Juan Cole: Top Ten Myths about Iraq

Juan Cole completely thrashes a list of myths about the US invasion of Iraq at Informed Comment. Get your facts straight for a coming year of attempted revision of history by the departing neoconservatives of the Bush administration.

1. Iraqis are safer because of Bush's War. In fact, conditions of insecurity have helped created both an internal and external refugee problem. (...)

2. Large numbers of Iraqis in exile abroad have returned. In fact, no great number have returned, and more Iraqis may still be leaving to Syria than returning.

3. Iraqis are materially better off because of Bush's war. In fact, A million Iraqis are "food insecure" and another 6 million need UN food rations to survive. Oxfam estimated in summer, 2007, that 28% of Iraqi children are malnourished.

4. The Bush administration scored a major victory with its Status of Forces Agreement. In fact, The Iraqis forced on Bush an agreement that the US would withdraw combat troops from Iraqi cities by July, 2009,and would completely withdraw from the Country by the end of 2011. (...)

5. Minorities in Iraq are safer since Bush's invasion. In fact, there have in 2008 been significant attacks on and displacement of Iraqi Christians from Mosul. In early January of 2008, guerrillas bombed churches in Mosul, wounding a number of persons. More recently, some 13,000 Christians have had to flee Mosul because of violence.

6. The sole explanation for the fall in the monthly death rate for Iraqi civilians was the troop excalation or surge of 30,000 extra US troops in 2007. In fact, troop levels had been that high before without major effect. The US military did good counter-insurgency in 2007. The major reason for the fall in the death toll, however, was that the Shiites won the war for Baghdad, ethnically cleansing hundreds of thousands of Sunnis from the capital, and turning it into a city with a Shiite majority of 75 to 80 percent. (When Bush invaded, Baghdad was about 50/50 Sunni and Shiite). The high death tolls in 2006 and 2007 were a by-product of this massive ethnic cleansing campaign. Now, a Shiite militiaman in Baghdad would have to drive for a while to find a Sunni Arab to kill.

7. John McCain alleged that if the US left Iraq, it would be promptly taken over by al-Qaeda. In fact, there are few followers of Usamah Bin Laden in Iraq. The fundamentalist extremists, if that is what McCain meant, are not supported by most Sunni Arabs. They are supported by no Shiites (60% of Iraq) or Kurds (20% of Iraq), and are hated by Iran, Syria, Turkey, and Jordan, who would never allow such a takeover.

8. The Iraq War made the world safer from terrorism. In fact, Iraq has become a major training ground for extremists and is implicated in the major bombings in Madrid, London, and Glasgow.

9. Bush went to war in Iraq because he was given bad intelligence about Saddam Hussein's weapons of mass destruction capabilities. In fact, the State Department's Intelligence & Research (I & R) division cast doubt on the alarmist WMD stories that Bush/Cheney put about. The CIA refused to sign off on the inclusion of the Niger uranium lie in the State of the Union address, which made Bush source it to the British MI6 instead. The Downing Street Memo revealed that Bush fixed the intelligence around the policy. (...)

10. Douglas Feith and other Neoconservatives didn't really want a war with Iraq (!). Yeah, that was why they demanded war on Iraq with their 1996 white paper for Bibi Netanyahu and again in their 1998 Project for a New American Century letter to Clinton, where they explicitly called for military action. (...)

GDP vs. Household Income

Yangshen Huan writes in the The Wall Street Journal about misguided focus on GDP and other simplistic measures of economic prosperity.

The fundamental problem, and a mortal bias of economists, is a fixation with simple measurements -- especially GDP data. Ask a professional economist how many provinces China has and you are likely to draw a blank stare. But ask him what the GDP growth of China has been and he'll quickly be able to tell you that China has grown at a double-digit rate for 30 years and that at this rate China will overtake the U.S. by 2035 (or some other date). GDP-centrism is endemic, and often comes at the expense of deeper analysis. Just look at the enthusiasm with which economists and analysts greeted Goldman Sachs's famed "BRIC" report forecasting dramatic booms in Brazil, Russia, India and China -- a report based on little more than fifth-grade mathematics.

This obsession with China's impressive GDP growth often ignores discussion of what's causing that growth and whether it's self-sustained. This is where the decoupling enthusiasts stumbled, and where policy makers can still go seriously wrong. Consider, for example, data about the very slow growth of household incomes in China. This is particularly apparent in rural households. For the past 20 years or so, rural household income has grown at a rate half that of GDP growth. The slow household income growth, combined with rapid GDP growth, means that China has created a huge production capacity but it has done so at the expense of its own consumption base. This fact alone should have disproved the decoupling hypothesis. All the new "excess" production had to go somewhere, i.e., to the U.S. What's more, the persistence of this gap suggests that over time, China's growth has become more, not less, a derivative of America's consumption appetite.

This is a global phenomenon, and not strictly restricted to China. Overflowing credit and growing income inequality have caused individual consumer incomes to stay way behind the overall size of the economy all over the world.

How Not to Stimulate Economy, Indeed

Harvard professor Greg "Bush advisor" Mankiw posts some first class crap in his blog:

In thinking through the fiscal policy options and their implications, it might be useful to compare a few hypothetical, fanciful scenarios. Suppose that the federal government borrows some money and then...

Case A: uses the money to give a lump-sum payment (such as a tax rebate) to Joe Average, who chooses to spend his free time sitting at home watching Mork and Mindy reruns.

Case B: uses the money to hire Joe to sit at home and watch Mork and Mindy reruns.

Case C: uses the money to hire Joe to sit at home and watch Family Feud reruns, which Joe does not enjoy quite as much as Mork and Mindy.

How about:

Case D: uses the money to hire Joe to upgrade the national railway system, or

Case E: uses the money to hire Jane to give better education for 20 children, or

Case F: uses the money to fund Jack's research on new energy sources, etc.

There is no shortage of public goods that a government can take upon when the private sector absolutely refuses to make use of the available resources, preferring instead to sit on its hands and watch those Mork and Mindy reruns, or even worse, engage in blowing bubbles.

The private sector, especially the unregulated financial one, has already proven its capacity to misallocation of resources. It is high time to do something different.

Naturally, the government should take it easy on investment at times when the economy is red hot and there is scarcity of resources, but this is definitely not one of those times. Besides, those much needed public investments are soon cheaper than ever before. The situation would be much better, if the US government had gathered some surplus in the good times, instead of letting rip with massive deficits.

It's easy to make your preferred solution look good when you only compare it to even worse propositions. Why is it that some people equate government spending to burning bills? As if being paid by the government somehow makes everything worthless.

Have a Cheerful Christmas?

Ed Halliwell writes in the Guardian under the headline "Reasons to be cheerful". He has a Buddhist view on the topic of happiness and makes the case that no reason is needed for being cheerful. He interprets the word "cheerful" as an attitude, unlike "happiness", which is a state of affairs.

The next week or so will bring most of us a higher-than-usual number of wishes for our "happiness". Whether it's "Happy Christmas" (which seems to have eclipsed the more traditional exhortation to be "merry"), "Happy New Year", or the religion-neutral American import "Happy holidays", so many hopes for contentment can have the unintended effect of seeming like a reproach, especially if we are not feeling as chipper as the season appears to demand.

[...]

However, there is another, much more useful phrase for describing the potential of the holiday period – "the season of good cheer". Whereas the word happiness implies an end state, the result of causes and conditions over which we may have little control, cheerfulness is volitional, a deliberate decision to be good-spirited. Indeed, it may be especially appropriate to rouse "good cheer" at times – such as midwinter – when outer circumstances seem wretched and we are more likely to feel downcast.

[...]

The acceptance part of the process is important – cheerfulness should not be confused with the sometimes-nauseating "everything's-going-to-be-alright" approach that positive thinking gurus often appear to advocate. The purpose of cheerfulness isn't to deny that life is sometimes shit, it's that we aren't dependent on the happiness that comes from circumstances in order to find ways to wonder at it – as one Buddhist elder once asked me: "Rather than just liking the smell of roses, or hating the smell of manure, perhaps you could start appreciating that you have a nose?" (Read the whole story)

I guess this is what is usually referred to as "Christmas spirit". I guess what Ed wants to wish for everybody is: take it easy. I couldn't agree more.

Debt as a Source of Short-Sightedness

As an addendum to the previous post, there is a reason for the increasing short-sightedness of businesses.

Shortening of the time scale of business decisions is a direct result from the overall increase in the level of gearing. When equity decreases in size compared to the overall level of debt in a company, the time scale is inevitably compressed. This is because creditors, unlike equity investors, are not willing to wait for profits. Interest must be paid on the debt at a predetermined rate, or a default is triggered. When the overall level of debt increases, time scales shorten and risk-aversion increases.

Below is a graph of the average rate of growth of credit/debt versus GDP in various industrial nations:


Here is the same thing as a graph over time:


There is no reason to assume that this statistic would not revert to a mean over time. Such relative measures can not keep developing in one direction forever. What is noteworthy, besides the huge level of the debt, is its remarkably monotonic growth. The developed world has not seen a real reduction in debt for over 30 years. Now we are finding out how painful that actually is.

Oversized Financial Sector vs. True Innovation

Micheline Maynard publishes a sharp observation by John Casesa of Casesa Shapiro Group in a New York Times article about the trouble at GM:

But G.M., despite its tradition of fostering innovation, has often been impatient for profits to emerge.

Mr. Casesa said that pattern stemmed from the fact that so many of the company’s top executives had a background in finance, not in engineering and designing cars and trucks.

This out-sized rule by financial professionals in a single company is directly related to the overall size of the financial sector in developed countries. The same short-sightedness rules today in the stock market, resulting in an oversized focus on quarterly results. A long term focus and a will to wait for profits is a requirement for successful innovation.

Hoarding - Coin "Shortage" in Buenos Aires

An amazing story about the dynamics of hoarding coins in Argentina is presented by Joe Keohane in The Slate: (hat tip to Paul Kedrosky)

Welcome to the world's strangest economic crisis. Argentina in general—and Buenos Aires in particular—is presently in the grip of a moneda, or coin, shortage. Everywhere you look, there are signs reading, "NO HAY MONEDAS." As a result, vendors here are more likely to decline to sell you something than to cough up any of their increasingly precious coins in change. I've tried to buy a 2-peso candy bar with a 5-peso note only to be refused, suggesting that the 2-peso sale is worth less to the vendor than the 1-peso coin he would be forced to give me in change. When my wife went to buy a 10-trip subway pass, which retails for 9 pesos, she offered a 20-peso note and received 12 pesos in bills as change. This is commonplace—a daily, if not hourly, occurrence. It's taken for granted that the peso coin is more valuable than the 2-peso note.

No one can say what's causing this absurd situation. The government accuses Argentines of hoarding coins, which is true, at least to some extent. When even the most insignificant purchase requires the same order of planning and precision as a long-range missile strike, you can hardly blame people for keeping a jar of monedas safe at home. The people, in turn, fault the government for not minting enough coins. In fact, the nation's central bank has produced a record number of monedas this year, and the problem has gotten even worse. (Read more)

When everybody does something in anticipation of others doing the same, things can sometimes escalate out of hands in a completely uncontrolled way. If everybody would stop the adverse behaviour all at once, things would rapidly come back to normal. But how could such a coordinated action be achieved?

Hoarding is a phenomenon that is going to be a hot topic in the coming decades of resource scarcity. It is a good research subject for economists, sociologists and anthropologists. Too bad I'm an engineer myself.

What to Do with Excess Financiers?

A hilarious outburst of frustration from Stormy at the Angry Bear blog:

I still think nationalizing the banking system is a clean solution. No more fancy derivatives or CDO's. Let's have an old-fashion banking system. Sideline the money boys. Send them off to China or Sudan. Let them watch ice melt in the Arctic. Count polar bears. Have them do something useful.

Borrowings of Depository Institutions from the Federal Reserve

The credit crisis just keeps escalating. A picture is worth a thousand words:

New York Times: Let's Make up Charges for "Heinous Terrorists"

New York Times wrote in its Sunday editorial about the "problems" of closing the Guantánamo prison camp.

Even with all those demands, there is one thing Mr. Obama must do quickly to begin to repair this nation’s image and restore its self-respect: announce a plan for closing Mr. Bush’s outlaw prison at Guantánamo Bay.

The prison is the premier example of the disdain shown by Mr. Bush and Vice President Dick Cheney for the Constitution, federal law and international treaties. Most sensible governments cannot see past Guantánamo to even recall America’s long history as a defender of human rights and democratic values.

We are under no illusions. Closing the prison will not be easy, or quick, but it can be done. It does not mean that the United States will set free heinous terrorists. But it may mean that these prisoners will have to be tried on other very serious charges than the ones supposedly for which they were sent to Guantánamo.

Hmm... So Times is proposing made-up charges? A majority of the detainees do not fit under the description of "heinous terrorists". If there's no concrete evidence, why should the US government try to squeeze out a conviction.

Does this mean that truly dangerous men will be set free, to go back to plotting more attacks against America? No. But it will require smart legal thinking by the new administration.

Oh, those very dangerous people. Time for a reality check. Releasing a few people with evil intentions is a big thing in comparison to keeping possibly innocent people detained for seven years, and tortured as well. Those "heinous terrorists", against which there just doesn't happen to be much evidence, can surely be kept under check after release, and captured, if they actually take up arms again.

Normal Level of Lending?

A quote from a Bloomberg article about the ongoing discussions in the US Congress:

Federal Reserve Chairman Ben S. Bernanke told lawmakers at the hearing that using the TARP for buying stakes in banks is ``critical for restoring confidence and promoting the return of credit markets to more normal functioning.'' He warned that lending in the U.S. is ``still far from normal.''

Quite true, Chairman Bernanke. Lending is far from normal in the US. It has only just started to come down to normal levels after 30 years of excess.

An honest analysis would discuss ways of slowing down the return to norm. Even more important would be measures that would help people and businesses to adjust to smaller levels of lending and debt.

Interfluidity: If only We Had a Financial System...

Steve Randy Waldman of the Interfluidity blog has posted a great piece of common sense, titled "If only we had a financial system...":

The elephant that is not in the room is a financial system. By a financial system, I don't mean the tottering cartel of banks and insurers loudly sucking newly printed cash into "collateral postings" and "deleveragings" and other meaningless nonactivities. That is no financial system at all. It is an ecology of intestines and tapeworms, tubes through which dollars flow and are skimmed en route to destinations about which the tripe-creatures have little interest or concern.

The post is a polemic for a financial system that doesn't think it can create wealth on its own, independently of the actual economy of manufacturing and trade. Read the whole thing. It's a great post.

Electronic Voting Stupidity in Finland

The Electronic Frontier Finland (EFFI) organization has published a highly critical press release of the electronic voting problems in three small Finnish communities.

It seems that the system required the voter to insert a smart card to identify the voter, type in their selected candidate number, then press "ok", check the candidate details on the screen, and then press "ok" again. Some voters did not press "ok" for the second time, but instead removed their smart card from the voting terminal prematurely, causing their ballots not to be cast.

Here, the issue is one of usability. 232 votes were ignored because of the missing press on the OK button. The number might seem small, but taking into account the small scale of this trial, the number adds up to about 2 percent of the whole electoral roll in the small communities that participated in the trial.

The most amazing thing is that even though the authorities admit that there was a usability problem, there will be no repeat of the vote.

It is very strange, though, that there is no mention in the EFFI press release about voter confidentiality issues, even though administration officials have admitted that they know the exact identity of each person that left an uncounted ballot because of this issue. There is no mention of verifiability of counting either.

EFFI does make a strong statement for abandoning such stupid experiments. A purposefully simplified and transparent voting procedure is an aim in itself. Traditionally, this has meant a paper ballot, into which a number is written with a pen. The vote counting is left to teams of voluntary people from all parties in each voting location. Even with such a system, the full count is usually achieved in hours. The additional good that is supposed to be provided by a computerized ballot is a complete mystery to me.

New Targets for IMF "Bail-outs"

The UK Telegraph writes under a headline: "Pakistan to receive $9bn from IMF in fight against bankruptcy".

Pakistan is to receive a $9bn (£5.5bn) bail-out loan from the International Monetary Fund as the country has three weeks to stave off bankruptcy.

Sound more like a bail-out of Pakistan's creditors. Pakistan will have just as much trouble paying to IMF as it has to its current creditors, and even more so after its public infrastructure, especially education, has been demolished by IMF demand. The same goes for Iceland and the others. Many earlier IMF clients would probably have done better by going bankrupt.

Now that the IMF is "aiding" both developed and developing countries at the same time, it will be most interesting to see it the same standards and conditions are applied for all, or if its demands for "tough medicine" are for developing countries only.

The demand for 18% interest rates for Iceland does seem to be quite insane tough. Expect a very hard landing indeed for the Icelandic economy. I guess the people in IMF will never learn from their experiences. What these countries need is debt relief and negotiations with creditors. Bailing out the creditors will just make sure that the same thing happens again and again and again...

Onion: Bush Calls for Panic

The Onion proves once again that is truly is the [US] Nation's Finest News Source in a great piece of satire titled: "Bush Calls for Panic".

In a nationally televised address to the American people Wednesday night, President Bush called upon every man, woman, and child to spiral uncontrollably downward into complete and utter panic.

It sure has been looking like inducing panic is the Bush administration's goal. The way that they suddenly switched from "everything is all right, our banking system is save and sound" to "we are doomed, unless we get to blow the lid off the national debt, in which case we are doomed anyway" is a sure way to create a massive panic.

This is not the first time, either. After September 11th, there was an equally sudden turn to scaremongering from absolute indifference. The initial approach to the threat of terrorism in the Bush administration was highly dismissive, even though the departing Clinton officials tried to raise awareness of the situation. This dismissive attitude was then suddenly switched to claims of existential threat.

If the purpose was not to create a state of panic, it can only be explained by complete incompetence. Maybe the administration will next produce a colour-coded economic warning system, directing the citizenry to selling into coordinated panics, followed by buying at the tops.

Learning from the Great Depression

N. Gregory Mankiw, the economics professor from Harvard, writes in the New York Times about the lessons learned by economists since the Great Depression. He takes issue with overconfident rhetoric from IMF's chief economist, Olivier Blanchard.

Like most economists, those at the International Monetary Fund are lowering their growth forecasts. The financial turmoil gripping Wall Street will probably spill over onto every other street in America. Most likely, current job losses are only the tip of an ugly iceberg.

But when Olivier Blanchard, the I.M.F.’s chief economist, was asked about the possibility of the world sinking into another Great Depression, he reassuringly replied that the chance was “nearly nil.” He added, “We’ve learned a few things in 80 years.

Yes, we have. But have we learned what caused the Depression of the 1930s? Most important, have we learned enough to avoid doing the same thing again?

The Depression began, to a large extent, as a garden-variety downturn. The 1920s were a boom decade, and as it came to a close the Federal Reserve tried to rein in what might have been called the irrational exuberance of the era.

So professor Mankiw clearly recognizes the significance of the prior excess. He then goes on to discuss the effects of the stock market crash.

But things took a bad turn after the crash of October 1929. Lower stock prices made households poorer and discouraged consumer spending, which then made up three-quarters of the economy. (Today it’s about two-thirds.)

Here Professor Mankiw is putting the carriage way ahead of the horse. The fact that the economy was almost completely built on consumption is clearly the primary cause of the depression, just as it is now. Such "hollowness" of the economy was the reason for the market implosion, not vice versa.

Is Professor Mankiw really trying to say that if only consumption could have been kept going, a downturn would have never come? Have we really learned so very little in those 80 years?

But such an assumption is partially correct. The consumption could have continued in a less diminished form, only not without a massive recognition of losses for those that had amassed huge savings in the form of debt receivables during the previous decade or two. Those savings were mostly imaginary. The "wealth" that was supposed to be so great in the roaring twenties was mainly a mirage. It was not backed up by actual assets, just a whole lot of credit.

But there was actual wealth, even though it was not up to the level of credit in the banking system. People can't eat credit. There was real production. Real buildings were built.

What resulted in losses to the real economy was the panicky scramble by the owners of the financial system to realize as much as possible of their inherently imaginary wealth. This resulted in factory closures, cuts to production and overall liquidations of everything in sight.

But preserving the imaginary value of the financial system in general was impossible. The value just wasn't there. Even if a few early birds might have salvaged an out-sized piece of the pie, liquidations of productive assets made the overall situation catastrophic, and actually reduced the pool of real wealth in existence.

The only way to prevent such a panic of liquidations is an abrupt and early recognition of the true base of value in the economy, combined with equitable distribution of losses to holders of imaginary wealth. This much is clearly understood by professor Mankiw.

Probably the most important source of recovery after 1933 was monetary expansion, eased by President Franklin D. Roosevelt’s decision to abandon the gold standard and devalue the dollar. From 1933 to 1937, the money supply rose, stopping the deflation. Production in the economy grew about 10 percent a year, three times its normal rate.

It is nice to see that Professor Mankiw recognizes the value of giving up on the gold standard. After all, the standard was effectively given up much earlier by letting the financial system grow so far ahead of its reserves.

Monetary stimulus can not be trusted to perform the delivery of losses in an equitable way. It hurts savers in actual assets and favours the owners of imaginary wealth in the financial system. Monetary stimulus must be accompanied by distribution of losses to all levels of the financial system, including depositors and other creditors. Professor Mankiw kind of admits this in a later paragraph.

The Fed and the Treasury Department, intent on avoiding the early policy inaction that let the Depression unfold, have been working hard to keep credit flowing. But the financial situation they face is, arguably, more difficult than that of the 1930s. Then, the problem was largely a crisis of confidence and a shortage of liquidity. Today, the problem may be more a shortage of solvency, which is harder to solve.

The comment about 1930's not being mostly about shortage of solvency is quite frankly puzzling.

It must be recognized that the free market does not much help us here. In a free market of rational people, there will be a completely rational panic in a widespread insolvency situation. This puts us in a prisoner's dilemma situation where the common good is seriously neglected by individuals acting out of rational self-preservation. If we are additionally ready to accept, as the economic theory of late has been very loath to do, that people in general are not very rational, or have no access to the necessary information for rational decision-making, we can assume that there will be complete carnage.

An equitable distribution of losses, as a necessary but inherently repulsive proposition, requires some kind of coordination. This includes taking bad banks out of business as early as possible, instead of letting them pile on the losses.

But human nature is not very well suited for early recognition of losses, even if that would be rational. Overall deposit guarantees has been the unfortunate (and very late) first reaction from governments in Europe. It just makes the situation worse and further delays the recognition of the differences in the values of the financial system and the real economy.

Instead of guaranteeing all deposits, there should be a way to rearrange all bank liabilities, including deposits, into new equity, while the old equity would be wiped out.

Deposits above a suitable threshold, which could be quite high, should be converted to new equity in a bank failure. This would directly address the solvency issues without causing a need for fire-sale disposition of the assets of the failed bank. This would also be useful for keeping bank management in a healthy state of fear: "Do your job properly, or face a mob of angry ex-depositors in the next general meeting of shareholders."

A solution to too much credit is not more credit. It is conversion of credit to equity and realizing losses from imaginary wealth.

Fannie and Freddie no Longer Run to Minimize Taxpayer Losses

MarketWatch reports of Fannie Mae and Freddie Mac getting new marching orders from the US government:

Regulators initially restricted Fannie and Freddie's growth when they seized control. To "promote stability" and lower mortgage costs to borrowers, Treasury Secretary Henry Paulson said the two companies would be allowed to "modestly increase'' their mortgage portfolios to as much as $1.7 trillion through the end of next year and said they would no longer be run "to maximize shareholder returns."

Since no returns of any kind are to be expected in a little while, the last sentence should actually be translated to a more accurate wording: They are no longer run to minimize shareholder losses. And "shareholder" now practically means the US government. Isn't that nice and reassuring. And a good way to promote the "free market".

Moral Factors in the Free Market

There is a very interesting review in Time magazine of an article, from a forthcoming Oxford University Press book, titled "The Recession of 2008: The Moral Factor — A Jewish Law Analysis.", by Aaron Levine, who is both a rabbi and an economics professor.

The article comes up with a pro-regulatory stance that has its basis on the ancient principles of Judeo-Christian ethics, including not putting a stumbling-block before the blind (economically so in this case), disclosure (of hidden flaws) and over-charging.

That economics professors start to discuss ethics is a much needed step towards creating a principled compromise between freedom and moral restrictions in the prevailing "free market" ideology.

The old adage of "no freedom without responsibility" has been greatly manifested by the current financial crisis. The free agents in a marketplace are suddenly not so free after all, when confronted with margin calls. If one does not act in a responsible way, one's freedom will we taken away, one way or another.

In our usual feelings of self-importance and entitlement, we could take a word from Abraham Lincoln: "I like to see a man proud of the place in which he lives. I like to see a man live so his place will be proud of him."

Cyclic History in Action

Finance professionals have had quite a negative attitudes to talk of paralles between the current situation and that prior to the Great Depression of the 1930's. Now that such comparisons are starting to appear in many mainstream publications, Scott Reynolds Nelson, a professor of history, in a guest post in iTulip.com, makes a claim that the 1930's depression is not the correct parallel with the current situation. Instead he makes direct parallels with the Real Great Depression that started with the panic of 1873. (Hat tip to Tim of The Mess That Greenspan Made)

When commentators invoke 1929, I am dubious. According to most historians and economists, that depression had more to do with overlarge factory inventories, a stock-market crash, and Germany's inability to pay back war debts, which then led to continuing strain on British gold reserves. None of those factors is really an issue now. Contemporary industries have very sensitive controls for trimming production as consumption declines; our current stock-market dip followed bank problems that emerged more than a year ago; and there are no serious international problems with gold reserves, simply because banks no longer peg their lending to them.

In fact, the current economic woes look a lot like what my 96-year-old grandmother still calls "the real Great Depression." She pinched pennies in the 1930s, but she says that times were not nearly so bad as the depression her grandparents went through. That crash came in 1873 and lasted more than four years. It looks much more like our current crisis.

He also provides a nice lithograph from 1875 that shows the get-rich-quick attitude of the time as people chasing bubbles that are blown by a devil-looking character. I have reproduced the lithograph here in a less compressed format from the US Library of Congress.



He also draws analogies to the global imbalances caused by unequal cost factors across the global marketplace.

Wheat exporters from Russia and Central Europe faced a new international competitor who drastically undersold them. The 19th-century version of containers manufactured in China and bound for Wal-Mart consisted of produce from farmers in the American Midwest. They used grain elevators, conveyer belts, and massive steam ships to export train loads of wheat to abroad.

[...]

The echoes of the past in the current problems with residential mortgages trouble me. Loans after about 2001 were issued to first-time home buyers who signed up for adjustable rate mortgages they could likely never pay off, even in the best of times. Real-estate speculators, hoping to flip properties, overextended themselves, assuming that home prices would keep climbing. [...] As in 1873, a complex financial pyramid rested on a pinhead. Banks are hoarding cash. Banks that hoard cash do not make short-term loans. Businesses large and small now face a potential dearth of short-term credit to buy raw materials, ship their products, and keep goods on shelves.

Wow. I hope that he is not proven right in this assessment.

Blowback from Economic Black Ops?

I've been reading John Perkins' book "Confessions of an Economic Hit Man". It has made me think how much the oversized financial trouble in the economies of the developed world is at least partly an instance of blowback from economic operations that were initiated in the 1970's.

Perkins claims in his book that he was approached by people from the NSA in the beginning of his career as an economist in a big energy engineering company. (Chas. T. Main, now part of The Parsons Corp.). He was encouraged by the government people and his superiors to produce overly optimistic economic forecasts to encourage foreign governments to take huge amounts of debt for oversized development projects. The aim of this was to bring nations into debtor relationships with the US and the World Bank, thus retaining significant political control.

One paragraph in a chapter that is otherwise focused on the problems of modern Ecuador lit up a lingering thought that had been floating around my head for some time:

"During those tree decades, thousands of men and women participated in bringing Ecuador to the tenuous position it found itself in at the beginning of the millennium. Some of them, like me, had been aware of what they were doing, but the vast majority had merely performed the tasks they had been taught in business, engineering, and law schools, or had followed the lead of bosses in my mold, who demonstrated the system by their own greedy example and through rewards and punishments calculated to perpetuate it. Such participants saw the parts they played as benign, at worst; in the most optimistic view, they were helping an impoverished nation." [emphasis mine]

If this "operation" was as widespread as Mr. Perkins claims, it might actually have had an influence in the behaviour of underlings that observed their bosses coming up with and encouraging the most hyper-optimistic assumptions of economic development.

Because people do not just stay at a single job, untold numbers of workers might have participated in operations that were led by people secretly but intentionally working towards creating financial hardship. These people would take this behaviour as the normal way to do business. Some of those people that had early in their careers in the 1970's unwittingly worked in such projects are now on the very top of the business world.

The stream of thought in the financial world that just like that crosses straight over into hubris has been somewhat a mystery to me. This explanation, though only partial at best, is a very tempting one.

Naturally such operations could not be single-handedly responsible for the psyche of a whole generation. But it could have produced an additional amount of cultural acceptance for seemingly short-sighted practices of financial overreach.

It is, of course, also perfectly feasible that Perkins' book is not completely honest, but an elaborate attempt at trying to clean his own image. It can be a drag on one's conscience to witness the economic ruins left behind by sloppy or self-serving economic assessments.

Perkins' writing style does have a certain bit of self-centredness. (I was a hit man, but a conscious one.) The story also project an image of a person with such a level of cognitive dissonance that makes it somewhat hard to believe. Perkins' possible exaggerations of his moral discomfort in the early years doesn't necessarily mean that he is lying about the alleged government collusion.

As an idea, especially knowing of other operations of the US intelligence apparatus, the situation described by Perkins has some credibility. If these operations did indeed happen, a part of the financial trouble today can surely be ascribed to blowback from these (hopefully foregone) misdeeds.

Are the Liquidationists Starting to Raise their Heads?

Princeton economist and NY Times columnist Paul Krugman makes an excellent point in his NY Times blog:

Ken [Rogoff] tells us that

The huge spike in global commodity price inflation is prima facie evidence that the global economy is still growing too fast.

And then he calls for

a couple of years of sub-trend growth to rebalance commodity supply and demand at trend price levels

Um, why? Basically, the world is employing rapidly growing amounts of labor and capital, but faces limited supplies of oil and other resources. Naturally enough, the relative prices of those resources have risen — which is the way markets are supposed to work. Since when does economic analysis say that the way to deal with limited supplies of one resource is to reduce employment of other resources, so that the relative price of the limited resource returns to “trend”?

Ken Rogoff's point can be understood in a more limited sense. We do need an actual reduction in the relative size of the financial sector, which has grown way out of its intrinsic value. But that doesn't mean that economic activity in itself should slow down.

The transition from financial labour to more productive uses does entail some amount of higher unemployment. It does take some time for all the extra mortgage professionals to find a more productive employment. But this process of adjustment has started to happen on its own. There is no need (anymore) to help it on by excessive tightening of monetary controls.

The instinctive reaction to long dormant inflationary pressure that is suddenly fully revealed is quite similar to a person in a rocket that has been launched in a gigantic thrust and is comfortably looking at the sky (growing asset prices). Then the upward momentum runs out (we are entering a permanently high plateu...). The rocket turns towards the earth (existing stimulus moves from assets to commodities).

Now what is the appropriate response? Some people have just only come to realize that we are way too high and heading downwards. Their instincts are saying: If we keep the thrusters on, we will crash into the earth.

But this is a wrong reaction. This parable is completely bogus. The "thrusters" have not been on for a while. And we are not in a rocket in which the thrusters are always behind us. What we have is closer to a hot air balloon (pun intended). The burners were on for too long when we left the ground.

Monetary stimulus works quite like the torch in a hot air balloon. It has no immediate effect on the level of lifting force. Instead it builds up a reserve of lifting force quite like the temperature in a balloon.

And we do need some extra lift to keep us from falling straight to the ground. We can not, and should not try to keep permanently high, or we risk running out of fuel. But we do need to slow down the fall.

But fall we will. The global imbalances are too great. But we should not try to accelerate these inevitable changes. They will manifest by themselves. We should try to land as fast as we safely can without running out of fuel.

Some people have been looking to the clouds far above, and have only recently come to realize how very far we actually are from the ground below. For some of these people the immediate reaction to the sudden realization is "full speed down!". This is the liquidationist viewpoint. "Puncture the bubble!". It could have been fine in the beginning (and some have been calling it as it is), but will result in a very hard landing if rigorously applied at this "altitude".

Our current altitude is a matter of reality. We have a massively out-of-size financial sector and a global economy that is quite heavily out of whack. Some people think that this condition can be kept forever. But should we attempt that, we would surely run out of fuel. We are actually quite close to that situation. And it would result in a crash just as devastating as the liquidationist approach, only somewhat later.

What we have is a pretty tricky situation. We should not aim for a permanent bubble. And we should not aim for immediate deflation. We should aim for a steady brisk pace of continuous adjustment until the financial "industry" is the size of its actual utility, productive labour has the value that it should, and people would by paid around the globe according to their actual productivity.

In that sense Ken Rogoff is right. We do need to head down. But we do need to head down by careful administration of the torch. Not by letting the balloon completely deflate.

And Paul Krugman is exactly right. There is no sense in underutilization of labour and capital. Closing down factories and cutting down production produces nothing but poverty. Collectively we can't keep wealthy just by holding cash or government bonds.

The currently low interest rates are more a function of people wanting to hold secure government bonds than any sign of excessively "loose" monetary policy. The Federal Reserve has actually been withdrawing money in its open market operations. The overall liquidity has been stagnant, while the money has been pumped back into the system through various special lending facilities.

Unfortunately US monetary policy is now quite irrelevant. Bank accounts are primarily made of promissory notes, and cash is just a tiny fraction. When banks stop lending, the money supply shrinks on each payment that the public makes to banks, including interest and equity injections.

Money came from thin air, and to the same place it disappears. And the less there are actual deposits, the less banks have any need for cash, and the harder it is to try to slow down the collapsing bubble through monetary policy action. The zero interest limit (and running out of "fuel") awaits.

Mechanical Economists and the Gold Standard

Bill Bonner writes well in the Daily Reckoning Australia about the difference between the humanistic viewpoints of classical economists and the technical viewpoints of modern day economists.

The first economists - the two Adams, Adam Smith and Adam Ferguson - called themselves "moral philosophers." They were studying the human economy as though it were an anthill -- to see how it worked. They figured it must follow rules - just like all other things under Heaven - and tended to see mistakes people made, such as spending too much money, as moral failings.

Modern economists are more like auto mechanics. They think they can control the economy with a screwdriver. And to some extent they're right. Which is why the world economy is in such a mess; they turned the wrong screws. But it's why we moral philosophers are having such a good time; finally, we get to laugh and say "I told you so."

Economic activity is inherently a human process, and economists would need a lot more understanding of psychology (especially mass psychology) and philosophy. Instead, they tend to treat economics like it was a branch of engineering. This is most strongly evident in the modern field of "financial engineering".

But Bill Bonner has a strange fixation on the gold standard, which is actually not so relevant in this issue. He writes:

Since then, the U.S. government could print almost as many dollars as it wanted. Arguably, it printed too many. For something - perhaps it was too much cash and credit in circulation - led American homeowners to think house prices would rise forever.

In this case it is mostly too much credit. Growth of cash has been relatively sluggish (except in the far east and the Euro zone). The reality is that the credit decisions of commercial banks are not tied to the amount of cash anymore. Reserve requirements have been taken to practically zero. And this has happened in a regulatory environment that has the near equivalence of cash and credit as a base assumption.

In earlier times, before the deregulatory wave of the last 30 years, banks were forced to acquire a certain amount of cash for each accepted promissory note. But this is not so anymore. The last major relaxation in the US was in 1995 when retail sweeps were taken into use. There is almost nothing in these regulations to relax anymore. Banks have been able to magic deposits from thin air by accepting huge amounts of promissory notes at a negligible opportunity cost.

This relaxation has been a main cause in the growth of speculative flows as well. When banks can accept a promissory note at zero cost to cash reserves, it is very easy for them to lend huge amounts to speculators that make leveraged short term bets on price fluctuations.

In earlier times banks had to find actual depositors for a fraction of each dollar that they lent out. But now they have almost no opportunity cost at all.

Without cash reserve requirements, the only thing that is left to limit the growth of credit is solvency, either regulatory solvency in the form of capital requirements, or actual solvency. It is only natural that any lower limits of a self-enforcing process will eventually be reached, so here we are, exactly where the deregulators put us, either willfully or unwittingly.

More importantly, the lack of reserve requirements has essentially decoupled the financial economy from any actual monetary policy. When no cash reserves are needed for the growth of credit, a gold standard would not have necessarily saved the banks from this kind of a "race to the bottom".

In a certain sense, a gold standard would have been a fear factor for the bank owners. It would have made many of the ongoing bailout efforts much more difficult, thus raising the impact of the current crisis. This would have encouraged more strident risk controls from bank equity investors, but not in any binding way.

Bill Bonner's orthodox take on the gold standard creates a strange contrast with the philosophical and practical outlook of the classical economists that he so admires. A strict attachment to a crude and inflexible tool like the gold standard is more like a mechanistic view of the economy.

After all, gold has no practical inherent value at all. It is durable and its quantity is hard to manipulate. But it has been responsible for some of the most useless undertakings in human history, like gold rushes, military adventures, occupations and wars.

Money can also retain its value too well in some situations. In a deflationary spiral, money is seen to have a rising value. But cash should only have value as a medium of exchange. It should not be infinitely storeable. Value is only in what goods or services people can provide to each other, not in some heavy and soft (if quite pretty) metal in a safe.

The purpose of monetary policy should be aimed at keeping people from excessive hoarding or excessive consumption, either of actual goods or of the medium of exchange. The only way to create actual savings is to invest in capital goods (no, commodities are not capital goods) that have a value in being able to produce goods and (increasingly) services.

Dictatorial Powers for the US President

Andy Worthington (author of "The Guantánamo Files"), has written a good review of the recent US 4th Circuit Court decision against Ali Al-Marri, a Qatari national and legal resident in the US.

This decision has upheld an indefinite military detention, as an "enemy combatant", of a person that has never raised arms against the US. It gives the US president the authority to designate just about anybody as an "enemy combatant" on the basis of hearsay "evidence" of assumed intentions.

Mr. Worthington finishes with a strong quote from the verdict's minority opinion:

I leave the final words to Judge Motz, and her clear-eyed awareness of the injustice of the al-Marri verdict. “To sanction such presidential authority to order the military to seize and indefinitely detain civilians, even if the President call them ‘enemy combatants,’ would have disastrous consequences for the Constitution –- and the country,” Judge Motz wrote. “For a court to uphold a claim to such extraordinary power would do more than render lifeless the Suspension Clause, the Due Process Clause, and the rights to criminal process in the Fourth, Fifth, Sixth and Eighth Amendments; it would effectively undermine all of the freedoms guaranteed by the Constitution. It is that power — were a court to recognize it — that could lead all our laws ‘to go unexecuted, and the government itself to go to pieces.’ We refuse to recognize a claim to power that would so alter the constitutional foundations of our Republic.”

Unless Ali al-Marri is allowed a meaningful review of his status as an “enemy combatant,” Judge Motz’s fears have already come true.

The Onion: Recession-Plagued Nation Demands New Bubble To Invest In

The Onion hits the nail on the head with a piece of satire on the state of the US economy.

A panel of top business leaders testified before Congress about the worsening recession Monday, demanding the government provide Americans with a new irresponsible and largely illusory economic bubble in which to invest.

"What America needs right now is not more talk and long-term strategy, but a concrete way to create more imaginary wealth in the very immediate future," said Thomas Jenkins, CFO of the Boston-area Jenkins Financial Group, a bubble-based investment firm. "We are in a crisis, and that crisis demands an unviable short-term solution."

Go ahead and read the whole piece. It would be quite hilarious if it wasn't so accurate.

Investors Worrying about Cheap Stocks?

Carter Dougherty writes in the New York Times under headline "Falling Prices Grip Major Stock Markets Around the World":

As the United States markets edge toward bear territory, losing nearly 20 percent of their value from last fall’s peak, investors might wonder where they can turn for relief.

The gloomy answer: nowhere.

This is a pretty typical viewpoint in the financial world. But there are two sides in every transaction: The buyer and the seller. There are a lot of people, predominantly young, that are currently accumulating their savings. They are looking for a place to park their surplus earnings.

These are the people that fit mostly under the headline of "investors". For these people, a stock market that goes cheaper is a very positive thing. Of course the situation would be better, if the price declines would not be preceded by even higher profit declines. But a lower price level is always preferable to a higher one if one wants to make long time investments.

The same situation was clearly visible in the real estate market. One person's unearned equity was another person being priced out of the market or going into crushing debt. There are a lot of young couples that are breathing a sigh of relief in the face of plummeting house prices. But there are also a lot of young couples in serious negative equity.

Then who are the people that are losing in a bear market? Naturally most damaging it is to people who are drawing from their savings, such as the baby boomers who are at the start of retirement. But they are not "investors" any more. They are more accurately referred to as "divestors".

So why are the baby boomers losing out on their savings? Simply, they have already eaten those savings, by letting the businesses that they have invested in take on huge debts to create premature earnings, dividends and market valuations. A huge part of future income has been already paid out, just like in the housing market. Many companies, like GM, are like squeezed oranges. Completely devoid of any significant equity. And this is at a time when those savings would really be needed.

Baby boomers have also taken out a significant portion of future taxes, which will be paid by the younger generations. Now that there is a day of reckoning, many divestors that are losing out on their investments are going to cry to high heavens. But one can't eat one's cake and save it too.

End to Price Controls by Central Banks

It is becoming to be quite evident that control of short term interest rates by central banks is prone to be a cause of market disturbances, including speculative manias and crashes. Financial bubbles have of course existed much before the existence of central banks. The current problem, however, is a common problem in situations where prices are set by a third party that is not fully in control of supply. Such price controls cause both rampant overproduction or overconsumption and shortages, depending on whether the prices are set too low or too high.

Central banks used to be in control of the supply of money, but since the early eighties, they have given this power away by drastically reducing reserve requirements of commercial banks. This means that commercial banks are now primarily in charge of the development of the money supply.

This divergence between the power to control prices and the power to control supply is inherently unstable, so we have to go back to the old days of strict control of bank lending, or we have to go forward to release short interest rates from the clumsy control of central monetary authorities.

Central banks seem to be aware of their loss of control, but there does not seem to be much thought about what this implies. Price controls by decree without control of supply have been found to be a bad solution to economic problems.

Discussion of the possibility of US Federal Reserve paying interest on bank reserve balances has been a hot topic earlier this month. The Fed seems to be working towards implementation of an interest rate corridor policy, which has already been adopted in Canada, UK, and New Zealand.

In this system, the central bank sets both a lower and an upper bound for the interest rates of over-night inter-bank loans. This is accomplished by paying a minimum interest on cash balances at the central bank. There is no reason for banks to offer loans to other banks on interest any lower than that. The upper limit is the discount rate, at which banks can borrow directly from the central bank.

A 2006 paper titled "Monetary Policy Implementation Without Averaging or Rate Corridors" by William Whitesell discusses a third alternative for monetary policy application, but the focus of this paper is hopelessly fixated on how the central bank could fix the inter-bank interest rates as tightly as possible. What is missing is any discussion of the sense in trying to achieve such a rigid goal in the first place.

My intuition would tell me that a fixed interest rate for short term lending is inherently a bad thing. Lending rates should accurately reflect the existing earning opportunities and costs of investment activity. A misalignment between opportunities and policy rates create bubbles of hyper-active speculation, because of seemingly risk free opportunities for arbitrage between short term borrowing and lucrative investment opportunities. On the other hand, a misalignment between costs and policy rates create unnecessary slow-downs in investment and savings.

An ideal would be a market-determined interest rate that would dynamically reflect changes in actual opportunities and costs. When a dislocation would suddenly create an investment opportunity, there is always a risk of a speculative bubble. Short term interest rates should react swiftly to sudden increases in demand for credit. If the opportunities are real, it is only just that the savings customers of banks get their fare share of the investment income. If the opportunities are a mirage, the sudden rise in interest rates would quickly deflate the emerging speculative bubble without letting it gather too much steam.

I have been thinking of a mechanism by which central banks could fulfill the function that they were created for, ie. liquidity support, without actually engaging in direct control of interest rates.

First let's be clear about what liquidity actually is. Liquidity is a multi-faceted concept. It has something to do with the volume of trade. It has something to do with transaction costs. Liquidity is not a synonym for lack of volatility, which is possible in perfectly liquid assets.

Liquidity can probably be best described by insensitivity of market prices to a unit volume of trade transactions. It is also related to the amount of losses incurred by simultaneous buying and selling in a single market.

In a trading system there is a certain volume of bidding and asking at different prices. In a real time system, there is a gap between these. This bid-ask spread can be used as a quite reliable measure of liquidity.

I have been thinking of a liquidity provision system through a dynamic interest rate corridor. Instead of a policy rate, set by a committee, the central rate of the corridor would be based on a market average.

In such a system, all interbank lending would pass through a transaction system that is managed by the central bank. The central bank gathers pricing information from this system, and determines an average market price. A suitable margin is then put around the central rate to determine an interest rate corridor. This corridor guarantees a maximum bid-ask spread, ie. a minimum liquidity, at with banks can directly transact with the central bank.

The central rate could be calculated by taking a significant amount, say $100 million, of both the highest asking rates and the lowest bids. By taking a weighed average of these, a neutral market rate would be determined. A meaningful bidding amount should be used for the determination to prevent market manipulation with insignificantly small bids.

Banks would be free to transact with the central bank at the corridor rates, but they could still get better rates by bidding inside the corridor. The corridor should be wide enough for everyday trading to occur between the market participants. But in times of uncertainty, when the spread would otherwise be stretched uncomfortably wide, there would still be a guarantee of minimum liquidity from the central bank.

In times of stress, such a market-based interest rate would be equally uncomfortable to both sides of the market, which is as close as one can get to neutrality. A strictly enforced policy rate, on the other hand, can create highly biased situations, in which either the lender or the borrower would benefit at the expense of the other.

I am quite completely ignorant of most issues of monetary policy, but I would hazard a guess that the level of activity in such a dynamic interest rate corridor could be used as a measure of monetary conditions. Persistent borrowing from the central bank could be a sign of the need for increasing reserves. Persistent deposits would signal a need for reduction.

Commodity Inflation and the Missing Wage/Price Spiral

Why are commodity prices rising worldwide? What does that do to western inflation pressures?

Permanent inflation is not possible without a wage/price spiral (the more usual term wage/price spiral has the cause and the effect backwards). There might be such a thing in China, but not in the strength that some foodstuffs have risen lately. In the US there seems to be no such thing, except for an insignificant 1 percent of the population. This fraction might be significant enough for gold, maybe, but not for other commodities.

So clearly this price growth is at least partly a financial phenomenon. I would say that it has been probably started by a spurt of speculative growth, based on a limited underlying fundamental scarcity, a surge of short term credit from central banks and a dearth of better speculative prospects. After all, one can't do much other than speculate on short term capital.

But this speculative start was most probably amplified by sudden hoarding by actual consumers, who were frightened by the initially speculative price surge. This hoarding has generated an actual (but temporary) shortage in some basic foodstuffs, like rice and wheat.

Some people, like Paul Krugman, have proposed that inventory levels do not support the speculative hypothesis. I think he is pretty much right when it comes to the gradual price development of oil and metals. But I think that the unofficial inventories created by simple consumer hoarding, which is just as speculative as anything, is quite enough to explain the extreme price movements of basic foodstuffs.

Let's study another example: Was there a big inventory of houses as a sign of the growing speculative bubble? No, there was a perceived shortage of houses, caused by consumer hoarding, ie. the inventory was held by the house flippers. The same goes with foodstuffs, and might go on with metals as well. End users are always hoarding somewhat when there is an expectation of price increases.

Such hoarding can create a false signal of shortage, which can then be met by a surge of overproduction and a price collapse, when consumers have filled their cupboards and return to normal consumption. When prices stabilize, they start to unwind their inventories, which results in a fall in demand to even lower levels than the actual consumption. This gives the consumers incentive to draw down their inventories as low as possible in expectation of further price reduction.

So what will happen in the western world where any evidence of a wage/price spiral just isn't there. An equation of rising cost of living with stagnant wages is not sustainable in the long term. In the Western world, there are, of course, significant "buffers" until people start to go hungry. What if we add ever extending credit into this equation? Growing debt repayment makes this equation even more unsustainable, as in prone to a violent snap-back effect. Credit is no substitute for income.

As wages are not going to grow, either prices or consumption must (eventually) come down. Debt will be simply defaulted on. People haven't understood that "free money" only refers to the interest, not the principal. One can not consume something today without giving up something tomorrow. If nothing else, then your credit score.

Unless wages are going to follow prices, there is going to be an eventual price deflation, no matter how much baseless credit is extended. US monetary base has been stagnant for two years. The Chinese have probably prevented massive printing with the nuclear option of massive Treasury liquidations.

An ounce of gold is always going to be worth an ounce of gold. There is no reason why its value should change (or not change) very much against other durable if nonproductive assets, including little green pieces of paper that can be used for paying taxes. But there are precious few (0.8 trn) pieces of green paper, compared to the mass of promises to deliver those pieces of paper on a later date (25 trn).

In these circumstances, the value of those few little green papers might actually rise significantly. But wouldn't that be an intolerable atrocity, because those little green papers are just little green papers, right? They can't be used to produce anything, except that special something, which until recently used to be called "AAA". But nowadays everybody knows what those three vowels really stand for, and that ain't much. So isn't it just appropriate that those little green papers should lose their value along with the worst of IOUs written on a paper napkin with lipstick?

Don't let yourself be fooled. Good credit still exists, even though "AAA" has lost its significance. Looking at how US stores have become a bargain basement for foreigners, it seems that the US dollar does have some value after all. Dollar has been getting a lot cheaper, but has it really lost value? That of course depends entirely on what you are going to buy. ("Price is what you pay. Value is what you get.")

BTW, since GDP is a measure of added value, shouldn't US GDP statistics for the last ten years be revised downwards for the "value" that is now melting away from housing? That value was never actually created, after all. It was just a pricing mistake. Think about that.

Since the instruments of exchange (promissory notes, not to be confused with cash) that were used to create those imaginary valuations are still in circulation, they will find a home somewhere else, like basic commodities. But those are still just promissory notes. They are not little pieces of green paper. I guess the Federal Reserve could convert all kinds of promissory notes to little green pieces of paper, but that wouldn't do the US external credit very much good at all.

So first the US economy was producing value in dotcoms, then in housing, then in commodities. Then what? How much of all that added value still exists? Maybe a little more than the value of a pair of collapsed Bear Stearns hedge funds. But all is fine as long as the fund managers get their 2 and 20 from each successive bubble.

Unfair competition from Northern Rock

From The Guardian:

Northern Rock offers a number of table-topping accounts, including an online account aimed at the over-50s paying 6.49% and a fixed-rate cash Isa with a rate of 6.2%. Its one and three-year fixed-rate savings bonds paying 6.45% and 6% respectively are also listed as best buys on the website of the financial data provider Moneyfacts.

Not only are the interest rates good, the state-owned Northern Rock, unlike other high street banks and building societies, can offer its customers a guarantee that any money in its accounts - whether it is £1 or £1m - is 100% secure.

The bank says its customers' cash is "completely safe ... The Bank of England and HM Treasury guarantee arrangements protect all savers in all accounts, regardless of the amount deposited, and applies to all existing and new accounts".

Ugh. "Give us your money. The UK taxpayer will be glad to give you a handsome return on you deposit."

More Shortsighted Dollar Speculation

From FT.com:

EADS, the Franco-German aerospace group, is preparing to adjust to a “weaker and weaker US dollar” by demanding that its big European suppliers bid for new contracts in the US currency, according to Louis Gallois, chief executive.

Not a good idea when the US dollar is in its weakest. Euro seems more and more like a bubble against the US dollar.

When US deflation hits in force--because US financial institutions have no choice but to reduce leverage--the dollar will start to regain its value. Of course, it might take a long time for the euro-bubble to pop, but it will happen.

For EADS this might be feasible, because much of its income is in dollars as well, but there's no doubt that those suppliers will put considerable risk premiums into their bids for the currency volatility.

European Companies Are Borrowing in Dollars

Financial Times reported about European companies borrowing in dollars:

European companies are increasingly being forced to turn to the dollar markets to raise funding as the credit crunch makes it almost impossible for them to launch deals in the euro-denominated market.

This is going to hurt these European debtors when the euro inevitably comes down from its overly high valuation. The draught in euro-denominated bond investment is probably a sign of disbelief in the sustainability of the euro's high exchange rate against the dollar.

European money supply growth has been much higher than its US counterpart, especially in the narrow sense, and the emerging deflationary environment is just raising the actual buying power of the US dollar.

Europe is fundamentally just as over-leveraged as the US. The possibility of a deflationary trend in Europe should not be dismissed as a possibility, at least when it comes to the property markets. The biggest differences are in the levels of consumer debt. High corporate leverage is not as prone to cause deflation as excessive consumer debt is. UK is closer to the US in this sense, but it is not a part of the European monetary union.

About the Theory of Efficient Markets

I have just read a book, The Crisis of Global Capitalism, by George Soros. It was written in 1998, but oh so fit for 2008. Soros is a critic of the efficient markets hypothesis. I think he is right in saying that markets do not succeed in finding a balanced state, but act instead like a wrecking ball that swings uncontrollably around a point of stability.

In this book he describes a phenomenon, which he refers to as reflexivity. In systems that are made up of humans, like all markets obviously are, the ground truth is not independent from those that are trying to observe it. Instead, there is a constant bidirectional relationship between the observers and the observed. Similar problems are encountered in observing elementary particles, hence the Heisenberg uncertainty principle.

The book was written as a reaction to the Asian financial crisis and the Russian collapse. These events started a strong flow of capital to the established capital centers of New York and London. These flows made up the peak of the tech bubble. They were further prolonged by loose monetary policy. Now we are observing the turning point, where the wrecking ball hits the wall and turns back towards the point of stability.

If we want to actually reach the point of stability and stay there, there would have to be some kind of forces that would slow down the velocity of the ball while it speeds towards the point of stability. At the current situation, the global financial system is like a car without shock absorbers.

Every automation engineer knows that dampers are essential for stability. Why is it so hard for economists to realize that?

Credit Default Swap Counterparty Risk

The enormous amount of counterparty risk that is associated with the $45 trillion market in credit default swaps seems to be finally hitting the radar screens of mainstream news outlets. Unfortunately this reporting interest is way behind the curve, as the said counterparty risk is being triggered in a big way in the problems of the ACA Financial Guaranty Corp.

The Wall Street Journal published a front-page article titled "Default Fears Unnerve Markets" by Susan Pulliam and Serena Ng. It is an excellent overview of the troubled CDS market.

Today, a struggling bond insurer, ACA Financial Guaranty Corp., will ask its trading partners for more time as it scrambles to unwind more than $60 billion of insurance contracts it sold to financial firms but can't fully pay off, according to people familiar with the matter. The contracts were intended to protect Wall Street firms from losses on mortgage securities and other debt they own.

The problem is that the insurer itself is teetering -- with repercussions across the financial world. Some of its trading partners, called counterparties, already are writing off billions of dollars because of its inability to pay.

This is the reason why some deals that looked like "free lunches" in February 2007 are not so free after all.

With many bond values falling and defaults rising, especially in the mortgage arena, some institutions involved in these trades are weakened. This has investors and regulators worried that, through such swaps, some market players could spread their own problems to the wider financial system.

"You are essentially counting on the reliability of strangers" to pay up on their contracts, notes Warren Buffett, the Omaha billionaire. In some cases, he says, market players can't determine whether their trading partners have the ability to pay in times of severe market stress.

What the article omits, though, goes even further. It doesn't mention that a very big part of these CDS contracts are written by synthetic CDOs that are by definition not prepared for major payments at all. If they were, they would not have been closed in the first place.

The current problems are all derived from the proliferation of belief in the efficient market hypothesis. This theory, which posits that market valuations carry meaningful information about the real world, is basically self-defeating.

A high proportion of credit market participants look at prices, believing that those prices actually represent expectations of future defaults, which they do, initially. Then those market participants start to make investment decisions based on the price level, resulting in even smaller risk premiums. These same investors now think that the reduction in risk premiums is a signal of lower risk, even though the price reduction was caused by their very own uninformed investment decisions.

This is just like Winnie the Pooh following his own tracks in the snow, round and round again, until a moment of truth arrives. The music stops, and some of the players are left without seats.

The Unsustainable Level of Public Debt in the US

A very sobre analysis of the problematic US debt situation was published in the Houston Chronicle this week. The column, titled "Wake-up call's for us all", was written by Loren Steffy.

On Monday, Moody's Investors Service, one of the credit-rating agencies that blessed those pungent loans that now beleaguer Citi and Merrill, warned that the U.S. could lose its triple-A credit rating within a decade.

That's a wake-up call for the rest of us.

We are addicted to spending. We buy based on want rather than need or ability. The bills are a worry for later, a someday that we postpone like a dentist appointment.

When the unsustainability of the US public debt becomes increasingly mainstream, it is going to be interesting to see the diversity of proposed solutions. It is a certainty that some of the proposals will contain fascist or other authoritarian ideas. It's going to be a hard time for champions of anti-authoritarian ideals.

Nostalgic for a Crack-Up Boom

An article titled "And the good news is ... hard to find" in the Observer by Ruth Sunderland discusses the developments in the financial markets.

It is hard to recapture the mood of this time last year. In January 2007, the City was still riding high, private equity was still on its buying spree, shoppers were still spending, house prices still soaring and Gordon Brown was still hailed as a paragon of economic competence. Northern Rock still seemed a decent bank; it delighted shareholders by kicking off the reporting season with a hike in its dividend, largely in anticipation of new rules that would allow it to hold less capital.

This paragraph is a perfect description of the sources of the problems at hand, which are caused by a runaway crack-up boom. Unsustainable credit expansion is initially caused by lax monetary policy, then further sustained by irresponsible dismantling of the financial safety buffers. Those buffers would have been provided by demanding reasonable levels of capital in depository institutions. Instead, the level of leverage in the system was allowed to grow like there's no end.

What leaves me wondering, is how Ms. Sunderland can write with such a longing tone for such a destructive trend. Did she really expect such financial self-destruction to go on forever? What is so wonderful about house prices soaring to levels that are out of the reach of first-time buyers?

It is indeed very hard to recapture an irrational and sentimental mood while being face-to-face with harsh reality. The humongous pile of bad debt that was created by this stretch of irrationality is now backing the savings deposits of the whole industrial world. The depositors are screwed, no matter which way the situation is defused. In the UK, it seems that the burden is going to be put on the taxpayers.