Lord William Rees-Mogg (Fleet Street Invest UK):
In the last six months there has been a rebound of 50% in the great majority of world stock markets.

There has also been a comparable rebound in the price of oil, with West Texas oil rising very close to $80 a barrel. In the oil market there has been heavy two-way trading in options. There could be a sharp spike in the oil price if speculators have to cover their positions.

At the same time the US dollar has remained weak, and now stands at $1.4886 to the euro and $1.66628 to the pound. This is close to a 14-month low on a trade-weighted basis. The poor performance of the dollar reflects the low US interest rates and the twin US fiscal and trade deficits.

The demise of the dollar

The dollar nevertheless remains the world’s leading reserve currency, with the euro in second place. Investors are naturally anxious to protect themselves against markets, including currency markets, which have shown such a high degree of volatility.

The Chinese, who have the greatest number of dollars in their currency reserves, have already suffered substantial losses.

In what amounts to a crisis of the dollar, the euro is in second place as a reserve currency, but there are potential threats to the future of the euro, due to the weak productivity of the Mediterranean economies. There is a big stretch in productivity growth between the German and the Southern European regions.

The fall in the dollar against other currencies includes a devaluation of the dollar in terms of gold, which now seems to have stabilized at a dollar price of $1,050 an ounce.

The circumstances do indeed appear to be uniquely favourable to gold.

Interest rates and therefore carrying costs are exceptionally low. The dollar is exceptionally weak. The technical market position is strong, including good demand for gold in terms of jewellery. The oil price – which is often linked to gold – is rising. Those who believe that oil is due for a further rise to $100 a barrel are likely also to be confident about holding a proportion of their investment . . .
Click here to read the rest of Lord Rees-Mogg’s article at Fleet Street Invest UK.

The reader’s letter comes from a Mr. D.P. Marchessini. I suspect that Mr. Marchessini is correct and the present credit crisis is the natural consequence of high leverage, the repeal of the Glass-Steagall Act and the creation of excessive and complex derivatives. The letter traces the sequences of events:

“In 1933, the United States passed the Glass-Steagall Act, which prohibited commercial banks from dealing in investments, and prohibited investment banks from doing commercial banking activities. This was a very sensible measure, and kept the banks in reasonable order until 1990.

“Unfortunately, in 1990, this Act was repealed — for reasons best known to the psychiatrists of the legislators. The result was that all the big Wall Street brokers became banks, as well as brokers, and the big banks started trading and speculating. This was combined with an enormous increase in “leverage” — borrowed money — by all the banks. Leverage is the ratio of a bank’s capital to its total assets.

“This used to be between five and seven times, pre-1990. But post-1990, it immediately started ballooning and, although the banks tried to keep it quiet, it was known that Merrill Lynch (NYSE:MER) was more than 40 times. Goldman Sachs (NYSE:GS) was 28 times, and Lehman Brothers (NYSE:LEH) was 30 times when it failed. Regardless what one thinks of such hair-raising tactics, the one thing that is clear is that they only work when the market is going up. Apart from their Balance Sheet, all the banks also had an enormous amount of ‘derivatives,’ which were kept off the Balance Sheet. Derivatives are an enormous cocktail of very exotic Options, on almost anything. In 1995, I was talking to someone at a dinner party, who was rich and supposedly very well connected in the financial world. I asked him what he thought the total amount of nominal value in derivatives were at that time. He said he thought perhaps $100 billion. In fact, at that time, they were $1 trillion. Today, they are $1.3 quadrillion — all off the Balance Sheet. They are also not included in any bankruptcy. Of course, this is the nominal value, and the actual amount at risk is much less. But five percent of $1.3 quadrillion is $65 trillion — still a tidy sum.”

I do not understand derivatives, certainly not at a level of $1.3 quadrillion. I am not even sure what a quadrillion is, though I assume it is 1,000 trillion. I do not feel ashamed of my inability to understand the global derivatives market, since the Sage of Omaha, Warren Buffett, himself has said that he does not understand them. What is clear is that they have been created in very large numbers. If Mr. Marchessini’s figures are correct, the gross value of derivatives is far in excess of the capacity of all the world’s governments to bail them out. Even a net value of $65 trillion is beyond the bailout potential of the major powers.

The Secretary for the Treasury, Hank Paulson, has asked Congress to authorise $700 billion as a bailout for those banks that have invested in sub-prime mortgages and other toxic assets. This is a sum one can reasonably understand. In London there are a large number of houses worth £1,000,000 or more. A thousand such houses are worth £1 billion. That is a solid reality. The $700 billion, which Secretary Paulson is asking for, is worth about £400 billion. It is therefore equivalent to about 400,000 good town houses in London.

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Plainly that would be a valuable estate, but it is conceivable. I can imagine the suburbs of London rolling out to Heathrow and the West. If one started at Canary Wharf and went on to Heathrow one could easily identify 400,000 houses worth £1 million each. If the U.S. Government chose to pledge itself for 400,000 such houses that seems reasonable. This may involve very large figures, but so does the Federal Budget.

It is the trillions that cease to be meaningful. I know several billionaires; I have certainly never met a trillionaire, let alone a quadrillionaire. If these derivatives hang over the whole banking system, then they should presumably be wound down and, over time paid off. They represent potential liabilities of the banking system, even if they are off the banks’ balance sheets. They cannot simply be consigned to a bad bank or simply be allowed to go into default. Even if Mr. Paulson gets his $700 billion, what will that do to settle the problems of quadrillions of derivatives?

Source: The Trouble with Trillions

In 1987, which is now more than twenty years ago, I published a book with James Dale Davidson. Some people still remember it for its title, Blood in the Streets, taken from a remark of Nathan Rothschild in 1815, at the time of Napoleon’s hundred-day gamble that ended in his defeat at Waterloo. “The time to buy,” said Rothschild, “is when blood is running in the streets.” The book arose out of our commentary in Strategic Investment.

The book attracted a good deal of attention at the time because it forecast the 1987 crash, which is still the largest fall in one day’s trading on Wall Street. I was in New York when the 1987 crash occurred. I remember an Australian broker observing that he had fought in a foxhole in Vietnam and that he found the 1987 crash more frightening.

Certainly we are experiencing a time of panic now, but there have been panics before. Some of them, like 1987, have had a benign outcome, with a recovery in the months following the panic. James Davidson and I did not forecast the post-1987 recovery; we expected a recession. The recession of the early 1990s duly came, but it was only a recession, not a crash. Even the ending of the dotcom bubble in 2000 did not produce a crash and certainly did not produce a depression.

The collapse of the U.S. housing and mortgage bubble has proved much more worrying and has already destroyed the independence of Bear Stearns, Merrill Lynch (NYSE:MER), A.I.G. (NYSE:AIG), Lehman Bros (NYSE:LEH), Fannie Mae (NYSE:FNM), Freddie Mac (NYSE:FRE), and, in London, Northern Rock and HBOS, with various levels of loss for the shareholders.

When we were writing Blood in the Streets, we did foresee the significance of the housing market. There is a section, in the book titled The Coming Real Estate Crash. Indeed we were able to identify in 1987 several of the weaknesses of the world’s political economy. It is not much help forecasting a crash twenty years ahead of its happening, but there are elements in the analysis we then made which turned out to be valid when the crash occurred. The 2008 crash comes as a natural consequence of long-term systemic failures.

Blood in the Streets was written fourteen years before 9/11. We did specifically refer to the threat to the twin towers in a subsequent book, The Sovereign Citizen. There is also a paragraph in Blood in the Streets in which I think we can take some legitimate pride:

“No V-day over terrorism. Disorder today is far more threatening because of the collapsing scale. As the margins of American power recede at the periphery, the raw power of these groups rises. So does their ability to disrupt arrangements they do not like. They cannot be stopped, as World War II was stopped, by forcing the surrender of a large-scale network of command. There is no single chain of command that has the authority to stop terrorism. Nor can anyone negotiate a compromise to meet demands of many of the small groups now wielding military force.”

We did foresee the significance of real estate and terrorism as factors that might undermine the stability of global finance. We also expressed concern about the reliability of the interbank market. “The danger of rapid deflation is more acute than it was in 1929. Why? Look no further than the geometric growth of the $700 billion interbank lending market. Each day U.S. banks are involved in interlocking transactions that total as much as $700 billion. This is the banking equivalent of having hundreds of trapeze artists swinging through the air — to what everyone hopes will be a safe landing. If even one bank failed to make good on its commitments, the whole criss-crossing show could come tumbling to the ground. This means that a liquidity crisis and a loss of confidence could contract credit almost instantly — on a far wider reach than in the past.” That is a fair description of what has been happening in the last thirteen months.

We correctly foresaw the bail-out of weakened banks, and the losses for their shareholders. “Remember that a bail-out of the banking system, which the authorities will surely attempt in the event of a debt collapse, does not necessarily mean a bail-out of bank holding companies or shareholders. Depending upon the political climate and administration at the time the music stops, there might even be a de facto nationalisation of major American banks — an outcome less far-fetched than it might seem. In a time of crisis, the government may be the only entity large enough to save the vulnerable banks.” Only the Federal Government was big enough to rescue A.I.G.

The U.S. real estate market, terrorism, debt, interbank lending and nationalisation of U.S. banks have all figured in the development of the present crisis. We did not get every issue right, but we did identify in 1987 the underlying insecurity of the global financial system. What we failed to foresee was the timing of the crisis. We saw its vulnerability, and pointed accurately to its weaknesses, but we did not see that so unstable a system could survive for twenty years of rapid economic and technological change. Will the Central Banks now be able to restore confidence after the events of last week? It will be some months, perhaps years, before we know the answer to that question.

Regards,
Lord William Rees-Mogg

Source: Forecasting the Crash

The United States is incomparably the stronger defense power; indeed the U.S. is now the only defense superpower in the world. As Britain found at the height of imperial power, it is not always easy to convert defense capacity into financial strength. Nevertheless, it was the sails of the British navy that maintained world peace in the nineteenth century and made the gold standard possible.

In 1797 the Napoleonic War led to the suspension of gold convertibility, which was not resumed until after the Battle of Waterloo in 1815. Gold convertibility was again suspended in 1914, on the outbreak of the First World War. Britain was able to maintain gold convertibility for the hundred years of relative peace, which allowed the industrial revolution to spread around the world. In the 1860s, the United States had to suspend gold convertibility, during and immediately after the Civil War. The euro is now protected by U.S. defense capacity.

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A more immediate concern is the growing divergence of European economies. Two big European economies, Italy and Spain, are perceived as more risky than the two core members of the Eurozone, Germany and France.

The traditional indicators of risk in debt markets, as reported in The Financial Times, are Credit Default Swaps (CDS) and 10-year bond yields. The 10-year bonds are particularly interesting as they are Eurobonds for which the different Euro countries are separately responsible. Currently the Italian 10-year bond yields about 60 basis points more than the German, which is the benchmark bond. Greek bonds also have high yields.

Financially, Europe can be divided into two zones. The Southern zone includes Italy, Spain, Greece and Portugal, of which only Portugal is not a Mediterranean country. Ireland is also financially overexposed, but Ireland is a small economy, and has separate problems over the Lisbon Treaty.

The Northern group of the Eurozone countries are the Franco-German alliance, which includes the adjoining three core countries of the original six nations of the Rome Treaty — Belgium, the Netherlands and Luxembourg. On present financial trends, there are three Europes, a Mediterranean Europe, led by Italy, a core Franco-German Europe and a peripheral Europe, in which Britain is the largest economy. The peripheral Europe includes Scandinavia, the Central European group and potentially, a Balkan group.

In American history, the original division was between North and South. That would now include the West as a separate economic zone. Europe is already divided in three ways. The risk is that North and South Europe will diverge in economic capacity. Can Italy or Spain maintain a fixed exchange relationship with Germany? The stronger the euro becomes, the greater the internal strains on the Eurozone are likely to become.

Source: You’re on Eurown

If you study economics from a mathematical view, the credit crisis must have come as something of a shock, says Lord Rees-Mogg.

But if you’re an economic historian, recent events won’t surprise you at all. Historical economists don’t see timing as any more predictable for economic shocks than for earthquakes. But they recognize a cycle of debt when they see on. And they know that the liquidation of debt has a deflationary effect…

There are two ways of studying economic theory. One approach is mathematical, and has been much enhanced by the computing power available to the individual economist. The other is historical and relies on the accumulated understanding of economic theory and practice.

The events of 2007 and 2008 have shown the limitations of the mathematical method. The credit crunch was not foreseen by anyone that I read, but it came as a shock to the number crunchers – it took them completely by surprise.

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It did not come as a shock to the economic historians, who happily settled down to discuss the resemblances between this credit crisis and earlier ones, going back to the South Sea Scheme in 1720 or the Wall Street Panic of 1907. The economic historians know that similar events had happened before, and had also learned, often by painful experience, that such events are quite common.

Neither group foresaw the actual events of August 2007, but the historians were quite able to put the credit crisis in a context of other crises. Even though both groups were taken by surprise, it was the mathematicians whose previous forecasts were stood on their heads.

By and large, historical economists, who follow the example of major English economists such as Maynard Keynes or W.S. Jevons, do not regard timing as any more predictable for economic shocks than for earthquakes.

One can say that there is a build up of stress in the system that will eventually have to be released. One cannot say that the release of pressure will occur next Tuesday or next August or even next century.

Some say the big earthquake will happen along the San Andreas Fault in California. It may come tomorrow; it may come before 2050; it may not happen for 500 years. We can usefully predict what and where, but we can very seldom predict when. This makes expectation difficult to quantify, though all markets are based on expectations

What we do know from economic history is that there is a cycle of debt that has to be relieved. In twentieth century history the war debts of the first war played their malign part in the European depression of the 1920s and eventually in the Great Depression of the 1930s. The Austrian School of Economics, and particularly Friedrich von Hayek, developed the Debt-Deflation theory of the business cycles. Hayek indeed foresaw the risk of a deflationary crisis as early as 1927.

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Keynesian economics, as expounded in his General Theory, 1936, were criticised at the time for an inadequate appreciation of the negative aspects of excessive debt. Bankers of the Gold Standard era attached great importance to the balance sheet rather than the profit and loss account. I get the impression nowadays that people read the current account much more carefully than they do the capital account — partly because they think that off balance sheet financing has reduced the transparency of the balance sheet itself.

As a result, government balance sheets, bank balance sheets, corporate balance sheets and personal balance sheets have all deteriorated. Finance ultimately depends on the security of capital, and weak balance sheets, at any level, are exposed to risk and to problems of opportunity cost.

An old-fashioned banker would now be calling for strengthening of balance sheets at every level. But the liquidation of debt takes years to accomplish and diverts fund from current consumption. The 2007 credit crunch calls for liquidation of debt, but that is bound to have a deflationary effect.

Source: Two Schools of Thought

As we reported earlier this morning, economists surveyed by Bloomberg estimate US growth will slow to 0.5 percent from October to December.

The US economy is not yet officially a recession. But most commentators are treating it as such, including Lord William Rees-Mogg, former editor of The Times and regular contributor to The Daily Reckoning UK. Lord Rees-Mogg says there won’t be a recovery until the first half of 2009…

The downturn in the global economy is now 11 months old, if one takes the subprime crisis of August 2007 as the starting point. It has spread like the forest fires in California, establishing itself in one area after another, putting out tongues of fire that extend the area of the fires, always a step ahead of the firefighters.

The housing and mortgage crisis is far from having burnt itself out. The oil price crisis also started in August 2007, when the oil price was only $70 per barrel, half what it now is. The price of other commodities, particularly foodstuffs, has moved with the price of oil. Equity markets behaved as though they were immune from the recession. That pretense lasted until last October.

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Since that time, the U.S. stock market has fallen by 20%. Only the art market seems to be exempt, with billionaires buying conceptual art at speculative prices. This may reflect the sheer weight of billionaire money, or it may follow the precedent of the art market being the lagging indicator among all asset classes.

Everyone would like to know how long — and, implicitly, how deep — the 2007 recession is going to be. There are always commentators who think that the end of recession is about six months away. In 2007, there were those who expected a recovery in the second half of 2008; that expectation has now shifted back into 2009, with the recovery starting in the second half of next year and persisting through 2010. Hardly anybody now expects even the first signs of a recovery to appear before the November presidential election in the United States, the fist big political date. If the American voters follow precedent, they will elect a Democrat as president; since the classic case of Herbert Hoover in 1932, economic depression has usually led to the incumbent party being turned out.

Source: Still Burning

House of Cards

Economic theory tries to deal with a limited number of factors and the mechanisms by which they interact. The main factors are population, food, energy, property, and manufactures, all of which are physical realities capable of being counted. They are the beans that bean counters count with. There are four mechanisms of exchange: money, barter, markets, and allocation. These are the mechanisms by which the beans are exchanged.

Different economists have put emphasis on different factors. David Ricardo, the classical economist of the 19th century, was a banker who gave special attention to money; Thomas Malthus, another founder of 19th-century theoretical economics, paid particular attention to population. Indeed, he is the founder of population studies.

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Karl Marx, the founder of socialist theory, paid attention to manufactures, and to population, seen particularly as labor. The leading 20th-century economists, such as Maynard Keynes, Irving Fisher and Milton Friedman, have been derivatives of the Ricardian or monetarist school, though Keynes was a rebel against classical Ricardian orthodoxy.

Unfortunately, it is impossible to think of all these factors simultaneously. Perhaps there will be a time in the future when some supercomputer will be able to calculate the interreaction of the global economy holistically. We are still far away from that day.

At present, the limitation of the human intelligence means that we can concentrate effectively on only one of these factors at a time. The selection of any one of these factors or interreactions for study draws attention away from other, equally important factors. One can be both a Ricardian or a Malthusian, but one cannot concentrate on both aspects of economic analysis simultaneously without a loss of focus.

However, one can simplify economics by using the different physical factors as a checklist to detect signs of difficulty. That does make economics the gloomy science. At present, the world is suffering from a crisis of overpopulation, with the human population stretching the food supply beyond its limits. Population is continuing to grow, although there is already an inadequate food supply for 6 billion people and famine is growing in Africa. It is possible that the 21st century will replace the 19th as the century of famine.

Food is very closely linked to energy. Food production is dependent on the oil industry, in cultivation, in transport, and in protection against pests. The food price has followed the oil price, to the point at which millions of people cannot afford a minimum food supply. That is already a catastrophe, and the trends are unfavorable. There is also a significant shortage of water.

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Markets have flagged food and energy as danger areas for the world economy, by raising their prices. Property and manufactures are secondary to food and energy, in that their prices can change without immediately affecting the price of food and energy. In fact, there has been a worldwide fall in housing prices, particularly notable in Britain and the United States, at a time of steep increases in food and oil prices. The price of manufactures has been held down by the growth of low-cost Asian manufactures.

There is much discussion of the scale of the global economic crisis. Some people expect it to cause a crisis comparable to the Great Depression, a wiping out of capital values, a liquidation of global debt. We cannot yet be sure, but we can see that the main factors of global economic development are all in difficulty. On the one hand, there is oil at $130 per barrel — on the other, there are banks writing off billions of dollars of assets.

I do not see any basis for economic analysis that would not throw up really alarming signals. These adjustments of the fundamental factors in any analysis put huge pressures on every government. In the 1930s, most governments were destroyed by the slump. In Britain, Labor lost office in 1931; in Germany, Hitler came to power in 1933, as did Franklin Roosevelt in the U.S. I fear that process will be repeated, even if only by democratic defeats. The storm of the world is still rising.

Regards,
Lord William Rees-Mogg

Source: Economic Alarms

I certainly can claim to be one of the early birds in detecting the strength of the movement towards Barack Obama. I am not sure that those early forecasts are of any importance except to the columnist himself, but they do reassure the writer that he, or she, is in touch with some sort of political reality.

On January 28th I wrote a column for the London Times, which started with the question: “Has Barack Obama developed the “Big Mo”, vital momentum that would take him through to the Democratic nomination, very possibly to the Presidency.” I answered my opening question in the last paragraph “Youth, idealism, style are powerful political weapons. On February 5th, we shall see whether they have captivated America. If they do, we shall find that they have captivated Britain as well. Barack Obama could have a message for us all.”

After Super-Tuesday, I went a stage farther. My opening sentence surprised many of my London friends and readers. I wrote that “it is hard to see who can stop Barack Obama becoming the next President of the United States…. Barack Obama has the future of America ahead of him.”

At any rate he has been fully tested by Hillary Clinton’s campaign. That had its own faults, and Bill’s interventions were usually disastrous, but we all came away with a new respect for Hillary’s resilience and endurance, even if many of us felt a great relief that she had lost. Now it is Obama versus McCain. Do I still feel that Obama is almost unstoppable, even though Hillary undoubtedly came closer to stopping him than I had expected?

There are of course inherent risks in being the first black candidate from a major party to be nominated for the Presidency. In 1968, the Vietnam primaries, Bobbie Kennedy, also a candidate of idealism, was assassinated. Separately from the primary struggle, so was Martin Luther King. Barack Obama is both black and idealist, a double challenge to the worst kind of American bigot. Everyone is aware of the risk, and nobody wants to talk about it.

There are other events which could change the ordinary pattern of political events, what the strategic study groups call “low probability, high impact events”. The classic low probability, high impact event was of course 9/11 itself. A crisis in the Middle East, or a terrorist attack on the U.S. itself could change the whole character of the Presidential debate.

However, these are not predictable events, they are merely conceivable possibilities. Outside those possibilities Senator Obama seems to me to be a very strong favourite to win the Presidency in November.

In the first place, he is the candidate of youth, idealism and change. Americans are tired of the Republican Presidency after two terms of George W. Bush. They are tired of the dynastic Presidency which proved a serious handicap to Senator Clinton. If she had won the Presidency that would have been the sixth successive term of the Bush or Clinton dynasties.

Senator McCain has much more experience of defence, and would be an impressive Commander-in-Chief, but he is already in his seventies – he is not a symbol of domestic renewal, because of his age. If the campaign concentrates on the recent Republican record, McCain will be hurt by that; if it concentrates on domestic issues, McCain is less attractive than Obama to the young and radical.

I still see Senator Obama as the candidate of change and vision. That was the appeal of John F. Kennedy. If America is tired of Washington cynicism, Obama is the Kennedy of the present generation.

William Rees-Mogg
The Daily Reckoning Australia

P.S. to get The Daily Reckoning direct to your inbox sign up to our free e-mail newsletter or if you prefer to use RSS, subscribe to the Daily Reckoning RSS feed.

Source: Barack Obama is a Strong Favourite to Win the Presidency

The American electoral system has never been designed to protect sound finance, and it has become more dangerous as the federal government and the Federal Reserve itself have become more skillful at manipulating the economy of the United States. The process of running before every gust of wind reached its limits under Alan Greenspan, who always chose to inflate, rather than deflate, a bubble. His successor, Ben Bernanke, is more cautious, but has made no attempt to reverse the Greenspan policy.

There has not been a chairman of the Federal Reserve Board with sound monetary instincts since Paul Volcker resigned in 1987. It was Volcker who brought the dollar back from the brink of hyperinflation in 1987.

On May 14, Volcker testified before Congress. Scattered around the monetary world, and particularly influential in Europe, there is a group of central bankers who admire Volcker, as I do myself, and share his analysis of the present situation. The Volcker analysis is very similar to that of the European Central Bank, and to that of Mervyn King, the governor of the Bank of England.

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Volcker testified that the Fed ought now tackle the threat of inflation more forcefully. He is particularly concerned about the danger of a return to the conditions of “stagflation” of the 1970s. The Bank of England also expects that the next two years will see the pressure of rising inflation combined with low rates of growth. In the 1970s, this unpleasant combination of economic trends resulted from the loose monetary conditions of the early 1970s and the oil shocks of the mid-1970s.

Those who experienced the 1970s were taught a painful lesson about the negative effects of inflation. In standard monetary theory, some emphasis is given to the initial phases of inflation, in which an increasing money supply funds economic expansion and tends to cause booms, bubbles, and speculation.

Less attention is usually given to the second stage of inflation, in which prices rise; interest rates are increased; and economic growth rates, after an acceleration, begin to slow down. There is an illusion that inflation is good for growth; that is true of the first stage, but only of the first stage. Staglation, in which rising prices are accompanied by reduced growth, comes as a second stage.

Volcker warned Congress that he saw a “resemblance” between present monetary conditions today and those of the early 1970s, when the economy had an overall tendency toward rising prices, including big increases in energy and agricultural prices. He observed, “If we lose confidence in the ability and the willingness of the Federal Reserve to deal with inflationary presses and to sustain confidence in the dollar, we’ll be in real trouble.”

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Tight Supplies Push Oil Prices Higher

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On the same day, the Bank of England published its latest quarterly forecasts and came to much the same conclusions. The bank’s inflation projections will not return to the 2% target figure until early 2010, which suggest that it will have no room for rate cuts until then.

Britain and the United States have different political cycles. The next presidential election in the United States will come nearly two years earlier than the next British general election; the latest date for a British general election will be June 2010. The Bank of England’s economic forecast suggests that there is little chance of interest rate cuts much before that time. The government’s reluctant tax cut on the lowest income tax band will strengthen the bank’s hand in keeping interest rates at their present level.

Mervyn King observed that “The consequences of price increases would be a squeeze on real take-home pay that will slow consumer spending and output growth, perhaps sharply.”

There exists what might be termed the Volcker consensus that inflation has returned as the real threat to world economic conditions. This consensus includes Paul Volcker himself, the Bank of England, and the European Central Bank. It does not include Ben Bernanke, the Fed, or the current president of the United States. After November, we may find out whether it includes the next president of the U.S.

Regards,
Lord William Rees-Mogg

“Whiskey & Gunpowder”

Greg’s Endnote: Stagflation: Yep, that’s one of them. One of the five supershocks that are threatening the very existence of our stock markets. These shocks are looking less and less like mere theories. They’re coming soon, and the markets as we know them may not be safe. Have you started making your plan for survival? Click here to become prepared…

Source: The Danger of Stagflation

It appears that inflationary concerns are being put on the back burner as the Fed scrambles to fix what it believes to be more pressing economic concerns. But what is this going to do to fix rising costs in energy and other sectors?
More Cuts, More Concerns

Markets exaggerate in both directions. They create bubbles of overvaluation when expectations are high; they create troughs of undervaluation when expectations are low. At the present time, there is a struggle between optimism and pessimism, in which London is a good deal more optimistic than New York or Washington.

The Bank of England has published the latest issue of its twice-yearly Financial Stability Report. The Financial Times leads on the story under the optimistic heading “Bank of England Signals Worst Is Over.” The report’s argument was summarized by John Gieve, the deputy governor of the bank: “While there remain downside risks, the most likely path ahead is that confidence and risk appetite will return gradually in the coming months.” The bank’s optimism extends even to the U.S. housing market.

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Even with a further decline in U.S. house prices, the bank does not expect any default in AAA-rated subprime mortgage-backed securities. That means that those securities are significantly undervalued and that some of the writing down has been much greater than necessary.

This optimistic review was published on the day that the Federal Reserve cut interest rates by a further quarter percentage point, to 2%. This was only slightly mitigated by the Fed’s hint that there might be a pause in rate cuts at the next meeting, in June.

There is now a very wide gap between the interest rate philosophy of European central banks, including the Bank of England, and the U.S. Federal Reserve. The Europeans have shown little willingness to counter the credit crunch by large and repeated interest rate cuts. The Fed has continued to follow the much-criticized Alan Greenspan policy of cutting rates early and often.

The pessimistic American view is supported by most New York opinion. Jim O’Neill, the chief economist of Goldman Sachs, says that Britain is “in the eye of the storm of a deleveraging world economy… The U.K. mortgage market is effectively frozen. House prices are going to go through negative changes. It’s going to be a challenge for U.K. policymakers.” This American view has even penetrated to the Bank of England’s Monetary Policy Committee, where an American member of the committee, David Blanchflower, has said that a 30% fall in house prices by 2010 is not implausible. Such a fall would be comparable to the fall in house prices in the United States.

My own view is that the Bank of England is probably premature in spotting a turn in the market. For some time yet, banks will be rewriting their capital bases. They will be concerned to reassure themselves and their customers about their own financial situation and will, therefore, remain risk averse and reluctant to lend. The banks have had a very nasty fright, in which it was impossible to value major investments and difficult to be sure of the true solvency position of major banks. That was a global phenomenon.

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It may be true that the worst of the immediate panic has passed, but the mood of caution, even of exaggerated caution, has not. There are also, in the U.K., problems with the falling valuation of commercial property that are as worrying as the concerns about U.K. residential policy. The Bank of England wants to help restore confidence, but it will take time for banks to return to their more relaxed attitude to the lending risk. Indeed, the Bank of England would not want them to go back to the mood of 2006, when lending standards were too low.

However, the European view is not merely one of optimism about the future trend of asset values, but one of greater pessimism about inflation. Record prices for property may have peaked; some commodities, including gold, have reacted, as well. But energy and food prices are at record levels and have not yet turned down.

European bankers remain relatively anxious about the threat of a return to inflation. That is why European Central Bankers are reluctant to follow the Fed in cutting interest rates. The Bank of England is also worried about the rising budget deficit of the British government. High interest rates tend to offset the inflationary effect of the deficit, which itself seems to be rising by the day.

I find it easy to see the pessimistic case. I expect the U.K. housing and commercial property markets to continue to fall. In London, they are very closely linked. I expect the U.K. budget deficit to continue to rise. I expect Bank of England interest rate policy to remain cautious, as will that of the European Central Bank. I expect these financial conditions to continue in 2009, and probably 2010, as well. There is not all that much encouragement for optimism.

Regards,
Lord William Rees-Mogg

Greg’s Endnote: For the time being, the dollar appears to be rebounding. But that’s not necessarily the case. If European central banks raise interest rates, you can expect the dollar to slide yet again. This means that oil and energy prices will go right back up, and will most likely push even farther. Click here to read about why oil prices are destined to stay on the rise…

Greg’s Final Endnote: If you’d like to hear more from our resident commodities expert and Resource Trader Alert editor, Kevin Kerr, on why he thinks the commodity bull market is far from over, you can see his full interview from MarketWatch.com which aired this morning by clicking here.