Finance Digest for Week of February 23, 2004

KERRY: FRIEND OR FOE OF US BUSINESS?

Republicans and right-wing commentators are alleging that John Kerry would be the most anti-business president of modern times. It seems an absurd charge when Kerry expects to raise tens of millions of dollars in corporate sponsorship; in fact, says the Washington Post, no serving Senator has taken more money from lobbyists over the past 15 years.

But many of America’s most influential industries have genuine cause to be worried if he makes it to the White House. Big Oil for a start. Kerry has been a fairly consistent environmentalist, supporting higher gasoline taxes, pushing for greater fuel efficiency in cars, and opposing George W Bush’s decision to allow drilling in Alaska’s nature reserves. He has regularly voted against costly defence budgets, called for the end of government subsidies across a span of business sectors, criticized America’s biggest corporate polluters, advocated accounting reforms, railed against stock options and Wall Street abuses, and blasted tax-dodging companies.

Kerry has promised to lead an “international coalition” against tax havens, claiming that $5 trillion of US assets have been moved offshore, beyond the legitimate reach of America’s tax authorities. The Senator’s interest in banking secrecy and tax havens goes back a long way. He was closely involved in investigations into drugs and the Noriega regime in Panama, Oliver North and Iran-Contra, and the BCCI banking collapse, all of which strengthened his awareness of the role offshore finance plays in facilitating transnational crime. Kerry continues to attack Saudi Arabia for allegedly failing to do enough to stem terrorist funding.

Everything said, he has long experience of fundraising, and knows how to schmooze party patrons. Kerry has also had some embarrassing moments of his own.

VODAFONE EXPLAINS AT&T WIRELESS DEFEAT

While Cingular is claiming that it snatched AT&T Wireless from under the noses of sleepy Vodafone execs, in The Sunday Times Vodafone CEO Arun Sarin counterclaims that Cingular paid $1.5 billion more than it needed to because Vodafone was not going to raise its bid any higher. Vodafone’s PR offensive in the weekend papers may contain for-the-record point-scoring, but the main thrust is to mollify big shareholders. The company has to assure the institutions that it will not go mad again in America. No, it won’t put in a bid for T-Mobile America, the smallest and weakest mobile network operator, and no it will not go for Nextel either. Right now and perhaps for a very long time, indeed, Verizon Wireless is out of the question, too. Because that would mean making a full-blown hostile bid for parent company Verizon Communications.

Often it is more important not to lose than to actually win. Judging from the reaction of the stock market which marked up Vodafone’s shares sharply last week, “defeat” was seen as a victory for shareholders.

CASH FLOW PROMISE AND PERIL

Operational cash flow per share (OPS) is cash flow from operations divided by the number of shares outstanding. OPS provides a gauge of actual cash generated by a company’s core business. Earnings per share (EPS) includes non-cash items such as receivables and depreciation, as well as gains or losses from one-time sales of assets. Generally a struggling company’s OPS will turn positive or negative before its EPS, giving a signal of a possible turnaround or deterioration. StockDiagnostics’ OPS Ratings are computer generated and range from 1 through 8, the lower the number the better. Each week, StockDiagnostics publishes a list of companies that have experienced significant (positive and negative) OPS changes. Two are found below.

TECH STOCK WIPEOUT?

Steve Hochberg, chief market analyst for Elliott Wave International, thinks the market might be weakening. His evidence? A bearish Elliott Wave pattern unfolding in the Technology Select SPDR Exchange-Traded Fund. According to Hochberg, it looks like this tech sector ETF is out of sync with the overall market, something that is particularly worrying because many of the stocks held in this fund are companies that lead the rest of the overall market. Hochberg’s worry is based on what technicians call a “non-confirmation”. XLK recorded a high a month ago, on Jan. 20, at $22.24, but as the Dow and the S&P were making new recovery highs on Jan. 26 and Feb. 11, XLK failed to push above its January peak. Hochberg thinks that this non-confirmation is evidence that the overall market’s uptrend is running out of steam. His Elliott Wave analysis of XLK (see chart) indicates that the fund’s next move could be to the downside.

A LOOK AT HEDGE FUNDS

As investment banking bonuses hit employees’ bank accounts, the managements of some of the City’s biggest firms are experiencing a frisson of nervousness. For a worrying trend is developing -- top traders earning millions of pounds are deserting their desks to set up their own hedge funds with the potential to make squillions. This trend is partly about lifestyle -- a chance to run your own show and escape the bureaucracy and politics of a large organization -- and partly about money. Why share the fruits of your labor with your employer when you are the one bringing home the bacon?

There is no legal definition of a hedge fund. The key characteristics of such a fund are that the manager can go “short” (sell something he does not own) and borrow money to “leverage” or enhance returns. Hedge funds are usually unregulated, offshore vehicles (domiciled in the Cayman Islands or Bermuda, for example) which charge hefty fees -- annual management fees may be 1.5%, but performance fees, earned if returns are above a certain threshold, can typically be 20%. Hedge funds promise “absolute returns”, unlike unit trusts or mutual funds which measure their returns against an index.

A mysterious veil shrouds hedge funds. Managers generally refuse to talk to the press. “They are terrified of scrutiny and the possibility of further regulation. It’s sort of a self-fulfilling prophecy of paranoia,” one proprietary trader says. And the best hedge funds do not need the publicity. “There are simply too many assets chasing too few competent managers,” says one banker. The CSFB/Tremont Hedge Fund Index (which claims to be a reasonable proxy for the market’s performance) rose by 15% in 2003, though this was rather less than the 26% increase in the S&P 500 index. However, average is a meaningless concept in this secretive world where essentially one backs a specific manager and annual returns can be over 50%.

Outside the US, investors are still predominantly private clients. However, in the past two to three years there has been a significant move by pension funds and insurance companies into hedge funds. Some are less than sanguine about the trend: they see the headlong rush into hedge funds as a “sell” signal for the sector.

OLD MONEY AND NEW

As F. Scott Fitzgerald noted in The Great Gatsby the rich are different from the rest of us. In fact not only are the rich different from the rest of us, the rich are different from one generation to the next. In the past, “old money” meant living modestly. Flashiness was considered outré, a kind of vulgar, tasteless expression of wealth. Truly rich people would not be caught dead in a red Cadillac convertible. Such manifestations of consumption were in the province of the “arriviste” or what might be called “new money.” While “old money” hid behind modest, dark cars and plain A-line dresses, “new money” was bedecked in jewels and décolletage. Of course, there were exceptions to this generation, but those were rare indeed.

At the risk of another generalization, old money attitudes have evanesced, interred along with humility. What characterizes wealth at the moment is excess. Despite all the revelations about the rich and famous who have looted their companies and taken from their shareholders, I believe that most corporate leaders are law abiding. But I also believe many wealthy people exhibit an unrestrained desire for excess decidedly different from their wealthy forbears.

Gone are the days when a wealthy elite realized it was supposed to be the model of propriety. Rich folks were expected to set a standard that might be emulated and possibly striven for. Admittedly the mediating institutions in society that served as moderating influences have been knocked down like bowling pins. Rather than mom and dad, television land produces standards. Teachers no longer educate youngsters to walk humbly in the face of God. For one thing they cannot speak of God and, for another, trash talking has replaced civility.

Of course, the rich are as free to spend their resources as anyone else. But there was a time when wealth came with responsibility. Wealth was presumably a reflection of manifest principles: hard work, sobriety, dedication, thrift. Now one gets rich with paper transactions. Most wealth is not generated from sweat and hard work. The very rich are intoxicated with their good fortune. This condition invariably results in self absorption and arrogance, the belief that one possesses unique characteristics that others do not have. Is it any wonder the Donald Trump is now tutoring the nation on business practices? It is fair to say the very wealthy -- in most instances -- have lost their bearings.

FINANCIAL RECKONING DAY: SURVIVING THE SOFT DEPRESSION OF THE 21ST CENTURY REVIEWED

Financial Reckoning Day shows, in gritty detail, the fallacy underlying all the economists’ mathematical models of markets and economies. Like all of human behavior, predicting the economic future from the recent past is dubious at best; human behavior is exceedingly complex, and the models break down somewhere in the transition from individual choice to aggregate results. As such, this is really more a book about what *not* to do to help yourself survive an economic downturn. Do not rely on today’s media darlings, do not expect to outplay the market, and do not rely on pension funds or other schemes that are subject to government meddling are some of the implicit bits of advice Bonner and Wiggin offer. The explicit advice is rather more scarce, but Financial Reckoning Day is not less valuable for that.

INTO SPACE! PRIVATELY

President Bush has proposed the U.S. set up a permanent base on the moon, and start making plans for a manned mission to Mars in a decade. One’s first reaction -- certainly mine -- is that it is way past time for humanity to get off the insignificant little rock called Earth, and spread out. I love the idea of space colonization. And the sooner the better.

But, regrettably, the proposition is not that simple. With the U.S. government running reported deficits in the $500 billion range, it cannot afford it. It is insane to borrow even more money to finance something you cannot afford, and arguably do not need, no matter how desirable it may be.

A bigger objection, in my view, is that it is a government project. That means it boils down to a welfare scheme for NASA, which has devolved into a bloated bureaucracy -- a government agency that builds rockets about as cost-benefit efficiently as the Post Office delivers the mail. And, inevitably, the project will be part of the military budget in disguise. What do I suggest? First, there is nothing the government can do that entrepreneurs cannot do at one-tenth the cost, and 10 times the speed. Space exploration should be, and could be, entirely a private effort.

Space industry shows interest in Isle of Man following tax break announcement.

“I cannot stress enough the positive impact this news has had within the space industry, promoting the Island’s good name and potential as a business jurisdiction,” observed Manx-born Chris Stott, the chief executive of Houston-based ManSat. “With this news the Isle of Man Government has taken a truly forward-looking approach to winning business for the Island.”

The new tax break, announced by Treasury Minister Alan Bell in the recent budget will encompass the “manufacture, operation, sale or other activities provided in respect of launch vehicles, satellites or similar assets, including those educational and other training activities that are directly associated with the industry.”

The jurisdiction currently has a zero tax regime in place for a number of industries, including shipping, insurance and fund management, and plans to move towards a zero tax rate for all businesses by 2006.

THE PERILS OF TANZI FINANCE

Special purpose vehicles which concealed liabilities from investors, asset-backed securities collateralized with fake invoices, bank loans rendered safe with credit default insurance, and a myriad of finance company subsidiaries registered in off-shore tax havens. These are just some of the innovative ways that banks found of channeling funds to Parmalat, the bankrupt Italian food company. It might be apt to refer to such practices as “Tanzi finance” in honor of the Parmalat’s imprisoned founder. After all, Calisto Tanzi’s financial arrangements conform very closely to the model of Ponzi finance, which is named after another Italian swindler.

In the United States, a “Ponzi scheme” is synonymous with a chain-letter or pyramid scheme. A stock market bubble, for instance, is a type of Ponzi scheme. Ponzi finance, on the other hand, is a more sophisticated concept. It forms a central part of the “financial instability hypothesis” of the late American economist, Hyman Minsky. Minsky saw the economy as comprised of individual companies and households, each of which had a balance sheet. Liabilities entailed future cash outflows which were matched by future cash inflows. “Ponzi finance”, according to Minsky, describes the situation when a company is unable to cover either its interest or principal repayments from current cashflow. Like Tanzi’s Parmalat, the Ponzi finance firm must continue to raise fresh funds in order to cover its financing deficit.

At first sight, Parmalat appears a classic case of Ponzi finance. Driven by their quest for profit, the investment banks found innovative ways to channel more and more debt to the stricken food company. The firm’s lackluster operating companies were unable to bear such an enormous burden of debt. Fraud, and eventually bankruptcy, followed from this. In Minsky’s view the painful consequences of excessive Ponzi finance can always be averted by the prompt actions the authorities. If an economy were to become dominated by Tanzi finance, on the other hand, there would be too much debt and too much corruption to deal with. It would, quite simply, be beyond salvation.

Parmalat USA files for bankruptcy protection.

Inspectors from the US SEC joined Italian investigating magistrates and are expected to focus on the work done by US banks for Parmalat, in particular their role in bond issues and private placements in the US. The inspectors might also look at possible shortcomings by other financial advisers and US credit rating agencies.

Meanwhile, Parmalat USA filed for Chapter 11 bankruptcy protection in New York. In its filing it claimed to have assets of $414 million and liabilities of $316 million. GE Capital, which has agreed to provide a $35 million loan to the US subsidiary, is understood to have pushed for it to be placed in Chapter 11 before going ahead with the funding. The move also makes it easier for Parmalat’s government-appointed administrator, Enrico Bondi, to keep control over the US assets while he considers his options for Parmalat’s various businesses.

THE CURE IS THE KILLER -- AN ECONOMIC CHECK-UP

Getting a diagnosis on the health of the economy from Alan Greenspan or Wall Street is like asking the Tsetse-fly how your malaria is. Greenspan’s actions and Wall Street’s schemes are the diseases that sickened the economy. They are not going to be the best sources for an unbiased analysis on its health. Greenspan’s easy money policy is responsible for the huge debt levels, declining Dollar and growing trade deficit. His prescription for keeping the economy going is more of the same. In other words, keep the drunk drinking and you can prevent a hangover. It is effective for only so long. The economy got drunk on easy money. More of it does not cure the problem

Below are the results of a recent check-up on the economy. It would seem the patient is much sicker today than 4 years ago. Measured by the P/E ratio, the stock market is still as overvalued as it was when it peaked in 2000.

Greenspan will say that all of this shows an increased confidence in the US recovery. People are borrowing more money and foreigners are selling their stuff over here. They must be confident about the future. No Mr. Greenspan, your strategy is comparable to feeding double banana splits to dieters. They are going to love the plan, but they will be worse off because of it. Adding all of the symptoms together, increased debt levels, poor earnings, a weak recovery, a ballooning trade deficit and declining Dollar and you get unhealthy fundamentals. Add on top of that a market that is as overvalued as it was in 2000 and you get an investment environment that is actually riskier today than 4 years ago. The only conclusion is that we are going to have to go through it all over again, and this time it may be much worse.

Greenspan’s Black Magic

In Greenspan’s eyes, the Fed’s aggressive expansion of the money supply and suppression of interest rates have strengthened the financial condition of American households and industries. If this is true, however, our nation’s “prosperity” is merely a temporary illusion based on smoke and mirrors. True wealth cannot be created simply by printing money; families and businesses cannot prosper by getting deeper in debt. Economist Frank Shostak of the Ludwig von Mises Institute cites statistics showing that American families have never been deeper in debt, never saved so little, and never consumed so much more than they produce. By any objective standard, U.S. families are treading on very shaky economic ground. Mr. Shostak also demonstrates that American businesses are not doing much better.

Debt is the fundamental problem the central planners at the Fed will not address. The total U.S. federal debt is more than $7 trillion, and government spending as a percentage of gross domestic product has never been higher except during World War II. Mr. Greenspan’s attempts to stimulate economic growth by printing money becomes more and more tenuous: today the Fed must create nearly $7 of new debt in the form of new fiat currency to generate only $1 of new GDP. Twenty years ago the figure was less than $1.50. Clearly this is a race that has run its course.

THE TRUTH ABOUT OFFSHORING

Economic reality frequently makes for poor politics. That is what N. Gregory Mankiw, chairman of President Bush’s Council of Economic Advisers, recently found out when he inadvisably spoke the truth: Free trade is good for America. Mankiw was restating for the 21st century the economic law of comparative advantage, which essentially says that nations should play to their strengths. No serious economist would disagree. But Mankiw soon learned a lesson: Better to cloak what you say in fuddy-duddy academic argot than to be clear and controversial.

Soon a typical Washington tempest began swirling. Democrats seized on Mankiw’s remarks as a way to paint Bush’s advisers as out of touch, especially when jobs in America’s information technology industry are seen as vulnerable to offshore outsourcing in China and India. Presidential candidate John Kerry railed against “Benedict Arnold CEOs” who are “shipping American jobs overseas.” Remarks likening CEOs to traitors may play well in the primaries, but how close are they to the realities of technology companies that must compete globally? Consider what would happen if Congress restricted companies from shifting jobs overseas.

ENTREPRENEURSHIP PROPERLY UNDERSTOOD

There exists a widespread hostility within society to entrepreneurs and entrepreneurship. This is due, to a certain degree, to envy on the part of those who are less competent, less visionary, less creative, and less successful than others. Attacks on such great enterprises tend to come from less efficient and envious rivals who attempt to achieve through the political process what they failed to accomplish in the marketplace. Envy is an egalitarian outcry against the claimed metaphysical injustice of the existence of individual differences in abilities, accomplishments, and monetary outcomes.

Perhaps the envious will be less likely to disparage the wealth creator once they have learned: 1) the true nature of the entrepreneur’s work; 2) the fact that there is no fixed quantity of economic benefits; 3) that the entrepreneur does not profit at the expense of his customers; 4) that the larger the entrepreneur’s profit, the better off individuals in society must be; 5) that the existence of differences in human talents is neither just nor unjust -- it just is; 6) that individuals possess the free will to use or not use the abilities that nature has endowed them with; 7) that economic equality is incompatible with nature; and 8) that each person should be allowed to use his aptitudes to their fullest in the pursuit of his conception of happiness.

THE STUBBORN TRADE DEFICIT

The dollar is falling, and has been for almost two years. But the trade deficit, instead of narrowing, continues to widen. What’s going on? One of the things a falling dollar is supposed to do is drive up the price of imports, thus presumably slowing down their purchase. Further, it should make American exports cheaper for the world to buy, which should increase demand for those exports. The combination is thus supposed to help solve the massive balance of trade deficit we currently have.

There is, of course, a lag time between the currency dropping and the balance of trade being affected. Now it has been almost two years since the dollar began its slide. And what has been the result? Record deficits with record high imports. So what gives?? Deflationary forces. We are importing more “stuff”, but we are paying less for it. This is not how currency devaluation is supposed to work. But are we not seeing inflation in commodity prices? The answer is of course yes. But it is evidently not translating itself into higher product prices, at least not yet. Yet it is hurting producers outside of the U.S., who are finding they cannot pass along higher prices. Witness Korea, who this week announced it is shifting part of its foreign reserves to buy commodities, and are clearly intent on helping their manufacturing sector by taking up the shock of higher metal prices. China, as well, is beginning to invest part of their reserves in commodities.

There are serious deflationary forces at work in the world at large. There is an imbalance in world trade, as the U.S. has accounted for 96% of the growth in world trade for the last few years (source: Morgan Stanley). Thus, foreign nations have to be willing to either not take depreciating U.S. dollars and suffer the inevitable slowdown in their economies, or take less for their products in order to be able to keep their work forces producing and economies bumping along. Certain preeminent economists see no immediate problem with this scenario. But as we review the facts and the lessons of theory, a dollar crisis appears to be a real possibility. As all the necessary conditions for this catastrophe are in place, no investor can afford to ignore risks of this magnitude. This is clearly an unsustainable trend. That does not mean it ends tomorrow, but it will not last for long.

China is the linchpin. When they allow their currency to rise, assuming it does, the rest of Asia goes along with them. There should be no illusion about this fact: we are no longer in control of our currency. We are subject to the tender self-interested mercies of the world, and especially China and Japan.

VINDICATION FOR THE FED? (WELL, NO)

Manifestly, there is general overwhelming optimism about the U.S. economy. More and more economic news-beating expectations seem to have carried away many people. Late in 2003, there was even widespread talk that strong economic growth in the New Year would soon force the Fed to start pre-empting inflation by tightening monetary policy. It did not carry us away. Much of what we read and hear reminds us of a book by Paul Krugman, published in 1990: The Age of Diminished Expectations. The main subject of the book was the observation that “relative to what everybody had expected twenty years ago, our economy has done terribly.”

It seems to us that in particular, there is a general perception that the anti-recession policies pursued by the government and the Federal Reserve during the last few years have been a great success. In the first place, we reject the general perception of America’s “exceptionally mild recession”. GDP numbers are an abstract statistical aggregate. What truly counts for people is what happens to their employment and their income. By these two measures, the U.S. economy is experiencing its longest and deepest recession since the Great Depression of the 1930s.

The U.S. economy’s growth pattern since the early 1980s has become increasingly geared toward consumption. Its share of GDP during these years has steadily risen from barely 63% to recently 70%. For most other industrialized countries this share is between 50-60% of their GDP. Since end-2000, the U.S. recession’s start, consumer spending has accounted for 101.6% of real GDP growth. To us, an economy in which consumption has been taking a steeply rising share of GDP for years is in essence an economy ravaging its savings and investments, both being normally the key source of productivity growth.

As we have repeatedly pointed out, the U.S. economy’s superior growth performance during the past few years, measured after inflation, had its source largely, though not solely, in the application of lower inflation rates. For the United States, the price deflator for GDP in the third quarter of 2003 since end-2000 had risen a mere 5.8%, as against a reported 7.5% for the eurozone. Considering the U.S. economy’s parabolic credit excesses, the relationship between inflation rates should be the opposite. But pressured by politicians and in particular by Mr. Greenspan to produce the lowest possible inflation rates, America’s government statisticians have worked hard to comply, in particular by counting quality improvements as price reductions. Understating inflation rates, in turn, overstates real GDP.

THE LATEST FAD TO COME OUT OF THE “GOLDEN STATE”: ACUTE FINANCIAL PAIN

California must find a way to pay its $14 billion debt by June 16th or declare bankruptcy. Last Monday (Feb. 16), California Gov. Arnold Schwarzenegger proposed a $15 billion bailout bond (Proposition 57) to resolve the I.O.U. If approved by voters, this will be the first time in history that California secured a long-term loan to pay for a budget deficit. But the alternative, as Gov. Schwarzenegger warns, is nothing short of “Armageddon” spending cuts. Sounds like the story line to another Terminator sequel: T4: Tight Fists Of Steel.

But Hollywood is one thing, state budgets another -- and as the new Elliott Wave Theorist writes, the east coast has already caught up with the west coast trend toward economic crisis. We are not talking sleepy hamlets in South Dakota here; we mean the biggest local governments in the Big Apple.

HIDDEN DEFENSE COSTS ADD UP TO DOUBLE TROUBLE

To measure actual spending by the United States on defense, take the federal budget number for the Pentagon and double it. That is the rule of thumb advocated by economic historian Robert Higgs, editor of the Independent Institute’s Quarterly Review. Early this month, President Bush requested $401.7 billion for the Department of Defense (DoD) for fiscal 2005. So doubling that would make total defense/security spending close to $800 billion out of a total federal budget of $2.4 trillion.

An oft-noted omission from the DoD’s 2005 budget is the extra costs for activities in Afghanistan and Iraq. The unwillingness of the Bush administration to ask Congress for extra money for Iraq will have “real consequences”, says Winslow Wheeler, a visiting fellow at the Center for Defense Information. To cover additional costs, DoD will “raid” its operations and maintenance accounts. He says that will mean less training for troops and poorer maintenance of military equipment. Some troops in Iraq lack sufficient body armor and equipment needed to storm buildings, says Mr. Hellman. Soldiers have also reportedly asked families to buy expensive night-vision goggles for them. Mr. Wheeler terms the Higgs numbers “a legitimate exercise to calculate all conceivable costs of national security.”

At the moment, Petter Stålenheim at the Stockholm International Peace Research Institute figures the US will account for between 45 and 50 percent of the world’s military spending in 2003. But Democrats are not likely to push for cuts in an election year when polls indicate the public perceives Republicans as stronger than Democrats on defense issues.

GREENSPAN: MORTGAGE DEBT POSES THREAT

Greenspan lent his influential voice to calls for reforms in the operations of the two government-chartered companies which dominate the multitrillion-dollar mortgage industry. Speaking to the Senate Banking Committee on Tuesday, Greenspan said he supports creation of a tough new government regulatory agency to supervise the two corporations, saying the new regulator should have similar powers to federal banking regulators, including the authority to set minimum capital standards. Fannie Mae and Freddie Mac have grown into two of the biggest financial companies in the world. They stand behind $4 trillion in home mortgages, or more than three-fourths of the single-family mortgages in the United States

Greenspan said the problem facing Congress was the fact that investors widely believe that if either Freddie or Fannie, as they are popularly known, got into financial trouble, the government would bail them out even though the bonds issued by the corporations say they are not backed by the federal government, and that this perceived guarantee allows the two corporations to raise money at lower interest rates than their financial competitors.

The two companies say their lower cost of funds is passed on as a benefit to home buyers in the form of lower mortgage rates, but Greenspan pointed to a Fed study that this subsidy had lowered mortgage costs on average by a tiny 0.07% with most of the billions of dollars in savings going instead to the corporations and their shareholders.

ARE POOR COUNTRIES BETTER OFF WITHOUT BANKS?

Good banks can be a major force for economic growth. They can transfer the public’s savings to those businesses that need capital for productive investments. Unfortunately, many banks in poor countries have turned out to be pyramid schemes in which most of their loans are bad (non-performing) and the banks are insolvent. However, as long as deposits are growing, they can use new deposits to pay the interest on the old and thus remain liquid. Such banks can continue to operate sometimes for decades until something causes new deposits to decline such as a macro-economic shock. The result is a banking crisis.

Is there a solution to these widespread problems? Experts from the rich countries argue that governments everywhere must regulate banks to ensure that they are properly managed and introduce deposit insurance to ensure bank stability. Ironically, this approach has not worked particularly well in the rich countries, even though they presumably have more honest and capable regulators than in poor countries.

There is an alternative. New Zealand’s unique system of bank regulation is a solid model for poor countries. The first step is privatization because politicians will use state-owned banks for political purposes such as subsidizing unprofitable state-owned enterprises or to enrich themselves and their cronies. Second, foreign banks should be allowed to enter the local market. If depositors do not trust domestic banks, they at least have the option of switching to reputable foreign banks. Third, bank deposits should be regulated like any other financial security primarily through information disclosure. Fourth, and most importantly, bank deposits like stocks and bonds should not be insured by the government. As with other investments, “depositors beware”. The formal banking system may decline in size, but this is far better than allowing pyramid schemes to squander the public’s savings. Bad banks are worse than no banks.

A TRILLION HERE, A TRILLION THERE ...

“We have a lot of senators in there that have been elected on nothing but a slogan. But what have they cost us after they got in? You take a fellow that has never juggled with real jack [money], and he doesn’t know the value of it; a billion and a million sound so much alike that he thinks all the difference is just in the spelling.” ~ Will Rogers

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“.. [T]he world is full of people who ... [know] nothing of millions but [are] well accustomed to think in thousands, and it is of these that finance committees are mostly comprised. The result is a phenomenon that has often been observed but never yet investigated. It might be termed the Law of Triviality. Briefly stated, it means that the time spent on any item of the agenda will be in inverse proportion to the sum involved.” ~ C. Northcote Parkinson, in Parkinson’s Law

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People argue in a committee over whether or not to spend an extra $5,000, but they vote to spend a million without much debate. That is because they understand $5,000. They do not understand a million. Earlier this month, the U.S. government’s official debt topped $7 trillion for the first time. The last time the official debt rolled over a trillion dollar limit was June 28, 2002. Not so long ago, really. You could say that we’re on a roll. Thirty years ago, Senator Everett Dirksen uttered his famous words about the U.S. government’s spending: “A billion here, a billion there, and pretty soon you’re talking big money.” Well, he should have said it. There is no record that he ever did say it. Too bad.

What is a billion? A billion seconds takes us back 31 years, to 1973: Richard Nixon’s first full year of Watergate revelations. A billion minutes takes us back to 101 A.D., over two decades before the Emperor Hadrian began building the wall across England to keep out the Scots, when the Roman Empire was at its peak of power. A billion dollars of U.S. government spending takes us back a little over 3 hours and 40 minutes. A trillion is 1,000 billions. Take all of the previous examples, and add three zeroes. We don’t understand this. We can pretend that we do, but we do not. Compared to the size of the unfunded liability of Social Security and Medicare, $7 trillion does not sound so bad, because the unfunded liabilities of Social Security and Medicare are now in the range of $50 trillion.

There are still a few holdouts who predict deflation. There are not many. They have been predicting deflation for two or more decades. They have been wrong for two or more decades. Those who predict outright deflation have not dealt with the reality of FED policy over the last two years. Those who predict deflation go on and on about commercial banks not being willing to lend money that is made available by the FED. This is utter nonsense, unless interest rates go negative. Banks make money by lending. They may lend only to the government, but they do lend. If they lend to the government, the government spends the money. Of that, you may be certain. Under normal times, the FED inflates mildly. But with a $50 trillion off-budget liability looming when retired workers go onto Social Security/Medicare, times will not remain normal. Normal times will be budget crisis times.

Bush has yet to veto a bill. The spending goes up and up. A trillion here, a trillion there, and pretty soon you’re talking debauched money. For old-timers who can still recall Oklahoma, let me remind you of the song, “I’m just a girl who can’t say no. I’m in a terrible fix.” Congress does not care enough to say no. The President does not care enough. The voters do not care enough. So, the majority says yes.

I have never been a big fan of technical indicators. But I have just been sent one that impresses me. I had not seen it before. I had not even considered it before. Like all e-mail users, you have received many versions of the letter from M’Bongo M’Bungo, the former treasurer of Nigeria -- or was it Liberia? He sent you and 30 million others a highly confidential letter. It seems he has a pile of money, but he needs your help to get it into a bank outside of Nigeria -- or was it Liberia? Now, however, the offer is different. He does not have a pile of money. He got the pile of money from a pile of gold dust. For years, gold got no respect. It is a sign of the changing times when the M’Bongo M’Gumbo letter changes the boodle from dollars to gold dust. If this offer continues, we will know that the dollar is heading for even more trouble.

IBM MAKES SURE OPTIONS GRANTS GIVE THE RIGHT INCENTIVES TO EXECS

IBM has changed the procedure for granting options to top executives. Option shares will now have a strike price 10% above the market price. So if the execs want their shares to be worth anything, the share price has to rise at least 10%. At the same time, the executives will have the opportunity to get market-priced options, but only if they invest their own money in an equal number of shares and hold onto them for three years.

CEO’S DONE WITH “COST CUTTING”, NOW FOCUSING ON “REVENUE GENERATION”

So says a new study from IBM that is being used to suggest that the economy is coming back. One silly question: Why can’t both elements of the profit and loss statement be given simultaneous priority?

WHY IS SO MUCH MONEY POURING INTO MUTUAL FUNDS?

According to Strategic Insight, a research firm, a net $60 billion flowed into equity and hybrid funds in January alone, on top of the $233 billion that investors popped into such funds last year. Strategic Insight estimates that this month the amount of money managed by mutual funds of all descriptions will top $8 trillion. “Without a doubt, mutual funds continue to be the preferred vehicle through which America invests,” says Avi Nachmany in the firm’s press release. “Faith in the mutual-fund industry remains extraordinary,” he suggests, notwithstanding recent scandals.

The proverbial wall of money, as well as being a sign of confidence in the stockmarket, is used by many as an argument for why it will climb higher. This argument seems flawed. If demand for a product is insanely high, then supply will eventually rise to meet it. And, points out Charles Biderman, founder of Trim Tabs, another research firm, the supply of equity is not so much rising as soaring. Mr. Biderman has a refreshingly harsh view of one reason why this might be so, involving the economics of investment banking: “If you’re paid 4% to 7% to sell new shares and one-tenth of 1% for trading them, what do you think you would want to sell?” The supply of shares from firms’ managers anxious to cash in their chips has also risen, to $600-800 million a day. And stock buy-backs from firms wanting something to do with their spare cash have tailed off sharply. “The new bubble is going to end up like the old bubble,” says Mr Biderman.

Whether the present, apparently insatiable, appetite for equities should be classified as a bubble is a moot point. What is certainly true is that Americans need to invest in apparently turbo-charged assets because they save so little. That investors’ appetite for risk is very high by historical standards is not in doubt at a time when valuations are already stretched, to put it mildly. Flows follow returns, and investors generally pull their money out of markets that are and have been falling and put them into those that are going up. This means that they sell assets when they are cheap and buy them when they are more expensive. The huge flow into mutual funds specializing in junk bonds started last year only after that market had enjoyed much of the year’s 28% rise. When the market was at its cheapest, in October 2002, investors were pulling their money out.

The same has been true for equity funds. Inflows into equity mutual funds last month were even higher than the previous record of $56 billion, set in February 2000. Those with longer memories than a goldfish might recollect that the stockmarket peaked a month after that first record was set, and fell with a series of sickening thuds for another two-and-a-half years. The worst of times, as it were, swiftly followed the best of times.

THE FEDERAL RESERVE’S POLICY: PUNISH SAVERS AND ROB THE RETIRED

Before the Alan Greenspan model of economic growth which relies on creating rising asset prices in stocks, bonds and housing to fuel spending, our economy ran on a traditional and conservative model. The old model relied on paying savers a real rate of return to forgo consumption so that precious capital could be made available for investment. The new model punishes savers and guarantees they will receive a rate of interest far below the inflation rate on cash, bonds or stocks. This rate of interest does not adequately compensate savers for the risk of default or loss. Moreover, capital will be provided for investment but not through recycling savings. Instead, capital will be provided by creating new money and credit. This creation of new money and credit defines inflation and favors debtors over creditors.

A major part of the new Fed economic model is designed to use savings to subsidize corporate profits. Psychologically, high stock prices make people feel so successful that they don’t feel the need to save when so much wealth is freely created by just owning stocks. Currently, 30% of the valuation of the S&P 500 is dominated by finance companies, and another 10% of corporate profits are related to financing activities.

So, in today’s world of leveraged finance, 40% of corporate profits are created by making sure savers only get 0.5% on their Money Market accounts and then get to borrow their own money back to mortgage their house or finance their credit card balance. Getting 0.5% on your bank balance, paying 4%-6% on a mortgage and 12%-18% on a credit card, is great for bank profits! Worse yet, at least another 15% - 20% of the increase in corporate profits come from the falling dollar. Any American traveling to Europe and elsewhere abroad this spring and summer will notice how savers are being punished!

It is no surprise, then, that savers and retirees on fixed incomes are in a world of pain. Savers and retirees are being punished so that Fannie Mae can make record profits. Moreover, principals at major Wall Street firms and hedge funds using leveraged finance as their business model, can once again trade up on their mansions in the Hamptons this summer.

GREENSPAN’S REAL LEGACY

The easy credit policy the Fed followed in the 1990’s led to the famous stock market bubble. The Fed spurred investment in the tech sector, malinvestments, through artificially low interest rates. In 1999, someone who could find the power switch on a PC could find employment and if you had highly desirable skills you could practically name your price. Software, hardware, telecom, you name it; it was a boom time for employment. The NASDAQ peaked at 5000 in March of 2000. Over the next couple years, the NASDAQ lost 75% of its value, easy credit policy and all. The malinvestment bubble had ended and with it the jobs it created. As basic economic theory would predict, employment and wages have been falling ever since. Compuware, a Michigan based tech firm, recently cut the wages for their employees not already laid-off 10%. It is tough out there.

This is the legacy of the Federal Reserve. The Fed creates malinvestment not only in private business investment, but they also create skill malinvestments and misallocations in the labor market. We now have large numbers of highly trained tech workers who can not find jobs or are doing low skill jobs not in their field. Lives have been turned upside down and families have had to declare bankruptcy as a result of the false dynamics created by the Fed. Even the Indians are going home since they can not find employment. In Bangalore, you can at least find a job even if the wages are lower.

INFLATION EVERYWHERE BUT IN THE STATISTICS

It is high time to realize that even in the world of Fed pointy-headed, Keynesian fiction, what the FOMC members seem to feel are “needed” higher prices are, in fact, showing up almost everywhere one looks -- except in the official data, naturally.

The Journal of Commerce index has risen 49% annualized since last Spring -- the fastest ever such rise. Steel prices, touched on above, are up perhaps 160% by some measures from recent lows while Aluminium is 50% above its 2002 nadir, Copper 120% and Tin 88% higher than their 2001 bottom -- all of these three standing at 8½-year highs. Lead is at a 17-year high, having doubled in 4 months. Nickel had more than quadrupled at its January peak, but is still 3½ times its base -- the best in at least 13 years. Zinc is up 50% to a 3½-year best.

Gold has fallen back a touch from a 60% rise -- a 14-year high; for Platinum, the numbers are 115% and the best in at least a quarter of a century; Silver is up by more than half to its best in 6 years; even Palladium is 60% off last year’s 7-year trough. Lumber has soared 93% in 9 months to break an 8-year trendline and to hit its best in 4½ years; Plywood is up 133% to 19-year peaks. Down on the farm, Cotton had lately tripled to an 8-year high -- its subsequent moderation still leaves it at twice 2002 levels. Coffee is up 50% in that same time.

Apologists have some merit in their protests that many of these price rises have been exacerbated by being reckoned in falling dollars, but remember that the Greenback has “only” lost around 25% of its trade-weighted value in the same period -- a drop which comprises a small fraction of the gains in these diverse and fundamentally disparate commodity prices. Besides, how else should we correctly define “inflation” other than as a perceived surfeit of money compared to all the other goods (and the other kinds of money) into which it thus becomes ever more eagerly exchanged?

THE BIGGEST DOMINO CHAIN IN THE WORLD

In the mid-1980’s, a man who was billed as the builder of the world’s longest domino chains proposed to build one with 8,000 dominoes. One of the T.V. networks sent a crew out to film the great domino effect. The man had been working on the project for days when the T.V. crew arrived. They wanted several overhead shots. The chain was almost finished when one crewman climbed overhead to set up his camera. A pen fell out of his pocket. You can guess the rest. The crew and the builder watched in impotent horror as several days’ work toppled, domino by domino. “Sorry,” said the crewman. The world’s longest domino chain was postponed.

The biggest domino chain in the world has been under construction for over three hundred years. It is called the international banking system. Every century or thereabouts it collapses, and the builders painstakingly set it up again. It is always larger than the last time, with the dominoes spreading out into every nook and cranny of the building. It winds around, reconnects, trails out in seemingly incoherent patterns. Several teams have worked on it in isolation. There is no master blueprint. The teams yell at each other once in a while, warning the others about how shaky the whole system seems to be, but everyone keeps building.

Some unforeseen event could set the process off by “dropping your pen” on any part of it. If this happens, nobody can tell you if the whole chain will collapse or if isolated mini-chains will survive because they are not connected to the main chain. It came close to taking place in the summer of 1998, with the failure and banking bail-out of Long Term Capital Management, a previously unknown investment company. Consider some hypothetical situations ...

GREENSPAN URGES SOCIAL SECURITY CUTS FOR BOOMERS

Stepping into the politically charged debate over Social Security, he said the country cannot afford the benefits currently promised to the baby boom generation. He urged Congress to trim those benefits to get control of soaring budget deficits, which he said threatened a “very debilitating” rise in interest rates in coming years. Democratic presidential candidates denounced his proposals, and President Bush and other Republicans sought to distance themselves from the Republican Greenspan.

Greenspan, who turns 78 next week, also suggested tying the retirement age for full benefits to longer lifespans with the age continuing to rise. The 65-year age for retiring at full benefits started increasing last year and now stands at 65 years and four months. It will increase to 67 over the next two decades and then stop rising. Greenspan said his comments simply voiced views he has held since he chaired a blue-ribbon commission two decades ago. But the remarks set off a political storm.

THE FED AND THE ELECTION

The market’s anxiety about the inevitable cyclical upturn of interest rates has little to do with economics. Investors know interest rates cannot remain this low forever and that they will rise only in a rising economy. Whatever the timing, we all know the Fed will let rates rise only if and when the economy is expanding at a decent clip. Higher interest rates will then be the consequence of good economic news, not the cause of bad economic news. So why has the stock market been so hypersensitive to any hint that the Fed may start letting interest rates drift up, even by a quarter point?

The most likely explanation is politics. A widespread assumption is that rising interest rates hurt an incumbent President’s chances of re-election. The election outcome would not matter much were it not for the fact that the leading Democratic contenders have been pushing an agenda far more hostile to investors than Bill Clinton’s “New Democrat” campaign of 1992. Kerry and Edwards threaten even more regulation and litigation expenses for business, protectionist retreat from global competition, grandiose new spending schemes, and abusing the tax and transfer systems to penalize extraordinary effort and entrepreneurship.

Common assumptions about how the Fed affects elections are not necessarily correct, however. Incumbent presidents usually do better when the Fed is pushing rates up than when it is pushing rates down, unless high inflation is involved (1980). This is not as paradoxical as it may sound. Falling interest rates are usually a sign of economic distress, while a reasonable rise in interest rates is a routine side effect of a vigorous economic rebound.

FORBES ANNUAL BILLIONAIRE TALLY RELEASED

Harry Potter author J. K. Rowling and 63 other new faces join the ranks of the wealthiest people on the globe -- link here. Cirque Du Soleil’s Guy Laliberte’s trip from busker to billionaire -- here. Dubai’s crown prince didn’t need oil to build an empire -- link here. Anil Agarwal took advantage of a changing India and made a fortune from scrap metal -- link here. Philip Green’s rise to the top of the British retail ranks has mouths flapping -- link here. Donald Trump takes a gander at billionaire brands -- link here.

BUSH’S BULL MARKET

I said last month that the world stock market should be up 20% in 2004, and I am sticking to the forecast. As I see it there are only two plausible outcomes for stocks this year, either a loss or a very big gain. A loss is very unlikely. So I see a good 20% as the result to bet on. I build bell curves of forecasts by market pros, and then work on the assumption that the end result will be anywhere but the middle of the curve -- because markets have a way of surprising the pros. Not surprising every forecaster, to be sure, just the ones who stick close to the consensus. This year the hump in the curve spans from flat to being up 20%. Expect the market to land outside that range. That means if you agree that we are not going to have a bear market in 2004, you should expect a very good year for equities.

My most controversial forecast may be about currencies. The consensus is that the dollar will suffer a further weakening against a world basket of currencies. I expect the greenback to strengthen by year-end. We may encounter some other surprises this year -- surprises that will combine to help the stock market. One of them is a reduction in the risk of terrorism (the consensus is more or less that we are in for some mass destruction). Another positive surprise: Combined federal and state budget deficits will twist unexpectedly to a more benign total than today’s consensus.

Politics favors a rise in the U.S. stock market. Election years tend to be positive for the stock market. In the history of the S&P 500 Index, which begins in 1926, there have been only three presidential election years that ended down: 1932, 1940, and 2000. When we have Presidents seeking reelection, it is more bullish than years of open races, like 2000 was. I am no fan of George W. Bush, but I predict he will be reelected easily. Even if I am wrong, we still have an election year, and it is still more likely to be a year with a 20%-plus gain than a year of loss.

A “FLIGHT TO GARBAGE”

Low-quality stocks lately outperformed top-quality ones by 55 points. That is the widest gap since the 1999 boom year. Remember what happened after that? So I am very cautious about this year. The market’s dramatic advance has left many stocks too expensive and investor expectations too high. Today’s valuations already reflect the economic recovery as well as good things to come for the next several years. Plus, my contrarian sensitivities are heightened when Wall Street investors are as uniformly optimistic as they are now.

LOOKING AT THE ECONOMY -- IN A DECADE

The Bureau of Labor Statistics has just issued a new report on employment growth over the next decade. Prepared by the agency’s career staff, it has an excellent record of forecasting industry and occupational trends. It contains good news for those seeking jobs -- if they have the right skills.