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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Saudi Arabia Drops a Bomb Shell

With friends like Saudi Arabia, who needs enemies. We’ve long been told by our Middle Eastern “allies” that there is plenty of oil out there for all of us. But now, new supply news is going to disappoint our president and shock out markets.

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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

Economic climate change…

Relentless rises in commodity price emissions is increasing the inflation content of the world’s economic atmosphere threatening the universal life force of the world economy – ie growth.

Economic climatologists aka central bankers are beavering away trying to contain the inflation content while scratching their heads about how to tackle spiralling commodity prices.

Or as Mervyn King would have it at a press conference this morning, a sequence of cost shocks is coming from abroad. No prizes for guessing what – oil, food, energy yada yada. OPEC’s not pumping enough, Indians eating too much (see below) etc. This is the increasingly heavy monkey on the back of a Bank looking to loosen monetary policy – mainly by cutting interest rates.

Dear readers looking for good news stop reading now and return in what Mr King calls the medium term, say 2010ish. By that time the economy may be growing at trend again, inflation may be back around 2%, a deflated sterling will have helped iron out the current account deficit and boost tourism and this increasingly wounded government finally will have been put out of its misery by the electorate. Recapitalised banks will be expanding their lending as they report bumper profits from the higher margin business they have been doing for the past couple of years…

Consumers will have rediscovered the wonderful bargains at charity shops and the benefits of making do. They have bought a cash ISA or two. First time buyers have returned to a more affordable housing market to snap up the bargain repos and negative equity distressed sellers. There’s a dearth of estate agents to help them out, though.

Meantime, back in the present, fasten your seatbelts say the Bank of England Inflation Report: “The near term outlook for inflation has deteriorated markedly over the past three months,” it begins. Rising prices will squeeze consumer spending and so cut growth “perhaps sharply”. Commercial property prices have fallen 16% since last summer and house prices are now falling too. Though Mr King agrees with your editor on one point on the housing market…

The ‘90s house price crash was precipitated by a doubling of interest rates he said (as a consequence of the ERM straightjacket) and a big increase in unemployment. Neither of which are present today. At least not yet. The Evening Standard reports the City is clocking up job losses at the rate of 300 a week. But are these the kind of types to linger on the rock and roll (dole) for months on end? Odds against methinks. New opportunities no doubt beckon in Dubai, Singapore and all points East. Time to follow the money.

The net net for the UK economy is the climate’s changed and we’re all affected. Or in Bank speak, the economy is “rebalancing”. It’s a process that’s going to take some time and could yet be torpedoed by Johnny Foreigner and those unwelcome “shocks from abroad”.

*** Americans should go on a diet…

They should rethink their energy policy too.

That’s the angry response from India at perceived slights from the Bush administration. Official comments appeared to lay the blame for rising food prices on India reports the International Herald Tribune.

Americans on average consume 50% more calories than Indians says Pradeep Mehta, the secretary general for the Centre for International Trade, Economics and the Environment. And if they would slim down to the weight of the average middle class Indian “many people in sub-Saharan Africa would find food on their plates.” He added money saved from the fall in liposuctions could be channelled into famine relief. Lardy Brits could no doubt chip in a bob or two on that score as well.

As to the comments, we can’t be sure but there appears to have been something lost in translation here. According to reports Bush commented in a press conference that “ when you start getting wealth, you start demanding better nutrition and better food, and so demand is high, and that causes the price to go up.” In our book that is no more than stating how it is. Basic economics.

Aggregate demand goes up; price follows it to a new place where supply can once again eyeball demand. If there was criticism in Bush’s words, it was of a subtle and coded nature which belies his plain speaking Texan reputation.

Perhaps the Indians are being a little sensitive…certainly more assertive. 300m middle class Indians is an awesome prospect. It’s the equivalent of the entire US population driving SUVs… demanding air conditioning, flat screen TVs and more calories. Their economic progress, amongst others, will prove an increasing shock to ours.

Regards,

Rob Mackrill
The Daily Reckoning

Source: Cost Shocks From Abroad 

A little less than 12 months ago, the world’s biggest financial players suddenly found they could not turn some $1.3 trillion of their assets into cash.

These assets — bonds backed by U.S. homebuyers with low (or no) incomes — had become utterly illiquid. No one would buy or lend against them, not at any price. And an asset you can’t sell or borrow against is worth precisely nothing.

The resulting mayhem? It would have sounded frivolous two years ago. But the subprime crisis caused the first run on a British bank run in 130 years, a forced collapse in U.S. interest rates, and the fire sale of Wall Street’s fifth largest investment bank for just 16cents on the dollar.

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“[Now] it seems that the financial system is slowly working its way through this subprime shock,” writes Gillian Tett in the Financial Times. “The largest banks and institutions have written off almost $200 billion and raised more than $100bn-odd of capital to plug this gap.

“Indeed, the write-downs have been so vast that some analysts expect to see some write ups in the next set of results.”

Crisis over? That key marker of investor anxiety, the gold price, fell 15 percent from its top of mid-March to the end of April. The preceding surge had taken gold bullion up from $650 per ounce in August to above $1,030 the day after Bear Stearns was sold to J.P. Morgan.

The proximate cause for gold’s jump — and then setback — was the Federal Reserve’s decision to slash U.S. interest rates. Gold turned sharply higher as the Fed began cutting rates in Aug. ‘07. It only flagged when Fed policy-makers implied a pause in their war against the Dollar (albeit it temporary) seven months later.

That’s why a significant portion of new gold investment since last summer has gone into physical metal — owned outright — rather than simply into paper promises or credit arrangements.

What makes physical bullion stand out for the growing number of private investors choosing outright ownership instead? Gold futures or options would, after all, give them leverage to the gold price, super-charging their gains if they call the short-term direction correctly.

Repeated studies also prove gold’s safe-haven appeal on the basis of its “non-correlation” with securitized assets, such as equities and bonds. Gold prices move independently of the broader financial markets — neither together, nor in opposition. This lack of correlation makes gold a crucial component of any diversified portfolio.

Owning the metal outright — whether as gold coins in your pocket or large bars held securely in market-approved storage — takes you “off risk” with regards to the solvency of banks and brokerages. And it leaves you holding a highly liquid physical asset that’s instantly valued just by checking the gold spot price online.

“While the subprime shock may be ebbing,” continues Gillian Tett in the Financial Times, “the problem is that…as the U.S. economy slows, there is a good chance defaults will soon emanate from the corporate and consumer debt world.

“And the more that banks are forced to tighten credit as a result of the subprime mess or other losses, the greater the risk that this second wave of defaults will emerge — creating the risk of a vicious spiral.”

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The Worst Is Not Over

You may see the markets tick upward as the occasional good news about oil or the dollar gets reported. But according to Fed Chairman Ben Bernanke, the markets are “far from normal.”

In reality, the markets aren’t just abnormal, they’re much worse. If you think the crisis is over, you’d better think again. Click here to see what problems are still out there…

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The current lull in the gold price says fewer investors are worried today. But only this week, Moody’s Investors Service — one of the three credit-ratings agencies now blamed for letting investment banks issue toxic subprime bonds as “triple-A” bonds — warned of a sharp rise in U.S. corporate-bond failures. It sees the default rate on low-rated junk bonds quadrupling to four percent by the end of this year.

Wherever the subprime shock has hit hardest, municipal debt also looks weak. Council members in Vallejo, California voted on Tuesday to file for bankruptcy, thanks in no small part to “house prices in Vallejo and the surrounding area falling some 26 percent on a year ago,” reports The Independent here in London. “The city is expecting $1.6 million less in property sales taxes.”

And all this while — 12 months on from the first trouble at UBS and Bear Stearns — the final cost of the subprime shock itself is still pending. Chairman of the Federal Reserve, Ben Bernanke originally put a $100 billion forecast. The International Monetary Fund (IMF) has since set the ceiling at $945bn.

But there are hidden costs too, as Bloomberg reports this week. Now State Street, the world’s biggest institutional fund manager, faces more than $625 million in lawsuit damages, for instance, after being sued by four insurance companies for putting their cash into subprime bonds without their approval.

Let’s imagine all of your wealth is sitting safely outside the next subprime-style blow up. A loss of confidence in one sector can still become a system-wide crisis. And the failure of subprime bonds to pay up should have reminded us all that counterparty risk remains very real, no matter how clever derivatives salesmen become.

I wrote this week that I had a hunch the Bank of England might keep rates on hold. It wasn’t a nailed-on prediction, merely a sneaking suspicion. Nonetheless, I said it, and I was wrong. The Monetary Policy Committee (MPC) today voted to cut the base rate by a quarter-point, to 5%.

There are a lot of questions arising from this decision. Is it enough? Will it do any good anyway? Are private lenders simply ignoring the central bank and tightening credit anyway? We’ll be looking at these questions in the days and weeks ahead.

Today, though, it’s the pound that’s concerning me most. We’ve grown accustomed to hearing stories of how much Britons can now buy in America, but this is a consequence of the weak dollar, not of a strong pound.

Sterling hit an all-time low against the euro yesterday, at €1.25. And there’s no reason to think the fall will stop there. While the MPC cut rates, the European Central Bank (ECB) left theirs on hold. There is widespread anticipation that the MPC will have to lower rates again this year. The ECB, however, is expected to take a more hawkish line. This suggests the pound will fall further against the euro.

Sterling’s decline is a serious matter — and not just for those planning holidays on the continent. One of the big challenges facing Britain’s economy is that, despite weakening domestic demand as we flirt with recession, there’s still a lot of inflation to contend with.

The big inflationary worries concern what’s called “cost-push” inflation. The prices of food, energy and raw materials are on the rise, pushing up our cost of living. These prices are set globally, so British policy-makers can’t do much to change them. How much we in Britain pay for such vital commodities depends on how strong our currency is.

The further the pound falls, the more skint we’re all going to feel.

Private equity’s on the come back trail… has the credit crisis bottomed?

Time to play the Rocky theme tune — private equity is back! Apollo, a distressed debt specialist, and Permira, a British buyout group, are snapping up the debt of UK bingo merchants Gala Coral.

Meanwhile, CVC and Blackstone, those stalwarts of leveraged deals, are teaming up to grab 29.9% of Mitchells and Butlers, the troubled British pub group.

After months of acquisitions being scuppered by frozen credit lines, the market is beginning to thaw. But Bill Bonner, who’s currently holed up in Argentina, sounds a note of caution for anyone tempted to think it’ll be plain sailing from now on.

Take stock markets. Bill points out that the S&P 500, for example, is still selling for more than 18 times earnings.

“There’s still plenty of room on the downside,” he warns. “The bubble in finance is over. It’ll probably take many years before value appears and prices begin to rise — just look at what happened in the Nasdaq. Or Japan! Many people thought Japanese stocks were a once-in-a-lifetime bargain after the Nikkei Dow crashed in 1990. Well, they’re an even bigger bargain today!”

Oil hits record high

Former gymnast Garry White is doing cartwheels today (at least, he is in his head). These days Garry, our commodities man, is far more likely to be found at a Bloomberg terminal than on the asymmetric bars. But the fact remains, today, Garry is a happy man.

“Oil’s hit $112.21,” he announced cheerily this morning. Stockpiles of both refined oil (gasoline) and crude oil have fallen… and it’s another shot in the arm for Garry’s oil plays.

Garry has more on this in today’s piece, together with the rest of the commodities news… including why one major authority thinks the gold price is about to soar.

Iran props up the dollar

An interesting story from emerging markets specialist Manraaj Singh today.

“Iran’s clerical regime is helping prop up the dollar,” he told me this morning. I gave him a puzzled look.

“I’m serious,” he said. “The Gulf states are desperate to break their peg from the dollar. It’s causing record inflation — but so far only Kuwait has dared to do it. That’s because the other states need America to protect them from Iran, and they don’t want to annoy them by breaking the peg.”

So, unable to ditch the failing greenback, what are the Gulf states doing to protect their wealth? Manraaj tells me they’re diversifying like crazy, and it’s creating great investment opportunities.

Find out which two investments Manraaj thinks will be the big winners as the Middle East spreads its petrodollars worldwide… and why he thinks the region is less than two years away from launching its own single currency.

Goldman finally buckles

More reason to fear the credit crunch will rumble on came from Goldman Sachs yesterday. I’ll let my esteemed colleague Theo Casey talk you through it:

“Yesterday Goldman was the first US bank to show its hand. The results were worse than expected.

“The world’s most profitable investment firm reported that its hard-to-value securities, so called Level 3 assets, jumped 40% to $96.4bn.

“There are three asset types to know when divvying up investment bank balance sheets:

• Level 1 assets are valued by available market prices in active markets. These include stocks, futures and options.
• Level 2 assets are priced using “observable inputs,” which means recent similar transactions. Loans, mortgages and over-the-counter stocks fall into this category.
• Then there’s Level 3. These assets are measured using “unobservable inputs,” and it’s as bad as it sounds. It means that even though the firms can’t actually see the value of their assets, they’re allowed to put them down as earnings based on their own “subjective assumptions.” In other words, they guess.

“When you hear the BBC News refer to “subprime-related” losses, what they mean is Level 3 assets that couldn’t be shifted. The world’s most profitable investment bank, we found out yesterday, has rather a lot of them.

“So it just got 40% harder to value Goldman Sachs. That’s because it involves guessing what the bank will fetch for its Level 3 assets, which has proven to be a market that no one wants to be in.

“With uncertainty in the market to the tune of $96bn — and that’s just one bank — it looks like suggestions that we’re over the credit crunch may be more to do with making headlines than making money.”

As Theo wisely notes, we need to look beyond the headlines. There’s plenty of bad news out there waiting to hit the markets.

Until tomorrow

Ben Traynor