A Week Late, but worth watching

The Supreme Court Decides to Stay Crystler Deal

Gross Is A Pessimist

Bill Gross's Monthly outlook for June was pretty interesting. It seems to be prediction:

1. higher taxes
2. a decrease in the US standard of living
3. higher yields on everything because no one will buy our treasuries or, hyperinflation because the buyer of last resort will be the FED, via quantitative easing
4. less rich people overall because of its harder to be rich and also a lot of rich people are no longer rich
   

From PIMCO

I remember as a child my parents telling me, perhaps resentfully, that only a doctor, airline pilot, or a car dealer could afford to join a country club. My how things have changed. Now, as I write this overlooking the 16th hole on the Vintage Club near Palm Springs, the only golfers who shank seven irons into the lake are real estate developers, investment bankers, or heads of investment management companies. The rich are different, not only in the manner intoned by F. Scott Fitzgerald, but also in who they are and what they do for a living. Whether some or all of them are filthy is a judgment for society and history to make. Of one thing you can be sure however: over the next several decades, the ability to make a fortune by using other people’s money will be a lot harder. Deleveraging, reregulation, increased taxation, and compensation limits will allow only the most skillful – or the shadiest – into the Balzac or Forbes 400.

Readers who are interested in such things as the Forbes annual list of hoity-toities will have noticed that more and more of them are global, not U.S. citizens. The U.S., in other words, is not producing as much wealth in proportion to the rest of the world. Its fortune-producing capabilities seem to be declining, which might suggest that its relative standard of living is doing so as well. If so, the implications are serious, not just for Donald Trump but for wage earners and ordinary citizens, as reflected in their income levels and unemployment rates. Stockholders, 401(k) investors, and yes, bond managers will be affected too. Last week’s furor over the possibility of an eventual downgrade of America’s AAA rating demonstrates that only too clearly. On the night of May 20, Standard & Poor’s announced a downgrade watch for the United Kingdom and since the U.S. and U.K. are Siamese-connected, financially-levered twins, the implications were obvious: the U.S. might be next. In the space of 48 hours, the dollar declined 2%, and U.S. stocks and long-term bonds were down by similar amounts. Such a trifecta rarely occurs but in retrospect it all made sense: a downgrade would cast a negative light on the world’s reserve currency, and since stocks and bonds are only present values of a forward stream of dollar-denominated receipts, they went down as well.

Ok, so he is probably right, our standard of living is going to have to decrease, and it should. If you look at any chart with years on the x-axis and private debt (aka the US consumer) on the y-axis, you will see why. People in the US have finally enter the new reality: if you make 30K a year you can't own a flat-screen tv, a humer, a 2-car garage, have 4 kids, and go on two vacations a year. Ok, maybe I am exaggerating, but there are [were] a lot of people in the US that thought like this two years ago. I think we can all agree now the rise in the standard of living we have seen since 1982 till 1999 when the dot-com boom crashed was attributed to spending money we didn't have. Now all of these people can get a nice wiff of reality that their house is foreclosed on, their credit lines are cut off, (oh wait, Obama is making sure these evil credit card companies do not punish people who spent too much... thank god!) and oh no, gas prices are up 20% in the past few weeks and they can't drive 2 hours to work everyday in their GM SUV and still have money left over. I feel bad for these people (not really), but the US needs to change.

I see a lot of articles about the coming metamorphsis of the US. There was a good one in the economist this week actually, title "Trading Down":

Americans are trading down. If they still have jobs (as 91% of the workforce do), they are worried about losing them. Their homes are no longer cash machines and their investments are in a ditch. Household net worth fell by a staggering $11.2 trillion last year. The rich are cancelling orders for yachts. Working Americans are forgoing even small luxuries. Lindt & Sprüngli, a maker of exquisite chocolate truffles, is closing 50 of its 80 stores in America. Hershey’s, a maker of less chocolatey chocolate, is doing rather well. Limited Brands, which owns Victoria’s Secret, is not.

Americans are rediscovering thrift. Retail sales fell by 11% from their peak in late 2007 to April 2009. Personal consumption has fallen 2.5% since last summer. The Boston Consulting Group (BCG), a consultancy, finds that nearly three-quarters of Americans plan to curb their spending over the next year.

Trading down is not difficult. Instead of, say, blowing $4.50 on a Strawberries and Crème Venti Frappuccino from Starbucks, Americans are popping into Dunkin’ Donuts for a basic cuppa Joe at a buck or so. Instead of shopping at Neiman Marcus (a posh department store known colloquially as “Needless Mark-up”), they are driving to the out-of-town Wal-Mart superstore or shopping online for bargains at Amazon (see chart 2). A recent Pew poll found that 21% of Americans planned to grow their own vegetables, 16% had held a garage sale or sold things online and 10% had either taken in a friend or relative or moved in with one. Pundits are coining phrases such as “austerity chic” and “luxury shame”.

Four-fifths of Americans told the BCG they would defer big purchases that can wait. The most obvious example is a car. After a home, this is the most expensive object a typical family buys. New cars are nice, but old ones can last a long time, as any third-world taxi-driver knows. So Americans are keeping their old wheels on the road. Repair shops are bustling. Desperate dealers are offering interest-free finance. Hyundai, a maker of unflashy cars, has lifted its share of the American market by saying: buy a car from us, and if you lose your job we’ll buy it back.

If there is one really great thing about this US, we are very dynamic. It is one of the reason our economy is [was] was great, and its one of the reason why important economist are predicting we will be one of the first countries to leave recession (that and we were one of the first to enter it).

Sorry about the rant ... Back to Bill Gross

The current annual deficit of $1.5 trillion does not even address the “pig in the python,” baby boomer, demographic squeeze on resources that looms straight ahead. Private think tanks such as The Blackstone Group and even studies by government agencies, such as the Congressional Budget Office, promise that Federal spending for Social Security, Medicare, and Medicaid will collectively increase by 6% of GDP over the next 20 years, leading to even larger deficits unless taxes are increased proportionately. Collectively these three programs represent an approximate $40 trillion liability that will have to be paid. If not, you can add that present value figure to the current $10 trillion deficit and reach a 300% of GDP figure – a number that resembles Latin American economies such as Argentina and Brazil over the past century.

The obvious solution to both dollar weakness and higher yields is to move quickly towards a more balanced budget once a sustained recovery is assured, but don’t count on the former or the latter. It is probable that trillion-dollar deficits are here to stay because any recovery is likely to reflect “new normal” GDP growth rates of 1%-2% not 3%+ as we used to have. Staying rich in this future world will require strategies that reflect this altered vision of global economic growth and delevered financial markets. Bond investors should therefore confine maturities to the front end of yield curves where continuing low yields and downside price protection is more probable. Holders of dollars should diversify their own baskets before central banks and sovereign wealth funds ultimately do the same. All investors should expect considerably lower rates of return than what they grew accustomed to only a few years ago. Staying rich in the “new normal” may not require investors to resemble Balzac as much as Will Rogers, who opined in the early 30s that he wasn’t as much concerned about the return on his money as the return of his money.

Ten years from now I would image if I have the time to re-read this article (and hopefully I will not even have the time at that point) that roughly half of this will turn out to be true. Yes, the US standard of living will go down. Yes, the interest rates are going to go up. I have serious doubts of entertaining hyperinflation at this point because:

A) If the US is going to have to print its way out of this problem, it seems as though they are going to have to do it under Obama's first term. Obama is not the God everyone thinks he is, he is just a normal man trying to be re-elected, and I know one thing is for sure, hyperinflation is not going to be good for the campaign trail.

B) Everyone talks about the FED's quantitative easing and the hyperinflation its going to cause the road so matter-of-factly, but the real fact of the matter is no one knows what the hell is going on. Yes, the FED is creating money, to the tune of $300-$400 billion out of thin air, and using this money to buy assets right now. Inflation expectations remain "tied down", and with the deflationary spiral out there right now (watch out for the crash of CMBS coming up in the coming months), I can't see "it" being raised anytime soon (besides increases due to relatively small fluctuations in fuel costs). If inflation does start to take off, then there are new ways (which have not been used in the past) in which the FED can control inflation (besides conventional monetary policy and raising interest rates) like:

a) paying higher interest on bank reserves
b) Congress could give the FED power to issue its own debt (aka f-bills)

Those are just two of the options I thought sounded pretty good when I read about them a few months ago. There are certainly other ideas. Regardless, the point is, I doubt we will see hyperinflation.

Weaker dollar: no shit Bill, we are issuing 1.5 trillion t-bills this year, its the law of supply and demand.

My bet is that the green revolution will play out to be another dot-com boom-and-bust scenario. I am sure when (its more a question of if, not when) it does take place, a majority of the start-ups will be in the US (assuming Obama's protectionist I-hate-rich people-but-now-I-am-one bullshit doesn't pan out), and just like in the dotcom boom, we will pay off a bunch of this deficit with the capital gains tax receipts.

That is it for now. Time will tell who is right. Hopefully its neither Obama or Gross!

Chinese Students Laugh At Geithner's Comments

Why do the Chinese save so much?

I do not have much to say on this one, besides the fact that its a question I had never really investigated until I read this blog entry. From Michael Pettis:

Demographic causes

• Declining dependency ratios, especially via decline in the number of young people. From the mid-1970s to roughly the middle of the next decade we know that China’s dependency ratio has contracted sharply. A much larger share of the population is of working age today than thirty years ago. Besides being a great source of rapid growth, I think this fact creates a bias towards savings since I think of working population as a proxy for production and total population as a proxy for consumption. This means that with China’s working population growing so much faster than total population (a process which will be reversed over the next three or four decades) Chinese production has grown much faster than Chinese consumption. The difference, of course, is the savings rate.

Structural causes

• Lack of social safety net. With a risky health care system, no social safety net, and limited ability to borrow, Chinese households have to self-insure. This means they save on average much more than they need on average to cover these costs.
• Rapid growth in wealth. When per capita wealth grows very quickly, it may take a while for people to change their consumption behavior as quickly, so growth in consumption lags growth in wealth. Of course the difference between the two is the rising savings rate.
• The generation of “little emperors.” I have heard not-always-satisfactory arguments that households save a huge amount because of the one-child policy — they are essentially spoiled, the argument goes, and parents will sharply limit their own consumption in order to provide everything for their only child. I am ambivalent about this explanation, but I do think the maturing of the one-child generations may have an impact on future savings. They are much more likely, it seems to me, to spend money on themselves, although this argument may be a little too glib.
• Lack of consumer credit. Without easy availability of consumer credit, households who want to borrow to purchase big-ticket items have little choice but to save today for a future purchases.

Policy causes

• Low exchange rates. The reasoning and causality are unclear, but there is evidence that countries with artificially low exchange rates tend to have high savings rates, perhaps because low exchange rates reduce real wages.
• Low interest rates. We also have a lot of evidence that low interest rates create higher savings rates in countries like China. This claim generates a lot of confusion, and I am often asked how this can possibly be true when the opposite is true in the West. My guess is that it occurs because of both portfolio effects and income effects. For the former, because Chinese don’t save in the form of stocks, bonds and real state, but rather in the form of bank deposits, declining interest rates do not increase the value of their savings portfolio, but actually reduces it. This is why reducing interest rates causes savings in the West to decline (Westerners feel richer) whereas it causes savings to increase in China (Chinese feel poorer). For the latter effects, with interest income such a large part of total income, low interest rates are similar to low wage rates in their impact on consumption.
• Policies aimed at running trade surpluses. This is generally a catch-all and must be true by definition. A trade surplus occurs when production exceeds consumption, so any policy aimed at growing production faster than consumption is also implicitly aimed at raising the savings share of income.
• Policies aimed at running fiscal surpluses. Of course this contributes by creating government savings.
• Policies aimed at forcing profitability in SOEs via interest rates and other policies. Another catch-all for policies that drive up corporate savings.

I am not sure if there is any over-arching reason for high savings in China, but generally I would argue that policies aimed at generating high levels of investment and at running trade surpluses must also, by definition, cause high levels of savings. In that sense the policies associated with the so-called Asian development model are policies that implicitly or explicitly cause high savings rate. if this is true, as I have written elsewhere, high Asian savings rates my be threatened in the future by rising savings rates in the US, since in the aggregate consumption and production must balance. The US trade deficits required for the success of high-savings policies in China may no longer exist.

Banks Used TARP money to fund lobbyist

As sad as it is, I have to admit that this article did not surprise me. After the botched billion dollar bailouts of AIG, Bank of America, Citigroup, Fannie, Freddie, GMAC, GM, Crystler ..... need I go on.....

Now its turns out these banks allegedly use TARP money to fund lobbyist to prevent regulation in the very same derivatives (mainly Credit Default Swaps) that got us into this mess.

From the NYT:

The nine biggest participants in the derivatives market — including JPMorgan Chase, Goldman Sachs, Citigroup and Bank of America — created a lobbying organization, the CDS Dealers Consortium, on Nov. 13, a month after five of its members accepted federal bailout money.

To oversee the consortium’s push, lobbying records show, the banks hired a longtime Washington power broker who previously helped fend off derivatives regulation: Edward J. Rosen, a partner at the law firm Cleary Gottlieb Steen & Hamilton. A confidential memo Mr. Rosen drafted and shared with the Treasury Department and leaders on Capitol Hill has, politicians and market participants say, played a pivotal role in shaping the debate over derivatives regulation.

...

Mr. Rosen and other bank lobbyists have pushed on Capitol Hill to keep so-called customized swaps from being traded more openly. These are contracts written for the specific needs of a customer, whose one-of-a-kind nature makes them very hard to value or trade. Mr. Rosen has also argued that dealers should be able to trade through venues closely affiliated with banks rather than through more independent platforms like exchanges.

Mr. Rosen’s confidential memo, dated Feb. 10 and obtained by The New York Times, recommended that the biggest participants in the derivatives market should continue to be overseen by the Federal Reserve Board. Critics say the Fed has been an overly friendly regulator, which is why big banks favor it.

Mr. Rosen’s proposal for change was similar to the Treasury Department’s recently announced plan to increase oversight. Treasury officials say that their proposal was arrived at independently and that they sought input from dozens of sources.

Even so, market participants, analysts and members of Congress who have proposed stricter reforms worry that the Treasury proposal does not go far enough to close several important regulatory gaps that allowed derivatives to play such a destructive role in the current financial crisis.

The main reason why the banks even hired this asshole:

But increased transparency of derivatives trades would cut into banks’ profits — hence the banks’ opposition. Customers who trade derivatives would pay less if they knew what the prevailing market prices were.

Blame it on Reganomics

Paul Krugman had an interesting op-ed piece today in the NYT blaming the Regan-era deregulations for the problems we are facing today. I have never really been impressed by anything Paul Krugman has written (books or op-eds), but this piece does mention some obvious, but yet important trends that began in the early 1980s. From the NYT:

The increase in public debt was, however, dwarfed by the rise in private debt, made possible by financial deregulation. The change in America’s financial rules was Reagan’s biggest legacy. And it’s the gift that keeps on taking.

...

But there was also a longer-term effect. Reagan-era legislative changes essentially ended New Deal restrictions on mortgage lending — restrictions that, in particular, limited the ability of families to buy homes without putting a significant amount of money down.

These restrictions were put in place in the 1930s by political leaders who had just experienced a terrible financial crisis, and were trying to prevent another. But by 1980 the memory of the Depression had faded. Government, declared Reagan, is the problem, not the solution; the magic of the marketplace must be set free. And so the precautionary rules were scrapped.

Together with looser lending standards for other kinds of consumer credit, this led to a radical change in American behavior.

We weren’t always a nation of big debts and low savings: in the 1970s Americans saved almost 10 percent of their income, slightly more than in the 1960s. It was only after the Reagan deregulation that thrift gradually disappeared from the American way of life, culminating in the near-zero savings rate that prevailed on the eve of the great crisis. Household debt was only 60 percent of income when Reagan took office, about the same as it was during the Kennedy administration. By 2007 it was up to 119 percent.

One of the reasons I dislike Krugman's editorials is for some reason, (and I havn't figure this out yet) he is a HUGE cheerleader of big government. There is no doubt in my mind, in the US, government IS the problem, and its NEVER the solution. The word "solution" can never be put into the same sentence as Harry Reid, Nancy Pelosi, or Barak Obama. We certainly have a lot of problems in this country, but partisan politics and trillion dollar deficits are not going to make them go away.

I think I may be underestimating Krugman's wealth. Very few smart people in the US that are mildy rich and successful (or aspire to be) would support this administration!

IMF Paper On the Bernanke's Monstrous Balance Sheet

IMF on Fed Balance Sheet

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