation. This sort of "reverse bailout" phenomenon does seem perverse and unsustainable though.

Roubini

Nouriel Roubini has been pessimistic for years now, and right for almost as long. Apparently he's got a new post on the endgame for the current monetary regime (which he calls Bretton-Woods 2). Unfortunately, it's subscription only, so we will have to rely on Naked Capitalism for a summary. The thing that caught my eye was how remarkably close this was to what I have been thinking, and this quote can almost be found (less eloquently of course) scattered across the last several posts on my blog.

However, Roubini, who has been prescient on this topic, sees another outcome: with world growth and demand looking wobbly, these countries (which are not the most politically stable, an important fact to keep in mind) are reluctant to risk a big slowdown or huge damage to exporters by letting their currencies appreciate.

Roubini believes they will let inflation run, and even allow it to become embedded. In the long run, this will achieve similar results to a revaluation (as local goods prices rise in nominal terms, it winds up increasing the price of exports, much as currency appreciation would. However, it would happen more gradually and (implicit in Roubini's argument) it would be hard to point fingers (while a change in the currency regime would clearly be tied to specific authorities).

A Macro view

For as complicated as global finance and the global economy is, it's actually possible to tell a fairly simple story about what's going on right now -- the US borrowed too much money to finance its spending, and now we're defaulting on the debt. Defaulting when you own the reserve currency is different though. Instead of the dollar falling dramatically, or domestic inflation running rampant, we are forcing the rest of the world to accept inflation in their currencies. The vast reserves of dollars piled up around the world are not being sold, and the consequence is the inflation springing up everywhere these reserves are being stubbornly held. The US has exported its default.

This would be an ingenious strategy if the rest of the world could be counted on to keep growing and keep absorbing this inflation. Unfortunately, the dynamic of the debt pile-up that got us into this mess in the first place means that the US has been the consumer of last resort and the engine for the industrialization of China and Asia. If this final link in the chain falters, these export led economies may not be stable enough to deal with the inflation a US default imposes on them. If they slow dramatically things could get really ugly, which is the conclusion of the post that inspired this line of thinking.

Idea

It would be interesting to try to use this same idea of tracking migratory animals via google earth to keep track of capital flows.

The Gnomes of Zurich

The Bank for International Settlements, the central bankers bank, has posted their annual report. Foiling all my expectations of gnome stylistic tendencies, the report is actually very directly and clearly written and remarkably sensible and without mercy with respect to its conclusions. I would particularly recommend the introduction and conclusion as probably the best overview of the state of the economic world I have seen to date.

Follow the money

Tim Duy has written another (and more accessible) post about why the commodity price spike makes sense in the context of global capital flows.

So, if we follow the money, where does that lead us? Everyone wants to know the answer to that question. I think that it will be difficult for capital inflows to gain traction in the US, essentially the same problem left in the wake of the 2001 recession. Lacking that traction, the money seems to be flowing into commodities. To halt the rise in commodity prices, I suspect that either global monetary policymakers needs to tighten meaningfully or, what I think the Fed is hoping for, the money will spontaneously shift to another, less inconvenient direction, optimally some real, productivity enhancing form of investment. Until we see one of those outcomes, I tend to fall back on that old Wall Street truism: The Trend is Your Friend.

Cross currents on speculation

So, I was never completely convinced by the argument many propose as a way to justify the fundamental nature of $140 per barrel oil -- namely, the purely financial nature of the futures market and the lack of inventories. Lots of people have made this argument, which does make sense, and is essential to consider. I do think that a lot of people don't follow up very thoroughly on the argument however. It's one thing to observe that the index funds are buying futures and not storing physical oil, and it's another to jump to the conclusion that the futures market has no impact on the spot market and hence there can be no speculation. The link between the two markets is indirect, but real, and can come from hidden inventories (kept in the ground), or from intertemporal calculations by refiners, or from fuel subsidies and very inelastic demand curves, or, as this post suggests, from the mechanics of the way contracts are priced.

Most crude oil is traded based on long-term contracts, and the prices in those contracts are set by a system known as "formula pricing". In this system, the price of delivered crude is set by adding a premium to, or subtracting a discount from, certain benchmark or marker crudes, namely: West Texas Intermediate (WTI), Brent and Dubai-Oman. Generally, WTI is used as the benchmark for oil sold to North America, Brent for oil sold to Europe and Africa, and Dubai-Oman for Gulf crude sold in the Asia-Pacific market (Source1, Source2).

"JD then provides a description of how the spot market became increasingly subject to manipulation, which led oil exporters to turn to the futures market, which was more liquid and hence less subject to games-playing, as the basis for contract pricing. JD cites a paper by Bassam Fattouh of the Oxford Institute for Energy Studies:"

[T]he futures market has grown to become not only a market that allows producers and refiners to hedge their risks and speculators to take positions, but is also at the heart of the current oil-pricing regime. Thus, instead of using dated Brent as the basis of pricing crude exports to Europe, several major oil-producing countries such as Saudi Arabia, Kuwait and Iran rely on the IPE Brent Weighted Average (BWAVE).11...

[11] The BWAVE is the weighted average of all futures price quotations that arise for a given contract of the futures exchange (IPE) during a trading day. The weights are the shares of the relevant volume of transactions on that day. Specifically, this change places the futures market, which is a market for financial contracts, at the heart of the current pricing system.

This is not to argue along with so many politicians that "it's all speculation". At this point I've formulated what I think is a reasonable view on this stuff -- the price increases from 2001-mid 2007 were by and large fundamentally based, despite the gradual shifting of money into futures indexes. When the credit crisis started and real interest rates went negative, speculation started to become an important factor, and occurred through a variety of channels, not all of which would actually fit the definition of speculation most people have (it's actually a damned slippery term when you try to apply it to a cyclical market like commodities). So oil and other commodities are in a bubble, if by this you mean that they may suffer sharp declines -- but they are not going to mean revert to their 2001 price, and there really is a fundamental supply and demand problem that needs to get solved one way or another (historically its been solved by a combination of recession/depression and supply growth/conservation). Right now things are just overshooting, and the greatest danger is in taking the easy road out by scapegoating the evil speculators and ignoring why the speculation got started in the first place.

And another thing ...

The interdependence of macro variables is so complicated that I have no idea how to keep all of it in your head at once. Tim Duy has some interesting reflections on the current imbalances.

Consider that the current account deficit will need to correct by some mixture of import compression and export expansion. The weaker Dollar encourages that correction, but Dollar-pegs prevent the full adjustment. But where currency adjustment fails, commodity price adjustment steps in as, for example, higher transportation costs support import competing industries. Indeed, we are learning that cheap oil, not just cheap wages abroad, was the critical force supporting offshoring of US production.

It's interesting to think about the effect of higher oil prices as a national rebalancing mechanism. It both cuts into your real consumption, and at the same time, by making imports that have to cross an ocean more expensive, shifts the mix of the consumption towards domestic producers. He continues on to the punch line:

I have long maintained that this adjustment should be characterized by weak consumption growth but better-than-expected business activity overall, particularly in export and import-competing industries. Effectively, the US is offshoring some of its weakness. The combination should be something that consumers clearly associate with recession, but with better than expected output, especially when policy stimulus is added to the mix. This is very much like the current environment, a recession that still lacks a single quarter of negative GDP growth. But the level of stimulus is starting to look excessive, and supporting a more inflationary environment than anticipated.

How long can this process continue? As long as global policymakers are willing to support it. Indeed, it is almost of a game of chicken, with US and emerging market policy makers on a collision course, neither wanting to accept the adjustment, a greater reliance on internal balance, necessitated by excessive US consumption.

Thinking about this, it seems to me that the Chinese are seriously fucked. They get caught on both ends of this bargain, as they too have to fork over more for oil and food, at exactly the same time as their exports become less competitive -- and they don't have any domestic demand to fall back on like the US. They can either continue to try to export, pile up dollars, let new direct investment come in (remember, they are accumulating reserves even faster than they can export) and simply accept the inflation this causes -- or they can revalue. Right now they are choosing option A (most of the world is choosing option A actually, not just the Chinese) -- exporting, putting up with the speculative inflows, recycling these into dollars as best they can, and just swallowing the resulting inflation. The fact that they're willing to do this is what is keeping the US afloat, but China must be paying the price for it in terms of bubble-like mis-allocations of these inflows. The whole thing looks like a positive feedback loop between Chinese fixed investment and commodity prices, with US monetary policy intervening in the middle and providing the juju to keep it going. If the fall of the Chinese property and stock markets, and the rise in inflation are any indication, we are at the last stages of this bubble.

The best way out of this for the US is for China to just accept that inflation. This would mean accepting lower export competitiveness, raising wages, and resigning themselves to the value of their dollar hoard in real Chinese terms going down. It would probably contribute to US inflation, and it would tend to keep commodity prices high. All of which would set up the conditions Duy describes in the US, which is really our easiest way out of the debt overhang from the Bush Binge, despite the fact that it may feel unpleasant for all involved.

On the other hand, in order to finally control inflation, they might raise rates and let their currency depreciate. It would have to be a sudden depreciation of course (say 20% in one go), to avoid people speculating on the currency. This destroys their competitiveness immediately, but does at least halt some of the speculation. It makes their pile of dollars worth a lot less, and the knock-on effects of that may be worse for the US, given that such an obvious policy failure might be accompanied by a remedy that makes it even worse -- namely diversifying out of dollars, or simply not adding so many new ones to the hoard. This should drive up US rates, and would probably tip the whole world into recession/depression.

Global monetary conditions

Naked Capitalism has a post putting together some stuff on the inflation-deflation debate and defending the Fed rate cuts in the face of the ECB. This would be related to my post of the other day where the PIMCO guy also defended the Fed, and suggested that there wasn't much danger of inflation in the US, given the weak position of labor, and that the problem with lower rates really stemmed from the currency pegs in the dollar block.

The crux of the problem seems to be what you do with the money supply when you experience a commodity price spike (if you are a commodity importer). To me, the logic of letting the money supply expand to deal with that shock, and thus balancing the pain of it between capital and labor, is pretty compelling. That seems especially true when the real wages of consumers are already tremendously fragile, and forcing them to bear all the burden would almost certainly tip us into a deep recession.

It seems to me that the normal consequence of this easing into negative real rates would be a fall in the dollar, as the US is essentially inflating away its obligations to the rest of the world (eve if domestic inflation remains fairly contained). The dollar would fall, the US would rebuild its manufacturing, and gradually we would save more and spend less and things would return to balance. In the middle US growth would be slow of necessity because 75% of GDP is consumption, which by hypothesis here has to fall relative to production.

The problem here is that the rest of the world isn't buying, and that in fact they're saving up all their dollars and refusing to let that currency adjustment happen. From their perspective this makes sense because letting their currencies appreciate makes all the dollar reserves they've built up over the years worth a whole lot less, and incidentally, reveals them as suckers once again in the game of global finance -- the insurance they bought by saving after the last round of problems in 98-99 turns out to be worthless.

Geopolitics of China

Fascinating post on the geopolitical situation of China. Really, go read about how geography plus demography equals destiny. Don't take the posts conclusion that China will always and forever be a export led manufacturing economy though. Eventually, China may develop a thriving middle class that sells all kinds of stuff to one another, even if it always has to have some exports available to pay for the food it will import.

The merits of inflation

An interesting speech by one of the PIMCO directors. The basic argument is that the US, as an oil importer is experiencing a negative terms of trade shock -- namely, higher oil prices -- and that the Fed shouldn't raise rates to deal with the inflation this causes because it makes labor pay the full cost of the shock, rather than sharing it between capital and labor.

Let me see if I can rehearse the idea. First, the price of oil goes up. In real terms, this means that you have to work more to buy a barrel of oil. Your real wage, as a nation, has decreased. The nation is composed of two groups -- those who labor, and those who hold capital. Let's assume for a second that holding capital means holding cash or T-bills or short-term assets in general. Now, if you raise interest rates to deal with this inflation, you can maintain the purchasing power of that cash. The Fed raises rates in the face of an inflationary shock in order to maintain stable real interest rates. Unfortunately, higher rates also make it less profitable to invest in real businesses, so they imply a slowing economy. This means that more people end up out of work, and those that remain employed see no wage increases. Therefore, the real wage declines, and has to account for all of the necessary adjustment to the decline in purchasing power of the nation. Labor suffers while capital (cash) skates.

If, however, the Fed leaves rates where they are, the real rate of return on short-term capital declines as the price of oil rises. This may even result in negative real interest rates. But this simply means that now some of the burden of the fall in purchasing power is partly absorbed by capital, and should protect labor from an economic decline. The lower rates should cut into economic growth less, meaning that fewer people lose their jobs and those that stay don't need to accept a reduction in (nominal) wages. So the purchasing power of capital is eroded along with labor if you keep rates low.

The problem is in dealing with the knock-on effects of negative real interest rates.

The "VC Crisis"

I really know jack-diddly about venture capital, but a post at peHub today resonates with other things I've read and what Christof has mentioned to me in the past.

I offer five forces that underly the observable change in modern venture capital:

• The technology industry has matured to the extent that startups are viewed as outsourced R&D by big companies.
• The consolidation of technology verticals via either winner-take-all competition or multi-billion dollar acquisitions has decreased the number of would-be customers and acquirers for focused technology offerings.
• The over-availability of growth capital promotes competition among startups for scarce resources such as technical employees and early-adopter customers and raises development costs accordingly.
• Attractive investments may be increasingly found through creative deal sourcing and structuring rather than sexy technologies, big markets or “hot” entrepreneurs. Similarly for successful exits.
• Successful firms have formalized their succession planning to preserve their virtuous cycle, making specialization an increasingly attractive strategy for first time funds.

These forces, in combination with the fact that the IPO window is now officially closed, makes me wonder aloud again whether there isn't a place for a private equity style firm to buyout the VC stakes in the more developed of their companies. I don't mean late-stage mez financing or anything, I mean a buyer with a long time horizon who is willing to actually own these investments as operating businesses.