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TIME TO PUT INVESTMENT BANKING BACK IN ITS BOX
"I'm not sure if a man ever recovers from a career in banking" is a quote we recall seeing somewhere, but have been unable to track down. The implication was that such a dull job, involving as it did being professionally parsimonious, left permanent marks on the human spirit. The bankers to whom the quote (if it exists) applied are of another era; modern-day financiers can party with the best of rock 'n' roll crowd.
Finance is supposed to grease the skids for the real economy, the economy that generates goods and services which contribute to everyone's standard of living. How big a portion of the pie the financial sector should get for helping spread risk (insurance), facilitate capital investment (banking, investment banking, mutual funds), and for making the market "more efficient" (trading, money management) is open to question. But traditionally the financial sector of the S&P 500 has hovered around 10% of its total capitalization, give or take. That it ballooned up towards 20% from the early 1990s to 2005-06 was a telling coincident indicator of the progress of the credit bubble.
This piece from Bloomberg's Mark Gilbert laments that bankers have let us down again, by having hopped aboard the latest run of the Bubble Express again instead of keeping their heads while others were losing theirs -- witness the huge writedowns and losses in the industry. The author's ideal outcome -- the "back in the box" part -- is that finance revert to its rightful state as facilitator, and that we stop granting legitimacy to those who are essentially con men. Interestingly, he quotes Sean Corrigan, frequent contributor to LewRockwell.com (we featured his writing earlier this year here, and another example of his writing is posted below), on the "legalized deceit" of fractional reserve banking. Pretty risqué for a mainstream publisher like Bloomberg.
"The rulers of the exchange of mankind's goods have failed," U.S. President Franklin D. Roosevelt told a Depression-blighted nation in his 1933 inauguration address. "There must be an end to a conduct in banking and in business which too often has given to a sacred trust the likeness of callous and selfish wrongdoing."
Fast-forward three-quarters of a century. Financial markets are in disarray. The global economy is throwing a tantrum that could spell recession for some nations. Central banks are publicly pumping billions of dollars into the money markets to keep the banking system afloat, and privately doing God knows what to avert the next Bear Stearns or Northern Rock Plc.
The importance of the finance sector to the global economy has swollen along with the bonuses it awards itself. Standards of behavior, however, have failed to mature at anything like the same pace. And, so far, nobody in banking has apologized for the chaos caused by lax lending standards and monumental hubris.
"One of the innumerable problems with Wall Street and the City is that they never do seem to learn from their mistakes," says Tim Price, director of investments at PFP Wealth Management in London. "Each generation seems obligated to re-experience the errors of its predecessors. There is little or no 'race memory' that might at least mean this year's crisis is brand-new rather than a tired retread of past embarrassments."
The backlash is gathering force. Every day brings fresh threats of increased oversight and tighter rules from blindsided regulators and angry lawmakers. The credit-rating companies have finally woken up, with the gradings of Morgan Stanley, Merrill Lynch and Lehman Brothers all cut this week by Standard & Poor's. Finance-industry chiefs are being pushed onto their swords, albeit with a thick padding of compensatory dollars to dull the blow.
The finance industry ceded its dominant role in the Standard & Poor's 500 Index to U.S. technology companies last month. Banks, led by Bank of America Corp. and JPMorgan Chase & Co., now account for about 15.8% of the index, second to the 16.6% weighting for computer and software makers such as Apple, Microsoft and IBM. In the past three years, finance companies contributed about 20% of the S&P 500 Index, with the technology industry a distant second at about 15%. Eight other industries, including energy and health care, make up the remainder.
Fifteen years ago, just 11% of the benchmark stock index derived from the finance industry. Companies that relied on discretionary consumer spending, such as McDonald's and Walt Disney, were the most important, with a 16% index share. Industrial companies had 14% of the index, followed by consumer staple-goods companies with 12%.
"Finance is supposed to be a service industry, an aid to the business of genuine wealth creation," says Sean Corrigan, who oversees more than $8 billion as chief investment strategist at Diapason Commodities Management SA in Lausanne, Switzerland. "Once we accord banks the sort of overblown importance they have enjoyed this past quarter of a century, we become hostage to the megalomania of their executives and head traders."
Collapsing share prices have eroded the importance of financial stocks. Banks are the worst-performing of the 10 groups in the S&P 500 index this year, posting a decline of 17% while the index itself is down just 6%.
Total writedowns in the banking industry are now running at more than $386 billion, according to data compiled by Bloomberg. To patch up their balance sheets, banks have tapped their shareholders for $283 billion of fresh capital.
There is more to come. Deutsche Bank AG, which has reduced its asset values by $7.6 billion, may report a further $5.5 billion of writedowns, analysts at JPMorgan said this week. Credit Suisse Group may add $2 billion to the $9.6 billion already posted, while Societe Generale SA's $6.2 billion hit may be exacerbated by an additional $2.8 billion, the analysts said. Meantime, Societe Generale, BNP Paribas SA and Barclays Plc may have to get out their begging bowls to replenish capital, Fitch Ratings said this week. Barclays may need to raise almost $12 billion, the credit-rating company said.
The deals done in the good times are threatening to sour. In Europe's leveraged-buyout space, the ratio of cash that companies have to cover their debts has melted to 2.2 times, from 2.5 last year and 4.0 in 2003, according to figures from S&P. Dwindling cash to pay debts makes defaults all the more likely. So much for claims that the end of the credit crunch might be in sight.
"Banking in a fractional reserve, fiat money world is inherently a non-market exercise in legalized deceit," says Corrigan at Diapason. "The unfettered finance which it allows is all too prone to wreak a devil-take-the-hindmost havoc once it becomes unanchored from reality and succumbs instead to the intense, positive feedbacks which operate within it on both a systematic and a psychological level."
It is time to put investment banking back in its box. Treat finance as an end to a means, rather than an end in itself. Encourage our brightest and best to become physicists and biologists, programmers and mathematicians, playwrights and artists, surgeons and architects.
Stop glamorizing the conjurors who propagate the confidence trick of banking by magicking shiny coins from behind our ears. Bankers have betrayed Roosevelt's "sacred trust." Until they redeem themselves, that trust should remain withheld from the finance crowd.
THE CRISIS POINT OF THE INFLATIONARY BOOM
This Sean Corrigan piece from last March is typically educational and elegant. His prose is the spoonful of sugar that helps the medicine go down.
An Austrian economist, Corrigan pokes so many holes so quickly in the ship of Keynes that its hulk has joined the Titanic before lifeboats could even be activated. While it is hard to believe they still truly think the Keynesian framework has any real-world validity, our policy makers and their academic enablers act as if they indeed do. Now, Corrigan says, they are at the point where reality and the theory are split asunder, and no man can join them together.
In a recent [February] survey -- jointly conducted by CFO Magazine and Duke University -- one of the top concerns being expressed by industry executives across the United States, Europe, and Asia was that of the rising cost and -- to a slightly lesser extent -- the reduced availability of labor, especially that of the skilled variety. The worry most forcibly competing with this angst was that of whether "consumer demand" would hold up in coming months.
For a Keynesian this conflict can have no meaning, for the central chicanery around which the General Theory [Keynes's magnum opus] is constructed is that depressions can be warded off through monetary debasement, simply by stuffing the workers' pockets with extra cash, while simultaneously fooling them as to the real value of the nominal wages being received in such a newly clipped coinage.
In the case where wages are rising (labor costs are mounting) because employment is near full (suitable candidates for work are hard to find) then, assuming the mythical "propensity to consume" remains broadly constant, consumer demand should be a shoe-in, and unlearned industrialists need not lose too much sleep over their prospects for either sales or profits.
Granted, "end demand" could also become (temporarily) curtailed by a sudden outbreak of thrift, that virulent, unpredictable strain of global pandemic feared by the macromancers more than dirty bombs, bird flu, melting ice caps, and a direct asteroid strike, combined, for its potency in disrupting the pristine, academic beauty of their consumption functions and ISLM curves [standard macroeconomic model tools]
The unlikelihood of this taking place in a world whose mail boxes bulge daily with unsolicited offers of new credit, and whose masses have been conditioned to view shopping as a sacramental rite, should be all too apparent. In fact, what our survey results really display are the classic symptoms of the unhealthy discoordination that an unbacked credit expansion induces in the body economic.
What we see here is that most of the businessmen canvassed are finding their costs are rising and, in particular, the dominant cost they typically bear: that associated with retaining a competent and motivated workforce. At the same time, those who do not directly play a part in satisfying the needs of end consumers (an overriding majority, if our sample is representative of industrial and commercial organization as a whole) are beginning to fret about a slackening of demand for their (mainly higher and intermediate goods) output.
As Mises, Hayek, et al. took great pains to explain, what this means is that the seemingly golden age -- in reality, a thinly gilded one -- during which the first, most favored issuers of cheap credit and artificially boosted equity prices enjoyed almost effortless success, has reached the limit of its ability to postpone the workings of fundamental economic law.
Even if financial capital once appeared so abundant as to provoke strange, Swiftian fantasies about the "saving glut" and the "asset shortage," real, physical capital was never called into being quite so readily, since its creation requires not the staccato keystroke of a fiat banker, but entrepreneurial vision, hard work, and genuine saving.
By that last we mean a voluntary abstention from current consumption, undertaken in order to improve the chance of greater plenty in the future, and not the corrupt preemption of a man's spending power -- effected with monetary trickery -- which inflationists laud as "forced saving." Being a species of initially unrecognized compulsion, this is a deceit doomed to fatal self-contradiction, once its dupes wake up to the nature of the con being practiced upon them.
Since the boom has been driven forward according to the projections of the borrowers and the low-hurdle eagerness of their lenders, rather than being predicated on meeting the imperatives of consumer sovereignty, we eventually find ambition has come to overmaster achievability and hope to have triumphed over hardheaded calculation.
To be harmonious and self-consistent, production should be guided by the wants of those whose ability to express them comes by virtue of being in harness to the same web of mutually supportive processes that help satisfy the needs of others, in turn. If not, scarce physical resources will be squandered in trying to realize misplaced visions of a world as overbrimming with affordable means as the unnaturally low interest rate treacherously seems to imply.
Worse still, once the fever of the boom spreads from its initial promoters and their preferred clients to infect the populace at large, sobriety and forbearance tends to vanish in a kind of Gresham's Law of the spirit. A world awash with "liquidity" is not one where the steady flame of good husbandry can outshine the neon-lit promise of instant gain.
To recap, what then we find is that not only does the availability of financial capital become wholly divorced from the extent of the pool of physical capital goods; not only does much of that pool become misused (and, hence, ultimately, stripped of its original "capitalness"); but that the wellspring of capital maintenance and augmentation -- namely, voluntary saving -- is concreted over to provide a gaudy, Baroque fountain of greater exhaustive consumption.
As this happens, many final-goods prices will rise as they are revealed to have been undersupplied in relation to the monetary means now pouring into the hands of their would-be consumers. Where such goods also comprise inputs to production taking place further upstream -- as is archetypically the case with, say, energy -- this increase in expense will primarily add to costs and may therefore begin to sap profitability, if these are not either offset with greater efficiencies or fully recouped in higher selling prices.
Furthermore, as they find their standards of living slipping, those workers who are so enabled -- and they will be legion at the height of the boom -- will be far less shy about insisting upon more from their employers, by way of compensation for their efforts. Labor costs will now feature in the list of boardroom anxieties.
Simultaneously, since "demand" will have come to a white-hot focus of insistency on end-consumer items, all those who can do so will be shifting resources towards meeting it. If this means abandoning half-completed schemes for long-duration projects in favor of pursuing more mundane but now more lucrative goals, such as putting food on the average man's table and keeping his boiler stoked with fuel in the here-and-now, so be it.
Unfortunately for the Keynesians, with their quaint, quasi-hydraulic depiction of the economy, such intensified end demand will not automatically translate into higher revenues for all the businesses strung out along the chain of production, just as a sudden appetite for beef will not instantly cause the grass upon which the cattle feed to grow more luxuriantly in the pasture.
What it will tend to do instead is to strip those not immediately involved in meeting that end demand of their ability to call upon productive resources on the same terms as before. Squeezing margins as in a vice, this development may also diminish the orders received from those closer to the shop front, since these erstwhile business customers will now be too busy scrambling to restack their emptying shelves to contemplate closing off the sales area for a refit, much less to ponder the purchase of a gimmicky new IT system, or to think of splashing out on an expensive and distinctly nonessential corporate makeover.
This last may not wholly be a matter of discretion since, besides seeing their own wage bill expand, consumer-goods merchants are likely to see inventory replacement come complete with higher invoices, so working-capital needs may soon start to crowd out much more deferrable fixed-investment schedules.
Costs up, labor more pricey, yet demand flagging: This is the fate of all too many of the myriad businesses which comprise the vast, hidden, submarine bulk of the iceberg that is our modern, highly specialized, vertically stratified, distributed assembly-line economy -- to the befuddlement of a mainstream lacking a proper theory of capital or a true appreciation of the role of time.
Welcome to the crisis point of the inflationary boom!
A LETTER TO A LEFTIST: THE TROUBLE IS GOVERNMENT
While we are on a Sean Corrigan roll, we decided to include a letter he wrote to arch-leftist Robert Kuttner. Like many leftists, Kuttner shows nascent signs of understanding some of the larger forces buffeting us in their flow. There is a competition among classes for economic spoils (we also believe). But leftists are blind to the idea that government is by design the means to effect the end goals of the ruling class, rather than a countervailing force for the rest of us if only "the right guys" could seize the instruments of power. Thus when a red fox is caught raiding the henhouse, their solution is to appoint a grey fox as a guard. The lack of corraborating evidence that this is effective never seems to discourage them.
In the case at hand, Kuttner correctly excoriates the inherent corruption of the U.S. financial system. Then, predictably, he recommended more regulation, a return to the New Deal, blah blah blah ... the whole sorry leftist litany.
In testimony before the House Committee on Financial Services, Robert Kuttner of the American Prospect, this week delivered a searing Philippic on the topic of the current excesses.
Like many from his part of the political spectrum, however, he missed the essential cause of the disease and so recommended the wrong treatment, as the following open letter to him tries to explain:
Leftists often analyze history and highlight institutional conflicts better than near-blind Rightists (after all, the whole doctrine of the former is about the clash of class interests competing for economic control), but they always fail at the juncture of true cause and effective remedy.
Though nearly all of what you have to say regarding the marrow-deep corruption of the present era is true, what you give no hint of understanding is that government itself brought this about, not a market which is therefore decidedly not a "free" one.
Government allowed deposit banks to function as "fraudulent warehouses" in the first place. Government extended them and other corporate bodies the privileged protection of limited liability for doing wrong. Government forced its subjects to accept its IOUs as money. Government founded the Fed. Government went off gold. Government favored debt over equity (both via preferential tax treatment and perpetual inflation). Government set up agencies to over-promote home ownership. Government instituted the next great office of "moral hazard" with the FDIC of which you so approve. Government routinely bails out and reinflates all failures which repeatedly shake the gimcrack system which has been its result.
So, no, Mr Kuttner, we will not remove all conflicts and enhance stability by a return to the Depression-extending, soft tyranny of your beloved, Mussolini-inspired New Deal, but only by a return to sound money and the strict and consistent rule of law.
Banking and money are themselves the intrinsic problem. The question of whether or not the rules and regulations of the day are doing a good enough job of covering up the flaws inherent in banking's anomalous legal and economic framework is merely a post hoc diversion from a much more fundamental issue.
Taking but a few of the present evils to which you allude, if banks were forced to obey the rules applied to all other custodians of property -- and if, additionally, money were hard and therefore potentially subject to the same consequences of scarcity as any other good -- highly-leveraged, destabilizing speculation would be well nigh impossible (or, at worst, it would be confined to a kind of specialized, self-contained, private gambling club); inflationary booms would be precluded, and capital would be both unblinkingly supervised -- lessening "agency problems at source" -- and scrupulously invested in genuine enterprise, not in the kind of destructive and debauched financial trickery you so correctly denounce.
Oh, and as hugely beneficial side effect, overweaning government -- the true bane of our existence, as well as the "bankster's" sword and shield -- would perforce become rigorously constitutional, minutely accountable, a great deal smaller, and far less intrusive and arrogant into the bargain!
The cause of both liberty and prosperity would be enormously advanced as a consequence and artificial layers of cloying, stable-door bolting "regulation" could be safely relaxed, with only the effective oversight of a watchful and self-reliant citizenry needed to restrict malfeasance and to see that malefactors receive their just desserts.
You never know, Mr. Kuttner, but if enough of your fellow Americans come both to endorse your indictment and to yet to reject your prescriptions, we might be afforded the chance to put the above assertions to the test. I say this, for the inescapable conclusion is that, in all good conscience, your compatriots could only then vote for the one true alternative to the yelping pack of statist, unimaginative, self-serving political jackals vying to secure their own four years as Ozymandias in your upcoming Presidential elections – namely the estimable Ron Paul. [This letter was written last fall]
~ Sean Corrigan
THE FED’S MEDICINE IS TOXIC
Richard Benson, president of Specialty Finance Group LLC, explains how the Fed's easy money policy is not only toxic, it is futile. It is designed to ward off a recession, but the resulting inflation is draining so much real purchasing power from the system that it is making the economic distress worse than it would otherwise be. Good job, Ben.
In medicine, good ethics go as far back as ancient Greek culture. Part of the Hippocratic Oath translates to say "I will prescribe regimens for the good of my patients according to my ability and judgment, and never do harm to anyone." Any good Doctor knows that a well-intended medical procedure can go wrong and unpredictably cause more harm than good to a patient, and that the side effects from medications can unintentionally make them even sicker and weaker.
In economics or central banking no one is ever asked to take such an oath, so when the Federal Reserve uses the only tools they have available to stimulate the economy and increase economic growth -- lowering interest rates and generating easy money -- they currently are administering a deadly procedure and prescribing toxic medicines to cure an ailing economy that is really hurting. Here is what I mean.
At the end of the 1990s, the easy money prescription drug worked so well for the previous Fed chairman, he never really tightened interest rates. In 2000, we experienced a wonderful stock market bubble and investors around the globe cheered. But when the NASDAQ bubble crashed, Alan Greenspan cut interest rates and called out for even more easy money, causing the housing market to boom and, ultimately, bubble. (To this day, Easy Al has yet to admit there was a bubble). Anyway, the Fed's moves had mass appeal to homeowners back then who took advantage of the situation by borrowing against their houses to live beyond their means. The economy absolutely roared ahead as real estate prices escalated to the moon.
Let's fast forward to 2008. The housing bubble has collapsed and Dr. Ben has been forced to cut a deep incision into interest rates, and goose the money supply to keep the ailing economy rolling. Today, real interest rates are actually negative (the Fed Funds rate less the rate of inflation). Moreover, if the Fed still reported the broad money supply measure, M3, the growth rate would look like 15%. Now we have too many dollars chasing too few goods. What happened? The U.S. Treasury and the Federal Reserve were counting on a weak dollar to boost exports and the economy, but the policy blew up in their face. The dollar has collapsed and oil, grain, food prices, and many metal prices, have doubled.
With a weak dollar, inflation is now imported from everywhere. The Gulf Arabs like Saudi Arabia have figured out that oil in the ground is far more valuable than an investment in U.S. Treasury paper yielding 2% [as long as they know they will not be overthrown]. ... Also, with China's rising Yuan and higher labor and material costs, the American consumer can expect to pay more at Wal-Mart now and over Christmas for things like toys, shoes or pants. The easy money policies created by the Fed will not cure our economic woes because the reduced purchasing power of money dwarfs any economic benefit derived from increased exports.
Also, most world central banks decided to play "follow the leader" with the Fed and cranked up their money supplies. In Russia, China, Venezuela, and the Gulf Oil countries (to name a few), double-digit inflation is common. Inflating food prices mean famine stalks the land of less developed countries, while the middle class in more developed countries are learning what it feels like to be poor.
Inflation means that people are buying less goods and services. Many can no longer afford even the basics without maxing out their credit cards. The Fed has yet to realize that the inflation they have created is robbing an unprecedented amount of purchasing power from the average consumer. The rising cost of living is so bad that it is taxing Americans about three times the equivalent of the $100 billion tax rebates that were supposed to save America!
Government-induced inflation comes with a horrible price as it erodes savings and salaries. It makes us feel poor because even if our wages have gone up, we can only afford to buy less. Businesses are discovering that the poor and unemployed make lousy customers because they do not spend enough. Lower real spending cuts into corporate profits and many businesses are starting to fail. Worse yet, the solvency of entire industries, including the airlines, automakers, retail stores and restaurant chains is on the line. We are saddened each time we read about yet another company that has been around for over 50 years, that is closing its doors forever.
Meanwhile, it is ironic to see the Congress blaming inflation on the speculators. With interest rates well below the rate of inflation, the Fed is paying commodity speculators to buy things that will go up in price with subsidized borrowed money! With low interest rates, a depreciating currency, and rapid money growth, inflation is not a surprise, it is a guarantee! Indeed, many people are not speculating but are acting rationally by getting out of a depreciating currency, rather than being robbed by their government.
If you own gold and silver, fear not. The Fed is years away from ever admitting a mistake, like printing too much money. Moreover, this is America. Congress will never call out for tight money. As long as the Chairman of the Fed still believes in the economic tooth fairy, rising inflation is guaranteed.
Unfortunately, the outlook looks grim. Inflation causes stagnation as people can afford to buy less and less. At the same time, a weak economy only encourages the Fed to print more money that will continue to rob me of my savings, and generate even more inflation. Bernanke may have been educated at Princeton but from what we have seen, he still knows very little. And in turn, this means we all get to learn firsthand what stagflation is all about.
THE FED’S BODYGUARD OF LIES
How academic guilds police higher education.
This great piece from Gary North details how the academic establishment and the leviathan state's handmaiden and enabler, the Fed, support each other in an unholy embrace. North also exposits on the formidable barriers that prevent any revolutionary thought from penetrating the carapace, even in the absence of formal laws preventing such.
Academia is a self-certified guild that is funded mainly by tax money. Each year, something in the range of $350 billion goes into higher education in the United States. This figure keeps rising. So, the stakes are high.
As with any guild, it must limit entry in order to preserve above-market salaries. It does so primarily by academic licensing. The primary licensing restriction is university accreditation, which is a system run by half a dozen regional agencies. To get degree-granting status, a college or university must be certified by one of these agencies. They certify very few.
The next screening device is the Ph.D. degree. This system was imposed on academia nationally by John D. Rockefeller's General Education Board, beginning in 1903, when Congress chartered it. He gave money to colleges, but only if they put people with Ph.D. degrees on their faculties.
Next comes faculty tenure. After about six or seven years of teaching mainly lower division classes that senior professors refuse to teach, an assistant professor comes up for tenure. If he gets it, he can never be fired except for moral infractions far worse than adultery committed with female students. Very few assistant professors are granted tenure. The Ph.D. glut then consigns the losers to part-time work in community colleges for wages in the range of what apprentice plumbers receive. I have written about this glut elsewhere.
To get tenure at a major research university, you must publish in the main academic journals in the field. This is limited to about a dozen journals in each field. They publish quarterly. They run perhaps eight articles per issue. Most of these are written by well-known men in the field who are already tenured. The average Ph.D. holder publishes one article, which summarizes his Ph.D. dissertation. This article is unlikely to make it into one of the top dozen journals.
Almost no one ever wins a Nobel Prize who is not on the faculty of one of these universities. He must also have published repeatedly in the dozen top academic journals. His articles must be cited widely by other authors in these journals. If an article is not widely cited within five years of publication, it is doomed.
In short, journal editors control access into the top rank of academia, who in turn assign manuscripts to be screened by teams of unnamed faculty members. Almost no one knows who these people are.
Robert Nisbet once told me that he had given up reading any professional journal in sociology decades before. [From his Wikepedia entry: "Nisbet was a very rare instance of a first rate mid-20th century sociologist who was also a conservative."] A decade before George Stigler won the Nobel Prize in economics, I heard him say in front of a group of academic libertarians and conservatives that he had a question. "I would like to know why there is only one journal article a year worth reading in my field." The answer is clear: the system is funded by the state and ruled by faceless committees.
At schools other than the top three-dozen, tenure is granted for publishing in a lesser-known journal. Also relevant is a book published by a major university press. These are presses that are subsidized indirectly by the government. Their books sell for very high prices, and are then bought mainly by university libraries.
If you do not publish in the top dozen journals, then you do not get tenure at a major university. Very few Ph.D.-holding academics get offered a tenure-track position in these schools. The old-boy network rules. A major professor at Harvard, Princeton, Yale, Stanford, Berkeley, or Chicago calls a buddy at one of the other top schools and recommends his top two or three Ph.D. graduates. A few of these get hired. Of these, maybe 20% ever get tenure. The losers here wind up at second-tier or third-tier universities.
If a person reaches age 35 and has not published in an academic journal, he is relegated to the limbo of academia. He may get tenure at a community college or a third-tier university that grants only the B.A. and a few M.A. students. If by age 40 he has not published several articles and multiple book reviews in one of the top dozen journals, he will never become a major figure in the profession.
The Old-Boy Network
If you did not get into one of these schools' Ph.D. programs, you do not get recommended to teach at a major university. If you are granted a Ph.D. by any lower-tier school, then you probably will not get a career job in academia, but if you do, it will be in a community college teaching for low wages, probably part-time. You may get a tenure-track job at a college no one has heard of except its alumni, who do not have much money to donate to the endowment. If a Ph.D. holder is granted tenure at one of these schools, he has lifetime employment in safety but obscurity. No one ever hears about him or her again.
The prospective Ph.D. student is told about none of this. The faculty is paid more for Ph.D.-level students. Faculty members have no incentive to cut the supply of lemmings. They keep these pour souls in the dark. These people work for minimum wages teaching sessions of lower-division students. Or they do the grunt work researching topics that their advisors will use to write articles and books, mentioning these students in a footnote or the Acknowledgments page of a book.
Then there is the textbook system. There is a lot of money to be made in textbooks for lower-division classes. A textbook may sell for $100 to $150. The market is huge: over half of the 15 million college students enrolled in America's 4,000 community colleges and 4-year colleges. Only a few textbooks make the cut: about a dozen. Textbooks shape the minds of the general academic public. They also set the criteria for those students moving into upper division as majors in a department.
The textbook must conform to certain standards. Those ideas within the guild that are considered representative touchstones of the guild's positions must not be violated. These ideas are used to screen textbooks.
In economics, the universal screening rule is affirmation of central banking in general and the Federal Reserve System in particular. The editors pay close attention to this chapter. The following rules must not be violated.
This chapter serves the economics guild in much the same way that the local altar to the emperor's genius served Rome. Every adult resident of the empire had to publicly worship the State by placing a pinch of incense on this altar. To refuse was to risk a death sentence. Similarly, any economics textbook author who does not toss a pinch of incense on the altar of the Federal Reserve System assures himself of publication death. His manuscript will be rejected. In the New Testament's terminology, you either make peace with the Beast, or else you are consigned to outer darkness by the guild.
- Only a brief mention of central banking as a government-licensed monopoly -- no detailed discussion of the central bank in terms of the textbook's chapter on monopoly.
- No mention of its structure as a member bank-owned cartel of commercial banks -- no discussion at all of the central bank in terms of the textbook's chapter on cartels.
- No mention of the fact that, under the auspices of the Federal Reserve System, the dollar has depreciated by 95% since 1914, according to the Inflation Calculator on the website of the Bureau of Labor Statistics.
- No mention of the well-organized, decades-long plans to create the Federal Reserve, except to dismiss all such (accurate) accusations as "a conspiracy theory." (This dismisses as a crank theory Part 2 of Murray Rothbard's book A History of Money and Banking in the United States.)
- No mention of fractional reserve banking as inherently inflationary and also immoral: a cartel-enforced wealth transfer, the position of Rothbard's book, The Mystery of Banking.
- No mention of the Great Depression without invoking Milton Friedman's assertion that the Great Depression was the failure of the Federal Reserve System in not inflating more. No mention of Murray Rothbard's book, America's Great Depression (1963). Instead, it cites Friedman's book, A Monetary History of the United States (1963).
This is why there has never been an Austrian School economics textbook. Ludwig von Mises and Murray Rothbard rejected all central banking as an illegitimate government intrusion into the economy. No other school of economic opinion takes this hard-line view of all central banking. A prospective textbook author must implicitly announce his rejection of Austrian economics by means of the chapter on banking.
A professor gets no tenure points for a textbook, but he can become a multimillionaire if his textbook sells well. Very few textbooks make it into classes of the top three-dozen universities. He may get an obscure book publisher to publish his textbook, but the book is marketed to academic limbo. It is highly unlikely that it will break through into the big leagues. It will not be assigned to students at the top three-dozen Ph.D.-granting universities or the two-dozen top four-year schools, such as Swarthmore, Pomona, Carleton, and Occidental. It will not be assigned at the 150 second-tier schools. The textbook may make the author some retirement money, but it will not shape the thinking of the future major players in the profession.
To De-fund the System
Take away government funding, and the system dies. Barring this, allow another dozen accredited schools like the University of Phoenix to market programs, as Phoenix does, to 300,000 students a year, and the system will not die, but it will be drastically modified. The middle-tier and lower-tier private schools will go under: hundreds of them. These lower-tier colleges ("universities") sell to students who were not good enough to get into the major universities and state universities.
This system cannot be modified until the funding is cut off by the state. Short of an economic disaster, this is unlikely. Parents are rarely in a position to tell their children to fund their own educations. There is too much peer pressure on the parents. So, the parents pony up their retirement money and send their children off to schools that are designed to undermine the students' faith in what their parents had taught them, unless their parents never changed from their own last years in college.
It is a self-policing, tax-funded system of indoctrination. It has worked for 70 years. This is unlikely to change in our time. Hope for a Few
There are alternatives in terms of books. The books on the Mises.org's free Literature section offer an alternative. So do the website and catalogue of the Liberty Fund. But these books are aimed at independent thinkers. Not one institution of higher education certifies them. On the contrary, the academic establishment is opposed to the outlook of these books and materials.
Because of the Web, it is easier to get these materials into the hands of bright graduate students who see what is being dished out to them in their classrooms. But this remnant is small. Until the tax funding is removed from higher education, the remnant will remain small.
THE FINANCIAL FURRY FREAK BROTHERS
The man who discovered LSD in 1943, Albert Hofmann, recently died. Found while looking for a stimulant for the circulatory and respiratory systems, he immediately partook of his own cooking and shared a first-hand account of the resulting "trip": "Feeling of anxiety," he noted, and later "Difficulty in concentration. Visual disturbances. Desire to laugh." Finally, Hofmann wrote "most severe crisis" and fled the lab on his bicycle. He felt possessed by demons. The furniture in his bedroom began to menace him. But later he experienced feelings of "good fortune and gratitude."
Adrian Ash thinks maybe a couple of other people have been ingesting the equivalent of Dr. Hofmann's discovery themselves, but doubts that the "good fortune and gratitude" will follow. He writes: "In the hot, fetid climate of low interest rates and surging credit supplies, central bankers like Ben Bernanke and Mervyn King are hallucinating if they think they can control the monsters spawned by the fiat money experiment."
When Albert Hofmann -- the Swiss chemist who discovered LSD -- passed away at the start of [May], newspaper editors the world over reported it as the death of the man "who experienced the first ever bad trip." But Hofmann's hallucinations seem little worse than most acid-induced visions. Or so people tell us ...
"Beginning dizziness," he wrote in his lab journal for 19 April 1943. Looking to find a stimulant for the circulatory and respiratory systems, he had just concocted -- and taken -- a big dose of lysergic acid diethylamide-25. "Feeling of anxiety," he noted, before adding in due course "Difficulty in concentration. Visual disturbances. Desire to laugh."
Finally, Hofmann scrawled the words "most severe crisis" and fled the lab on his bicycle. It seemed to stay stationary even as it wheeled him back home, where his neighbor -- who brought him a nice glass of milk to calm him down -- appeared as a witch in a colored mask. He felt possessed by demons. The furniture in his bedroom began to menace him. All pretty run of the mill stuff if you dabble with psychotropics, in short.
But such "fantastic images" do not always ease into the sensations of "good fortune and gratitude" Hofmann got to enjoy later that day. Hallucinations can still cause the "most severe crisis" -- even without some fool laying "Witches Hat" by the Incredible String Band on the turntable.
"Inflation will return to the two percent target," claimed Mervyn King, head of the Bank of England, and one half of the financial furry freak brothers running Anglo-American monetary policy. "Growth will eventually recover to a sustainable rate."
Just a central banker's wide-eyed hallucination? Maybe not. Like Albert Hofmann's wobbly bike-ride six decades ago, the credit cycle will get us home in good time, ready to turn once again from boom to bubble to bust. But like any powerful psychedelic, the trip gobbled down by Western investors could last much longer than anyone dares hope right now.
And just what was the Governor smoking when he claimed, "In these [current] circumstances, the household saving rate is likely to rise ..."?
The Bank of England has been cutting U.K. interest rates since December. Its latest Inflation Report says it will continue to cut interest rates "in line with [bond] market expectations," too.
And U.K. households have grown their savings only once when interest rates fell in the last 4 1/2 decades. That brief period lasted for two years at the start of the 1990s. [See chart.] Both before and since -- and most markedly during the previous post-war recessions (of 1974 and 1981) -- people have tweaked their savings almost precisely in line with changes to the rate of interest, as set by the Bank of England itself. King's starry-eyed vision, however, "is part of a rebalancing of the U.K. economy, away from spending and importing, toward saving and exporting," he told reporters last week.
The sky has turned all purple in Washington too if U.S. policy-makers think the credit crunch will somehow boost household savings there.
Put another way, "who had heard of collateralized debt obligations just 10 years ago?" as Niall Ferguson, history professor at Harvard, asked in a speech opening New York's new Museum of Finance back in January this year. "Collateralized loan obligations? Credit derivatives? These forms of financial instrument are of very recent origin. So are the hedge funds; so are the private equity partnerships; so are the sovereign wealth funds; and so are those wonderfully named entities, the conduits ..."
Ferguson then flashed up a series of charts "to illustrate the speed with which these phenomena have proliferated." First, mortgage-backed securities. Starting in 1980 -- "when scarcely any such thing existed" -- they total $3.5 trillion-worth today. Then he cited "the whole range" of other newly born asset-backed instruments -- automobile loans, equipment loans, student loans, credit card-backed debt derivatives ...
"Over the counter derivatives outstanding?" the professor asked. "Well, if you'd asked someone to name that figure in 1987 it would have been a very small number indeed." Ferguson's theme bears repeating. He likens the huge growth in complex financial products to an evolutionary spurt, "an explosion of life forms [amid an] unusually benign climate."
Whereas I see it more as a chemistry experiment gone horribly wrong. The hare-brained PhDs mixing up the medicine are too spaced out to even guess at what is now sitting in the Petri dish. And the financial monsters it has spawned are not merely in the scientists' minds.
Take hedge funds, for example. Ferguson notes that in 1990, those financial life forms known as "hedge funds" numbered around 600 (also including funds of funds). Now they have reproduced and multiplied up toward 10,000. "As a form, the hedge fund dates back to the 1940s. But this population explosion is of very recent origin."
The raw numbers also hide a "regular, annual dying out." There is chronic survivorship bias in the data. In 2006, for example, 717 hedge funds were culled. The 2007 figure should be even larger. And here, believes Ferguson, we see survival of the fittest in action. If he is wrong, perhaps it is just the contingency of life itself, allowing the standard proportion of idiots to thrive and market their "top decile" performance to a new generation of unwitting investors.
"A lot of reporters ask me these days whether we are in the midst of a commodity bubble," said Dr. Benn Steil, senior fellow at the Council on Foreign Relations, at the Hard Assets Conference in New York in mid-May. "In fact, I am going to Washington to give a Senate testimony. [Because] my perspective is that the more interesting, and indeed more important, question to ask is whether we are at the end of what I would call a 'fiat currency bubble'."
Like Professor Ferguson, Dr. Steil looks back "to the early 1980s" to find the origins of whatever it is we are now watching mutate, if not die out. Under Paul Volker at the Federal Reserve, "inflation, and at least equally importantly inflation expectations, were driven out of the system through a pretty ruthless policy of very tight money, high interest rates. Very tight money."
What followed was "the golden age of the fiat Dollar" says Steil, reminding us that credit expansion was unshackled from gold in 1971, when Richard Nixon stopped redeeming the U.S. currency for bullion altogether. It took tight money -- "very tight money" -- to bring the resulting inflation of the 1970s under control.
The fiat money experiment then broke out of the lab with the "explosion" of financial life-forms witnessed from 1980 right up to last summer. Indeed, it all ran just fine until around 2002, when the cost of key raw materials -- notably wheat and oil, as in Steil's charts [here and here] -- began to shoot higher in terms of dollars and other government-backed currencies.
Measured against gold prices, however, they have barely budged. "That should not surprise people," says Steil, "because as we go back to the era of the gold standard from about 1880 until the outbreak of the First World War in 1914, prices around the world in countries that were on the gold standard were also remarkably flat. "The figure looked just like this. So gold is behaving as it has historically."
In the hot, fetid climate of low interest rates and surging credit supplies, central bankers like Ben Bernanke and Mervyn King are hallucinating if they think they can control the monsters spawned by the fiat money experiment. And tripped out on delusions of "minor god" status, these furry freaks really do believe they can talk Wall Street and the City back down from their current wave of "worst crisis ever."
Inflation and Rising Costs
Following up on his inflation-themed piece posted immediately above, Whiskey & Gunpowder's Adrian Ash explains the money illusion created by inflation, and why the family budget never seems to balance.
"Ever wondered why your family budgets never seem to work out as planned?" asked Harry Browne in his 1970 bestseller How You Can Profit from the Coming Devaluation.
The book sold more than 100,000 copies in hardback. Some three decades later, a dear reader sent me a copy of the 1971 paperback when I ran The Daily Reckoning's desk here in London. "You guys ... you're just saying the same as Harry Browne did 30 years ago! What's new?" he wrote in an e-mail. And on first reading, Harry Browne's book confirmed the jibe. On rereading it on the train between Waterloo and Hammersmith this week, the cold fact stands out colder still.
A couple of the book's reviewers at Amazon.com declare the book to be the best introduction to economics ever.
"In the short run," wrote Browne -- variously an investment adviser, newsletter tipster, and U.S. presidential candidate for the Libertarian Party -- "inflation seems to be producing a ‘boom.’ Prosperity appears to hit the economy when the government pumps new inflationary money into circulation ... The so-called gains from inflation are always spectacular, while the losses are generally hidden from view. ... But the truth was that nothing had actually changed. We still had the same amount of resources to work with; we still had the same general level of technical competence. Inflation deceived us into redistributing our resources temporarily toward more glamorous industries."
What is wrong with that? Demand for granite countertops grew some 15% per year -- worldwide -- between 2000-2006, according to Dimension Stone Advocate News. More glamorous still, demand for marble rose by 12% annually.
Come September 2007, research from the Freedonia Group (costing $4,500 for the full report) said sales of kitchen and bathroom countertops in the United States alone would rise to 540 million square feet by 2011. That would fetch some $14 billion for "natural and engineered stone" manufacturers in Italy, Spain, China, and Brazil.
OK, so nobody's food got any tastier simply because they chopped onions on new marble plinths. And we all ate fewer meals at home anyway. By August 2006, consumers in Britain were spending more on dining out than they spent on eating at home; across the Atlantic, the restaurant and fast-food business employs 13 million staff -- one in 12 of the work force!
But what is not to love about a little glamor each day?
"Let's take a hypothetical engineer," wrote Harry Browne back in 1970, "working in an aerospace company. ... One day, his boss calls him into his office to tell him some good news. ‘Bumstead,’ he says, ‘the company has just received a new government contract. That means we can now give you a raise. Your take-home pay is going up by $100 per month.’
"[Bumstead] rushes home, tells his wife, and they spend all of four minutes deciding what to do with the raise. They rush out and buy a swimming pool, probably by obligating themselves for the $100 per month the new raise is bringing him."
Here in the 21st century -- where $100 hardly buys a tankful of gas in the U.S., let alone here in the U.K. -- the total number of swimming pools for U.S. homeowners now stands around 8.6 million, by one industry estimate. The pool maintenance and equipment market, having grown by 8% per year since 2002, approached annual sales of $3 billion in 2006.
"There is only one problem," as Browne noted. "Prices are rushing upward to meet the increased paper money supply caused by inflation -- the same inflation that deceived Bumstead into thinking he had received a raise."
That is why, just as in 1970, Reuters reported, "April Personal Spending up as Expected." The Commerce Department said U.S. consumers spent 0.2% more last month than they did in March. But after adjusting for higher prices, real consumer spending was unchanged -- despite the impending arrival of economic stimulus checks, set to total $106.7 billion for 2008.
Real spending grew just 0.1% in March. It fell 0.1% in Feb. But who's counting?
"Of course, what is happening to our hero," Browne went on, "is also happening to millions of others, in various positions along the handout line. Businessmen are gearing up to these new demands -- swimming pools, expensive restaurants, better cars, etc.
"But as soon as the inflationary currency has made one complete pass through the market, prices will begin to stabilize at a new, higher level. That is the point where consumers realize that something has gone wrong with their calculations."
Buying a swimming pool on installment, in short, starts to look very expensive. Because it costs more -- in terms of poor Bumstead's outgoings -- than simply the new raise he brings home each month. Now he and the family must adjust their spending on all those other things (such as food, clothes, entertainment, meals out) they had previously enjoyed regardless.
"The key number here is real spending, which has now been more or less flat since January," said one talking head in response to this week's personal income and expenditure numbers. "With credit tightening, cash flow being squeezed and confidence near record lows, this will surely continue."
So no -- in short -- there really is nothing new in the world of money and finance. Just a fresh generation making the same tired mistake of confusing more money with wealth.
IT’S MY RECESSION: I CAN SCRIMP IF I WANT TO
Servicing the fickle teen fashion market is tough enough in boom times. A recent survey of the April teen shopping market indicated a whopping 20% year-over-year decline in spending on teen fashion. Nascent signs of "recession chic" are showing up, as Elle magazine's editor says that it is no longer cool to carry around expensive, high status stuff when there is so much "economic unrest." Leave it to teens to turn necessity into a fashion statement.
March was a rough month for those trying to scratch out a living selling clothes to teenagers. It is a tough enough gig in boom times, finding clothes that will stay hot enough long enough to get them from the loading dock to the sales rack. Betting on whether the clothes should be faded, ripped, pastel, black, retro, cutting edge, or something that made perfect fashion sense back in the '70s is tougher than picking a number on the roulette wheel.
Then there is that whole store ambiance thing. Should the clerks be friendly, or is it cooler if they are too cool to be friendly? And the music must be just right. It must make adults flee like rabbits from the coyotes while keeping the teen crowd breathlessly awaiting the next song.
Just ask GAP how tough teens can be. Back in 2001, teens rated the Gap the #1 brand in all of teendom. Today, teens do not even mention the GAP in the Top 10.
Times are particularly trying today. March same store sales in the teen apparel sector fell 5.9%. Teenagers dunked Pacific Sunwear for -8%. They took American Eagle Outfitters on a -12% cliff dive, and punched Abercrombie and Fitch right in the sixpack for -10%.
Of course the retailers will tell you that they were hampered by an early Easter and too little fluoride in the water. April should be better, they say, while furiously rubbing a Polo logo for good luck. However, according to Piper Jaffray's April survey of teen shopping (the same survey documenting GAP's fall from grace), spending on teen fashion is down 20% year-over-year. Twenty percent!
And why not? The credit crunch is crunching one of the key drivers of teen buying power -- parents. So if teenagers do not have enough angst already, they may be shocked to learn that mom and dad no longer rank traditional department stores (like Macy's) as their favorite places to shop for their beloved teens. The new number one for those bankrolling the younger set is Kohl's. (Kohl's? OMG.)
But according to Piper Jaffray, teens are not cutting back on clothes because they have to, but because they want to. Piper Jaffray calls it a "discretionary recession" for apparel because teens keep spending on electronic gizmos.
Maybe. But a recent AP story quotes a Deloitte Research economist who figures that fickle teens have at least one thing in common with us Dads who choose where to buy a shirt based upon how close the store is to Home Depot -- teens are not immune to the higher gas and food prices. Plus, teen employment is down 5% year over year. With mom and dad crunched and employers not hiring, no wonder $40 teen tee-shirts are not selling.
Some even argue that there may be a secular trend at work here. The same AP story reports that the teen-oriented web version of Elle magazine features the "Self-Made Girl" who shows teenagers how to make their own clothes. (Double OMG!) The site's editor explains that it is no longer cool to haul around a high dollar designer handbag with all the "economic unrest" going around. Meanwhile, Aeropostale, a purveyor of cheaper jeans, delivered surprisingly strong March same store sales. Sellers of bargain priced second hand clothes like Buffalo Exchange and Plato's Closet are also faring better than traditional teen retailers.
UBS calculates that teen retailer same store sales fell 0.5% last year, vs. a gain of 3.3% in 2006 and 12.1% in 2005. Is that a secular or cyclical trend? Some even argue that teens are justifying buying less in the name of greener living. Leave it to teenagers to get all frugal with a big recession just getting underway.
TIME TO DO SOMETHING ABOUT OIL
Martin Hutchinson often has a refreshing realpolitik perspective on matters polical and economic, and does not hestitate to offend political idealogues of all stripes. As this review of his book Great Conservatives, phrases it: "He resolutely insists on offending the many shibboleths of every wing of the American conservative movement, even while celebrating the greater whole."
Here he considers the problem of what to do about the runup in oil prices, which have hit the point where they are removing nontrivial amounts of purchasing power from the consuming countries' economies and ballooning the coffers of some notably unappealing regimes. The major issue is, in Hutchinson's perspective, that oil prices are "sticky downward". Even if the runup was shear speculation, it can take a long time to retrace back to the equilibrium level, as we saw in the first half of the 1980s.
The oil price rise of more than $50 per barrel since the Fed started cutting interest rates in September is beginning to get serious. Since the rise of oil import prices alone removes $170 billion [in purchasing power] from the U.S. economy, more than 1% of GDP, it is both inflationary and highly recession-producing, especially since it has been accompanied by similar rises in other commodity prices. Its full effects have not been seen yet but they are coming -- don't worry! At some point we are probably going to have to do something about it. The question is: what?
In general, the populist clamor to "do something" about a sharp move in commodity prices makes no sense. The price mechanism acts as a shock absorber for supply and demand hiccups, so that if storms shut down the Gulf oil platforms or rapid growth in China causes its use of automobiles to soar, oil price rises can signal to other consumers to cut back consumption and to producers to enter into new exploration projects. That is why the fuel subsidies in Third World countries are foolish -- they encourage the consumption of a substance that is increasingly scarce and at times like the present impose an appalling burden on local taxpayers or the government's financing mechanisms (as in India, where government deficits threaten to derail that country's magnificent economic boom).
While oil prices were rising from $20 to $80 per barrel in 2002-07, this rationale seemed unquestionable. The rise was gradual, and the price remained well within the parameters that the world economy had survived, albeit with some difficulty, in the early '80s. (Although the peak 1980 price of $40 per barrel was equivalent to about $105 in today's dollars, that peak was ephemeral; the major economic effect of expensive oil came from the roughly six years of oil prices hovering around $30-$70/80 in today's dollars -- in 1980-85.)
However the $50 rise since September has been sudden, has taken oil prices to a level never before experienced, and shows no sign of abating. Its principal short term cause has been the excessive lowering of interest rates and relaxation of credit conditions in the U.S. and elsewhere, but there are a number of long term factors which may make it difficult to reverse.
The International Energy Agency is said to be producing a study showing that future oil supplies will be more restricted than had been thought, topping out at about 100 million barrels per day rather than the 115 million that had been thought necessary to accommodate the world's growth to 2030. The IEA's new caution is probably inevitable, given the rise in prices and the considerable uncertainty in reserve and production estimates. It is mostly a matter of IEA geologists seeing the inexorable rise in prices and deciding to use more pessimistic assumptions about future trends. In any case, since current production is only around 85 million barrels per day, the decline in estimated future production is not an immediate problem. However its psychological effect on the market is considerable.
Whatever the views of the IEA, it should be clear that the recent rise in oil prices is not driven by fundamentals. Economists differ about the price elasticity of oil, but the lowest plausible estimates for short term price elasticity are around 10%, with medium term elasticity being much higher. Thus if oil legend T. Boone Pickens is right that oil supplies are currently 85 million barrels per day and oil demand is 87 million, that is a supply shortfall of 2.4%, which at a 10% elasticity should produce a price increase of 24%, not 60%.
The principal influence behind the huge rise in oil prices has been speculation, whether by the international oil companies, by hedge funds deprived of easy pickings in the housing and equities markets, or by the oil suppliers themselves, drunk with the glory of their new-found wealth. Naturally, easy money provided by Ben Bernanke, Jacques Trichet and the rest of the gang since September has empowered the speculators. Indeed, while real interest rates remain below zero, oil speculators would appear to be onto a one-way bet, provided they are rich enough to sustain their buying -- and the combined resources of the world's hedge funds, oil companies and dubious energy-rich Third World dictators are very great indeed.
Hence if we do nothing, but continue to focus on housing, consumer inflation and the NBA playoffs, oil prices will continue rising. This will have only a modest short term effect, but a highly damaging effect in the medium term, as the recession-producing tendency of high oil prices works its malign magic on the long-suffering world economy.
Further rises are additionally dangerous because they may not quickly be reversed. In a market of entirely rational trading robots, the 1980 oil price spike to $40 might have been just a spike, with prices reverting within weeks to the $15 or so that was then the equilibrium. In the world of fallible speculators and other humans, the psychology of a rise to $40 made the price "sticky" on the downside at around $30, so that it was November 1985 before prices collapsed to $10. Thus if the oil price soars to $200 next week, we are probably condemned to $150 oil until 2013 or so, after which the price will collapse to $25 for several decades, as new supplies and bizarre and expensive government-mandated conservation schemes overwhelm the market.
To avoid this dreadful fate, what should we do? There are a number of possibilities:
We could invade somewhere. Considered as an oil acquisition exercise, Operation Iraqi Freedom has been a smashing success, and only appalling Wilsonian wimpiness in the U.S. government has prevented the United States from taking full advantage of it. Iraq's known oil reserves have been increased by about 100 billion barrels since the invasion, as competent U.S. oil companies have been free to explore for new oil employing techniques more advanced than the 40-year-old dowsing sticks used by Saddam's oil operation. At today's oil price of $130, less a generous $20 for drilling and extraction, those additional reserves have a value of $11 trillion -- approximately 10 times the most alarmist estimate of the cost of the war to date.
The problem is that the U.S. did not secure itself a proper royalty on the new oil finds (even 10% would have been worthwhile -- $1.1 trillion over the next few decades.) Nor did it ensure, by setting up a privatized oil company and a trust fund for the Iraqi people diverting oil revenues from the Iraqi government, that the new oil finds would be exploited in an efficient manner and the supplies directed properly into the world oil market. Any future invasion of an oil producing country should avoid these two mistakes and thus make itself self-financing.
The obvious place to invade is Venezuela (even if current estimates of Venezuelan and Saudi reserves are wrong and there is in reality more oil in Saudi Arabia that could be unlocked if ExxonMobil and the boys were given free rein, the Saudis are nominally our allies, so an invasion would be considered unsporting by world opinion.) Since the 1.8 trillion barrels of Venezuelan oil deposits consist largely of the Orinoco tar sands, a Venezuelan oil-related invasion would impose an additional requirement: to keep the environmentalists away, in order that reserves could be exploited with maximum efficiency.
For those who feel that invasion-for-oil is altogether too Bismarckian in its implications, there are other alternatives. The most effective would be to use the interest rate weapon, reversing the damage caused by the cuts since September and ideally going a little further, to fight the resulting consumer price inflation. A series of small interest rate rises would not be effective, because it would enable speculators to adjust. (The 17 0.25% rate rises in 2004-06, we now know, were completely ineffective in quelling housing speculation as they allowed the speculating frog to bask in the gradually warming interest rate water, rather than being forced by a sudden temperature rise to jump out of the saucepan.)
The most effective interest rate trajectory would probably be an immediate reversal of the post-September cuts, jumping the Federal Funds rate from 2% back to 5.25%. This would still be too low to be effective in fighting consumer price inflation, currently around 4% even on the suspect government figures. However it should shock commodity speculators sufficiently to cause a sharp drop in oil and commodity prices which might, if we were lucky, become self-reinforcing enough to push oil prices down to the $80 level which is probably the lowest we can currently expect. Once the immediate effect of higher interest rates had worn off, further rate rises, probably to around an 8% Federal Funds rate, would be needed to wring out inflation, but those could be undertaken over the next 18-24 months in the normal manner.
It is quite certain that the interest rate weapon, if used with sufficient vigor, would quell oil prices, but it is not entirely clear whether a single rise to 5.25% would do it. However draconian rate rises beyond 5.25% to quell oil price rises would be deeply unpopular and would cause further catastrophe in the U.S. housing market. Since invasion is presumably off the table, the political classes may thus attempt to impose other remedies for high oil prices, all of which would be either counterproductive, disastrous or both. These might include some or all of the following:
In summary, a sharp rise in U.S. and world interest rates is the best way to solve the problem of spiraling energy and commodity prices, which will probably not solve itself. If that does not work or is "politically impossible" it is time to prepare the 82nd Airborne for jungle warfare in the Orinoco Basin.
- Price controls on oil companies. These would have the cathartic effect of eliminating the profits of Western oil companies, but would have little effect on the market, since the majority of oil supplies are today not controlled by Western oil companies.
- Subsidies. The effect on consumers of spiraling oil prices could be reduced by cutting petroleum taxes (as recently proposed by Senators McCain and Clinton) or subsidizing gasoline prices directly. Such subsidies would increase rather than reduce consumption and would divert income from taxpayers (the ultimate providers of the subsidies) to OPEC and other oil producers. Terrible and counterproductive idea.
- Rationing. Britain did this at the time of the Suez crisis in 1956, when overall rationing was still a recent memory. Its initial psychological effect would be considerable and it might well prove politically appealing to a populist, economically illiterate President after January 2009. The principal gainers from such a measure would be the Mafia, who would find a new business in stolen and forged ration coupons.
- Intensified Corporate Average Fuel Economy standards, ethanol mandates and public transportation subsidies. These would be highly politically attractive to the left, and are thus probably quite likely. Their effect would be far too long term to change short-term price movements. Apart from increasing costs in the economy, they would result in tens of thousands of additional fatalities a year, as the feeble mini-cars took to America's roads.
- Intensified drilling in Alaska and offshore U.S. areas. The right wing alternative to CAFÉ standards; equally ineffective in the short term but much more helpful long-term. Would probably intensify the 2013 price collapse as the new sources came on stream.
- Closing down the commodities exchanges. The speculators have already found the counter to this one; a new crude oil contract is opening for trading in Dubai. To close that down, we would need to revert to the invasion option.
A STOCK FOR ECO-NUTS
Ken Fisher (still) thinks stocks look "wonderful", and has a couple of "megacap" stock ($80 billion and higher market cap), which he particularly favors now, recommendations. All of them look pretty reasonably priced.
Some of the recommended stocks have a "green" angle. Fisher believes capital will be poured into "green investing" to a degree that will make the "socially responsible investing" movement look like chickenfeed. This will translate into a premium, so the theory continues, for any "green" stock -- kind of like how in tech stock booms, tacking "ics" or "ix" to a company name is good for a couple of multiple points even if the company grinds sausages.
Now that we have had a full-fledged correction that scared the dickens out of everyone, stocks look wonderful. But I have said all that in recent columns. I particularly love megacap stocks -- those, by my definition, with market capitalizations of more than $80 billion -- and again for reasons I have clearly stated recently. But here are two smaller ones I like, too.
The Chilean firm Enersis (18, ENI) is the largest private-sector electricity generator in South America, serving Argentina, Brazil, Chile and Colombia. Generation is 40% of its revenue; electricity distribution is the rest. As South America modernizes and develops, Enersis will grow. It is controlled and majority-owned by Spain's giant utility Endesa, which I have recommended many times over the decades. So you know it will be well run. At 1.4 times annual revenue and 19 times likely 2008 earnings, and with a 2.4% dividend, it is more than cheap enough for a nicely growing firm. The ADRs for it trade on the New York Stock Exchange. Its market cap is $12 billion.
If you are an eco-nut, buy France's Veolia Environnement (70, VE), which is postured as the quintessential green company. If you are not an eco-nut, buy it before all the eco-nuts do. In a few years you can sell it to them. Veolia's basic businesses are hardly glamorous. It makes fuel cells, runs mass transit systems and desalinates water. It also turns scrap metal into steel and uses solid waste to generate electricity. Its revenue last year was $44 billion. Its market cap is $33 billion.
Guilt is terrible. It leads people to irrationality and terror. The political and social forces behind the movement to combat global warming and turn energy green are, to me, a form of paganistic spiritualism displacing conventional religions. But they are real forces nonetheless. I believe green investing will soon become a hot social trend throughout capital markets on a scale that "socially responsible investing" never began to approach. It is only a matter of time before big public pension plans, endowments and foundations start carving out specialized allocations for green investing. The cost of guilt will translate into a premium price on green stocks. Veolia will be in every green portfolio.
Veolia is internationally diversified. It gets 55% of its revenue outside France. Revenue breakdown: 33% water treatment, 28% waste management, 21% energy optimization (greenie buzz lingo for heating and cooling gadgets) and 17% outsourced public transit systems. The stock is cheap at 80% of annual sales and 16 times likely 2008 earnings. Its dividend yield is 2.1%. If recycling waste does not make you all warm inside, earning your capital gain will. You can do that with this next stock, too.
Jeffrey Immelt wants General Electric (32, GE) to be the prime choice for greenie investors. This has been his ambition for a while; Forbes described it in a cover story three years ago. He is way too late to this party, and in any event most of his company's revenue sources have nothing to do with saving the planet. But GE is still a great firm, and it is soon to be a great stock. Dominant in pretty much everything it does, GE has nonetheless lagged the global stock market since 2004 and is down 23% since last fall. That is because Immelt missed earnings expectations in what the media described as GE's worst blowup since 1987. That year, by the way, was a great time to buy GE.
The unpleasant earnings surprise is a small blip in GE's century-long growth story, and this is a good stock for the megacap era I expect over the next few years. It costs 13 times 2008 earnings and yields 3.7%.
The Finnish handset maker Nokia (28, NOK) is a megacap, with a $112 billion market valuation. It has pretty well wiped out its competitive threats, one after another. Years ago those threats included Qualcomm, with its CDMA channel-access technology, Motorola, Siemens and more. Since 1999 they have all shrunk in importance, while Nokia has tripled in size. There is more ahead, but in the correction Nokia's stock melted. It is down 25% this year.
The world's cell phone explosion is far from over. Nokia will be the prime beneficiary. Now, at 1.4 times annual revenue, at 10 times 2008 earnings and with a 2.7% dividend yield, it is a buy.
Last on this month's list of premier megacaps is Intel (23, INTC). This $137 billion (market value) firm is far and away the world's largest and leading chipmaker. You can get it for only 16 times 2008 earnings. It yields 2.3% -- better than the S&P 500 index. How many premier-quality technology companies can you find that yield more than the market average?
POSTCRISIS BANK STOCKS
David Dreman moves from "Looking Beyond the Bailout" to looking around after the bailout. He thinks the worst of the liquidity crisis is over, ergo now is a good time to start picking through the wreckage. Perhaps.
The good news is that the worst of the liquidity crisis seems to be over. After a slow start the Federal Reserve Board under Chairman Ben S. Bernanke has done an outstanding job containing the panic in the financial system and dispelling the fear of a total meltdown. The Fed's most controversial move, its guarantee of $29 billion of Bear Stearns assets ... prevented a possible freeze in the derivatives market that could have resulted in a brokerage and bank holiday like that of 1933.
The purported outstanding job comes at who knows what cost in terms of economic destruction. See, e.g., the "Fed's Medicine Is Toxic" posting elsewhere on this page. But we will grant that Bernanke's hands were more or less tied with Bear Stearns.
It is time to ask: How could the managers of so many banks and brokerage houses have thrown out the rule book on risk? These experts bought mortgages that had been issued to borrowers with dangerously low credit scores or whose incomes had been sharply overstated by their initial lenders. Sometimes the mortgages were on homes that had been appraised at higher than market value in the overheated climate.
The high paychecks they could garner by playing a greater fool game only slightly more sophisticated than buying dot-com stocks at 100 times revenues made ignoring the rule book easy to do -- as Martin Hutchinson explains in this article.
To make matters worse, the risks were significantly increased by the use of adjustable-rate mortgages with very low teaser rates that after several years would jump to fixed rates approaching 8%. There were even negative-amortizing mortgages where buyers paid only a portion of the interest owed, so the debt balance climbed. Sounds pretty stupid, doesn't it?
Yes. And it sounded stupid at the time.
But there were hundreds of billions of dollars of subprime, adjustable-rate and negative-amortizing mortgages issued through sloppy lending practices. Subprime, Alt-A and home equity loans went from a volume of $308 billion in 2001, or 14% of all mortgage originations, to $1.4 trillion in 2006, or 47% of the total.
Why were institutions so foolhardy on such a massive scale? Because of the irresistible returns, which, with leveraging, could reach 15% a year. To add to their profits some banks bought thrifts or other mortgage originators. Wachovia purchased Golden West Financial, one of the largest, at a premium price, $24 billion -- nearly half Wachovia's current market value.
That purchase also sounded stupid at the time, to everyone except Wachovia's management.
Golden West was heavily weighted in adjustable-rate mortgages. Altogether, the estimated total loss in the U.S. and elsewhere from bad mortgages may approach $1 trillion.
After these errors that cost their shareholders 40% to 50% or more in market price, do senior managements show any remorse? Charles Prince, the former chief executive of Citigroup, took a retirement plan of $29.5 million plus a $10.4 million bonus. Stanley O'Neal at Merrill Lynch took home a $161.5 million paycheck.
At Washington Mutual, Kerry Killinger, whose policies caused WaMu's stock to drop from $44 to $8.72, arranged an offering that left shareholders diluted by 50%. Some of the stock was sold by WaMu's underwriters at the bottom to hedge funds and to a giant mutual fund group that had not owned it previously. There were special terms that even gave a few privileged buyers no-cost warrants that immediately were worth a significant amount.
Wachovia also had to sell new stock at a discount, and the fire-sale price was offered to few existing shareholders. Instead Wachovia's principal underwriter, known for dishing out hot offerings to high-commission clients, made its high rollers happy yet again. But Kennedy Thompson still has his job as chief executive.
Despite all this, the market is beginning to show signs of a comeback. The underlying fundamentals of the U.S. economy are still strong. Here are three relatively well behaved banks I would look at now:
- Regions Financial (19, RF) has lost half its share price amid ongoing writeoffs in its residential construction portfolio. However, its reserves appear adequate to prevent earnings from deteriorating much further, and it trades at nine times trailing earnings.
- Shares of Citizens Republic Bancorp (6, CRBC) have dropped by two-thirds as investors have grown concerned over the company's earnings reductions and suspension of its dividend. Its bad-loan reserves appear to be adequate, though, and it is likely to earn 70 cents this year and significantly more next. It trades at a 35% discount to tangible book value.
- UCBH Holdings (6, UCBH) has a strong base among Chinese-Americans in California. An increase in reserves to cover bad residential construction loans has pushed its price down by two-thirds from its 52-week high. It is likely to earn 50 cents a share this year and more next year. Its stock yields 2.7%.
None of these look unreasonable on the face of it. Nor are they inconsistent with Dreman's contrarian investment philosophy. But with the degree of leverage used routinely in the banking industry, he better be correct with his "appear to be adequate" assessments of loan loss reserves. After a credit bubble for the ages, it is very hard to know which loans anywhere in the system are truly good loans.
HIGH ENERGY STOCKS
Some unconventional ways to value the players.
The ghost of Benjamin Graham, Warren Buffett, and just about every value stock buyer under the sun will suggest that you try to buy a stock at a discount to its "intrinsic value." The conservativeness of your value assessment and the size of the discount both provide a "margin of safety" against judgement errors and the vagaries of life.
How to estimate intrinsic value? Ideally, someone would tell you the appropriately discounted present value of future cash flows. In the real world you have to guess the number and let the future show its hand. Your cause will get a major boost if you are deeply knowledgeable about the industry you are evaluating (as Buffett is about any company he and Munger consider acquiring).
Various shorthand value calculations can be used across industries -- some of which make some sense, and some of which are used to justify stock prices that otherwise cannot be fundamentally validated. For example, in the 1980s cable TV stocks were initially valued at multiples of cash flow when earnings were low because the depreciation on the huge investments in infrastucture was so high. Fair enough, if maintenance capital spending was substantially lower than book depreciation.
As cable company valuations rose due to takeovers and a bull market in media stocks, the cash flow multiples ascended into nose-bleed territory. So analysts started justifying stock prices and purchases based on a "dollars per subscriber" valuations. A company was cheap if its enterprise value (market value of debt plus equity, minus cash) divided by subscribers was cheaper than the value realized during the latest takeover. (Such pseudo-reasoning was a precursor to the credit-fueled nuttiness of the 1990s and this decade. It seemed crazy at the time, but looks comparatively rational now given how subsequent history lowered the hurdle to ankle height.) The value per subscriber is the expected discounted net cash flows that can be milked out of him or her, which would ultimately bring us back to the cash flow multiple ... if you bothered. Similarly, cellular companies were valued by "dollars per pop," i.e., net enterprise value divided by the customer base, when cash flow multiples failed to provide enough fuel for buy recommendations.
Some rough-and-ready valuation approaches are pretty good. It is reasonable to guess that a conservatively run bank with impeccable loan loss reserving could sell off its loans at book value, pay off the depositors, and sell its fixed assets at book value. Thus it should be worth at least book value. If the bank has ready access to a stable base of depositors who accept low interest rates, that is an off-balance sheet item of some worth. If the service area is attractive and the bank's book value can be expected to grow at double-digit rates for many years, then liquidating does not make sense because it is worth more that book value. And so on. Bottom line is, subject to the usual provisos on understanding the loan portfolio, a well-run bank with a deposit gathering franchise that can be bought at less than book value is an attractive investment possibility. (Such opportunities have not been readily available in the last 15 years.)
The assets of banks and certain other financial companies -- one's whose asset valuations are mark-to-myth based need not apply -- are straightforward in theory. How about companies whose principal assets are fixed? If -- big if -- the industry is growing then the replacement value of the chemical plant, oil reserves, drilling rigs, land, office buildings, warehouses, etc. is a valid input into the valuation. If there is an active market in the such assets, so much the better. But if the industry is mature or shrinking, as Buffett found out when he bought some textile mills in New England, then book or replacement value is irrelevant. Only the cash you can take out of the operation while it maintains or shrinks matters then.
Forbes has published a "Beyond the Balance Sheet" series going back some time now which looks beyond the standard "The stock's P/E is this and it should be that" pap that passes for analysis on Wall Street. Some of the series tackles an industry and attempts valuations using approaches akin to the discussion heretofore. (One on banks was published last fall.) This most recent one looks at the energy industy, passing quickly over the conventional oil and gas outfits to solar, wind, biofuel and nuclear companies, plus companies "set to capitalize in other ways on the shift to cleaner energy production." Their metrics are interesting. As with dollars per subscriber or pop, people should understand how things will flow throw to the bottom line before blindly buying based on some apparently compelling number.
Booming economies in China and India, a Federal Reserve that loves to print money and a Congress that believes in big subsidies for alternative fuel have combined to do wonders for all kinds of energy stocks the past five years. As the price of oil has gone from $35 to $130, shares of ExxonMobil have merely doubled. So have shares of ethanol producer Pacific Ethanol. But photovoltaics vendor Evergreen Solar (ESLR) is up 5-fold since 2003.
Are energy stocks still a good bet? That is an impossible question to answer unless you can predict the price of oil in 2013. We do not pretend to have that ability but would feel safe in recommending that a fraction of your net worth, as much as 10%, be invested in energy producers as a hedge against your consumer exposure to energy costs. In the tables that follow, we offer some off-the-beaten-path metrics that shine a spotlight on possible value plays among energy producers.
Previous installments of our Beyond the Balance Sheet series put banks and retailers under the microscope. This time we look at oil and gas, solar, wind, biofuel and nuclear companies, plus five companies set to capitalize in other ways on the shift to cleaner energy production.
Like most big integrated U.S. oil outfits, ExxonMobil is very efficient at getting oil out of the ground and refining it. On the traditional measure of price to earnings it is fairly inexpensive -- 12 times trailing net. But it is so good at extracting profits from the wells it owns that there is limited earnings growth to come from greater efficiencies or better refineries. A very different sort of bet is PetroChina (NYSE: PTR). This stock trades for 13 times earnings, a slight premium to Exxon. But there is a lot more that it could do to exploit its resources. Exxon's enterprise value (essentially, value of common stock plus debt) is $21 per barrel of reserves. PetroChina's enterprise value is only $13 per barrel. PetroChina is currently replacing reserves twice as fast as it is pumping them out, so it is building a valuable resource base. [See "Cheap Reserves" and "Steady Majors" tables.]
Our solar table shows companies that are cheap relative to their output, which we measure in kilowatts of solar collectors manufactured per year. (A panel producing one kilowatt under the noonday sun will cost the customer $5,000 to $8,000.) You probably want to avoid companies like First Solar, even though analysts at industry researcher Isuppli see it roughly doubling production capacity annually over the next three years. First Solar's shares are up 10-fold since its November 2006 stock offering, and the company, including debt, costs $115,000 for every kilowatt of solar components it shipped last year. The German firm Aleo Solar comes in below $4,000.
Like solar shares, the windy ones trade on rich expectations for growth. That growth might come, with help from subsidies. The U.S. Department of Energy is saying it wants 20% of U.S. electricity derived from wind by 2030. Shares of Indian wind turbine manufacturer Suzlon Energy and France's Theolia are expensive, at $8,000 and $13,000 per kilowatt of output. (See table) Like vendors of solar systems, the wind energy companies measure their products in peak watts, even though sun and wind are fickle. Cheaper: Vestas Wind Systems, at $5,000.
Biofuels were all the rage in 2007 but have recently fallen out of favor with the recent revelation that they are destructive to the environment. If you must own a producer of these things, you should at least aim for a cheap one. In the biofuels table we score vendors on their enterprise value per gallon of annual output. The cheapest comes in at 48 cents, the most expensive at $4.99.
With carbon out of favor, nuclear is seeing a renaissance in social acceptability. If coal users get punished with taxes or limits on greenhouse gas emissions, vendors of nuclear-fired electricity will be at a financial advantage. Which utilities are they? We got help from Sofia Savvantidou, an analyst at JPMorgan Chase. She backed out the value of nonnuclear assets to come up with an enterprise value for nuclear power plant owners. We divided that number by a company's average output in kilowatts to come up with a cost per nuclear kilowatt. (See table.) Electricité de France, which gets 87% of its power from nuclear energy, comes in at $4,090. That looks expensive but is probably a good deal less than U.S. utilities will be spending to build new nuclear plants.
Our final table ("Green Dividends") looks at an assortment of potential winners in an era of costly oil and penalized carbon. Nigel Hart of hedge fund Reach Capital Management bought shares of French power utility Alstom following its announcement that it would acquire Spanish wind company Ecotecnia. "The order book is full for the next two years," says Hart. "Despite lackluster management, [wind turbine manufacturers] can't fail to do well because the end markets are so strong."
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