Finance Digest for Week of February 27, 2006

BERNANKE, LIKE GREENSPAN, WILL NOT GET IN WAY OF ASSET PRICE RISES

Federal Reserve Chairman Ben S. Bernanke, like his predecessor Alan Greenspan, does not plan to get in the way of surging home or stock prices. Bernanke, staking out a key policy in his first month on the job, said yesterday at Princeton University that the central bank “doesn’t really have good instruments for addressing asset price bubbles should they exist, particularly if they are in one particular segment or another.”

Bernanke’s views on dealing with rising asset prices match those of Greenspan, who was faulted by some economists for allowing a stock-price bubble to inflate in the late 1990s and for letting U.S. home prices soar in recent years. Timothy Geithner, vice chairman of the Fed panel that sets the benchmark U.S. rate, said last month the role of asset prices in Fed policy may expand. “It’s generally a bad idea for the Fed to be the arbiter of asset prices,” said Bernanke, 52, who became chairman Feb. 1, succeeding Greenspan, who was in the post for 18½ years. “The Fed doesn’t really have any better information than other people in the market about what the correct value of asset prices is.” Bernanke, a former economics professor at the New Jersey school, said in response to a question after a speech on inflation that the Fed does need to “pay close attention” to changes in the prices of assets because they can affect spending and economic growth, important factors in the Fed’s assessment of the economy.

“To use interest rates to try to puncture the housing bubble would be a disastrously bad idea, and Bernanke obviously agrees, because he’s not going to come close to doing that,” said Alan Blinder, a former Fed vice chairman who is now a Princeton economics professor. He wrote a paper last year saying Greenspan may have been the “greatest central banker” ever. Blinder said the Greenspan-Bernanke approach to bubbles is “basically, you do nothing, and then the corollary to that is that you mop up after they burst to keep the financial system from taking a big fall.” Bernanke’s hands-off approach has “been his position for years, since he was an academic,” Blinder said.

Paul Volcker, who was Fed chairman from 1979 to 1987 and attended the speech, won plaudits for defeating the inflation that plagued the U.S. during the 1970s and early 1980s. Volcker, asked whether Bernanke would benefit from taking office at a time of low inflation, said the new chairman would have to deal with the imbalance in U.S. trade with other countries. The U.S. trade deficit last year was $726 billion. “Bernanke is not inheriting the best of situations,” Volcker said in an interview after Bernanke’s speech. “How would you like to be responsible for an economy that’s dependent upon $700 billion of foreign money every year? I don’t know what I would do about it, but he’s going to have to do something about it sooner or later.”

REWRITING THE SOCIAL CONTRACT

Rick Doty is a 30-year veteran of Caterpillar, the big tractor and earth-moving equipment manufacturer. He is paid $23.51 an hour as a machinist, and he receives additional benefits worth almost as much. That sets him far above newly hired workers consigned to a much lower wage scale. To these fellow workers, Mr. Doty, who is also a local union leader, struggles to justify an inequality that he helped to negotiate. “I remind them they are making more now than they were before they came to Cat,” said Mr. Doty, who spends part of his day at the one-story union hall of United Automobile Workers Local 974 arguing that $12 to $13 an hour is good pay. “And I assure them that five years down the road, when the present contract expires, we in the union are going to improve their lot in life.”

That does not seem likely. After more than a decade of failed strikes and job actions – mainly in Illinois, where Caterpillar has its biggest factories – the U.A.W. reluctantly accepted a two-tier contract that provides for significantly lower wages and benefits for newly hired employees. The new second tier is as much as $20 an hour below the cost of employing Mr. Doty, 50, and a dwindling band of other veterans.

As older workers depart, at Caterpillar and at other companies, the longstanding wage advantage that manufacturing workers enjoy over their counterparts in services or construction is shrinking fast. The trade-off is the promise of a manufacturing revival at long last in the old Rust Belt, as new hires come aboard at much lower labor costs. “What we’ve done is reposition ourselves to actually grow employment in our Midwestern plants,” said Jim Owens, Caterpillar’s chief executive. “We finally have a labor cost that is viable.”

Caterpillar is adding a significant chapter to the labor cost-cutting that is widespread in America, particularly at old-line manufacturing companies. Until recently, cutbacks in the wages and benefits of hourly workers were limited mostly to money-losing companies: failing steel mills, for example, and struggling airlines. They have said that their survival was at stake. Now, however, even healthy and highly profitable companies like Caterpillar are engaging in the practice, and as they do so, the longstanding presumption that factory workers at successful companies can achieve a secure, relatively prosperous middle-class life for themselves and their families is evaporating.

HEDGE FUND’S MONEY IS AWOL

Only about $150,000 of the allegedly $150 million in assets of an Atlanta-based hedge fund has been found by investigators probing allegations of fraud. According to the Wall Street Journal, a bench warrant has been issued for the arrest of Kirk Wright, founder and CEO of Atlanta-based International Management Associates, in hopes of getting his help in the search for the firm’s assets. The paper reports that over the past week, the SEC and a receiver appointed to mind International Management’s assets have scoured the hedge-fund firm’s offices, records and accounts, but found only a fraction of its reported net worth.

Among the clients of the fund to have charged they were defrauded are several current and former professional football players who said they invested more than $15 million with International Management. The paper reports that authorities have spoken with Wright on the phone, but are eager to get more details on the firm and its accounts. During an interview on February 15, he told the Journal he was aware of “no irregularities” in the firm’s operations or accounts, although he acknowledged that no audits of any kind had been done since 2003. He also has claimed that one investor has threatened his life, according to the paper.

Man Group says hedge-fund fraud a U.S. phenomenon.

Hedge-fund fraud has been rife in the U.S. because books are not valued independently and because the industry there until recently was unregulated, London-listed Man Group (EMG.L) told Reuters. Hedge funds in the U.S. now have to sign on with the S.E.C. unless investors agree to tie up their money with the fund for more than 2 years, a loophole some managers have used to avoid registration. But there are still no rules to force hedge funds to get their books valued independently by fund administrators, one of the reasons behind some of the recent collapses in the U.S. Many still value their books themselves.

“It really is more of a North American phenomenon,” Stanley Fink, chief executive of the world’s largest listed hedge fund firm Man Group said in an interview. “Until recently hedge funds were not regulated in the United States and it hasn’t been standard to have (independent) valuations by fund administrators. … The checks and balances weren’t there … There are a number of fraudsters there who simply use hedge fund vehicles … as a method to extract money from their victims and our industry gets tarred with the same brush.”

The U.S. accounts for about 70% of the 8,000 to 10,000 hedge funds estimated to be in existence. Around 25% are based in Britain where managers have for some time had to be registered with the Financial Services Authority. Also, common practice in Europe is to use independent fund administrators. Investors are normally wary of those who do not. “There are no real examples of European or UK blow ups or misvaluations,” Fink said.

REAL ESTATE CONTINUES TO COOL

After five adrenaline-pumping years of real estate sales, 2006 is already fulfilling predictions of a weaker market. Sales of existing homes fell in January for the fifth month in a row, the National Association of Realtors (NAR) said. The same month, new-home sales slid 5%, the government said. Builders are seeing more orders canceled. Meanwhile, the number of homeowners who are late paying their mortgages has been creeping up. Even so, prices are expected to rise about 5% this year despite the cooler market. “January’s weak existing- and new-home sales numbers are the strongest evidence yet that after five remarkable, record-setting years, the housing market is in decline,” says Patrick Newport, the U.S. economist for Global Insight. The drop in home sales defied unseasonably warm weather and cash and give-away incentives from builders that had raised hopes for a brighter showing. “Imagine if the weather had been terrible,” said Phillip Neuhart, economic analyst for Wachovia.

No one needs to tell that to Fran Floyd. She took her Houston townhome off the market after nearly six months – even though she was willing to sell it for $3,400 less than she paid in 2002. “It’s just sad,” said Floyd, 81. “I’ve got to sell. I don’t know what I’m going to do. What I’m thinking about and praying about is renting it for a year, hoping the real estate market gets better.” Unfortunately for her, the NAR projects a 5% decline in existing-home sales this year, to what would still be historically high levels. Home sales have been a huge engine for the economy as buyers spend to refurbish existing homes and sellers spend their proceeds on new homes or consumer goods.

In January, existing-home sales dipped 2.8%, to a seasonally adjusted pace of 6.56 million, down 5.2% from January last year. At the same time, the number of single-family homes for sale rose to the highest since 1986 – and 34% higher than a year ago, according to Insight Economics. That is a sign would-be buyers are not so quick now to take the plunge. “We’ve just got tons of inventory,” and prices are coming down in Grand Rapids, Michigan, said Pat Vredevoogd of AJS Realty. One in five builders said they are seeing more cancellations of new-home orders than they did six months ago, according to the National Association of Home Builders, with 4% saying the problem is significant. To entice home shoppers, many builders are offering free TVs, swimming pools, landscaping and other incentives.

That is good news for buyers, but not for sellers such as Kent Anderson. Kimball Hill, the developer of his Las Vegas community, is now offering home buyers so many incentives – including free granite countertops and stainless steel kitchen appliances – that Anderson had to cut his asking price on the home he bought from Kimball Hill less than a year ago. “As builders close out a community, those last homes are pure profit” for them, says Bruce Hiatt, Anderson’s Realtor. “It really changes the comparable sales in the area.”

One key reason fewer people are buying: They cannot afford to. The median price – half cost more, half less – was unchanged from December at $211,000 but was 11.6% higher than in January 2005. It is clear that some homeowners are having trouble paying their mortgages. The number of homeowners who are 90 days or more behind on their primary mortgages rose to 3.6% in December, up from 3% last March, according to Loan Performance. For subprime borrowers – those with impaired credit who carry higher-interest loans – the number of delinquent loans has jumped to nearly 10%.

Why we are at risk in a housing chill

The fruits of the housing boom have not benefited all alike. The Federal Reserve’s survey of consumer finances for 2001-04 illustrates how divided the economy is between the haves and have-nots – and how vulnerable we are to a cooling housing market. The wealthiest 10% of Americans experienced a 6.5% rise in net worth; the bottom one-fourth of earners actually lost 1.5% of their net worth. As Merrill Lynch aptly put it, “The Fed survey shows that this tide did not lift all boats.” As for paychecks, median income across all strata rose by a measly 1.6% after inflation, a sharp slowdown from about 10% in the prior period surveyed, 1998 to 2001.

Not surprisingly, debt played an integral role in the deep slide. After falling for years, mortgage and other debt as a percentage of total family assets rose to 15% in 2004 from 12%. Moreover, fewer saved in the latest period. The Fed survey found 56% squirreling away acorns for a rainy day, down from 59% three years ago. This week’s report on the savings rate showed that it remains in negative territory, where it has been for seven of the last eight months. Other data confirm that debt’s stress on households is rising. Moody’s reported that for the first time in three years, auto loan delinquencies have started to rise. More telling is that serious delinquencies in the home equity sector are up 32% over the last year. Maybe squeezing into that home with a piggyback loan and buying a second SUV despite being upside down on the trade-in were not good ideas after all.

Such poor judgment calls are common among 35- to 44-year-olds, who experienced the greatest decline in net worth. Those between 55 and 64 saw the most dramatic increase in net worth. We are talking about the people who were already in a home when the boom began and have counted their winnings in the form of fat capital gains. Which brings us to a recent Census Bureau study. In the last four years, the age group that has experienced the most pronounced decline in homeownership rates was those between the ages of – you guessed it – 55 and 64. Could it be that the notion that retirees will keep their homes is fundamentally flawed?

In sum, the wealthiest of Americans are net sellers of homes and have the most wiggle room on their balance sheets. The most-stretched households have the least in the way of give. And those who are selling at the peak and pushing prices downward may be forcing the hands of many who are in no position to give up the roof over their heads.

Consolidation and lay-offs hit mortgage industry.

A major transition is underway in the U.S. mortgage lending industry, with consolidations and lay-offs at the forefront as companies try to deal with waning demand for home loans. This shift is expected to pick up steam in 2006 if the housing market, as widely expected, cools off from its record-breaking 5-year run. “There are some very important signals emerging in that we have seen some pretty good companies go on the block for sale or have been sold recently, which is a clear sign that consolidation is seriously underway,” said Douglas Duncan, chief economist at the Mortgage Bankers Association, an industry trade group.

Countrywide Financial Corp., the largest U.S. mortgage lender, recently announced it plans lay-offs for sometime this year, partly in response to lower profits on sales of mortgages. On its Q4 earnings conference call in late January, the company’s chief executive, Angelo Mozilo, said intense competition should force some smaller lenders out of the market. Employment in the real estate and mortgage industry peaked at 504,000 in October of last year but fell to 501,000 in December, according the Bureau of Labor Statistics. That is a noteworthy shift, given that the sector has been gaining jobs over the past five years. Employment stood at 283,000 in March of 2001. Mortgage rates are expected to continue ratcheting upward from their historic lows, and that will limit lending and refinancing activity, putting more pressure on firms to find new efficiencies, said Duncan.

The U.S. housing market surged for five years, shattering sales and construction records and sending home prices up more than 55% on average nationwide. But now the market has taken on a “survival-of-the-fittest” atmosphere, said Celia Chen, director of housing economics at Moody’s Economy.com, a consulting firm. The MBA’s seasonally adjusted refinancing index, which hit a record level near 10,000 in May of 2003, stood at 1,571.4 for the week ended February 17. While refinancing has been trending lower over the past few years, the drop in volume for home purchase loans has gained substantial momentum in only the past year. According to Duncan, lenders have been holding “slowdown” meetings with their employees, a move he said historically coincides with a turn in employment.

Aspen has not heard U.S. housing bubble may burst.

If the U.S. real-estate bubble is about to burst, no one has told Aspen, a former silver-mining town in Colorado. Aspen is lucky enough to have the altitude, climate and slopes to have transformed itself into one of the world’s ritziest resorts since the first skiers were transported up Aspen Mountain in 1947. Every bar, restaurant and hotel lobby in Aspen is littered with glossy magazines advertising McMansions for chief executive officers, trust-fund kids or lottery winners. Even self-confessed ski-bums are donning chinos to hawk property.

It may be a bit of a stretch to draw conclusions about the outlook for the U.S. housing market from what is happening in Aspen, whose famous residents include Ringo Starr and Jack Nicholson. It is not just about location, location, location, though. Strict planning regulations curbing the growth of the housing stock and the willingness of buyers to load up on debt are equally important, and prevalent in cities that do not share Aspen’s quaint charm or celebrity inhabitants.

Cut Fannie’s holdings, critics say.

Critics of Fannie Mae renewed calls to rein in the company and its smaller rival, Freddie Mac, following the release of former senator Warren B. Rudman’s report on the mortgage finance company’s $10.8 billion accounting scandal. Though the report documented no new problems, the critics said, Rudman’s detailed account of widespread accounting violations makes it important to adopt a tougher set of regulations for the company. Senate Banking Chairman Richard C. Shelby (R-Alabama) said the report in particular emphasizes the need for Fannie to be forced to cut the size of its mortgage investment portfolio, an important source of profit that has grown so large that some analysts think it could destabilize the country’s financial markets if the company were to fail. “Many of these issues arose because of the large retained portfolio held by Fannie Mae,” Shelby said. “While a portfolio of this size is not a critical component in achieving their housing mission, it did serve as a mechanism to allow Fannie Mae to ensure earnings growth. I remain committed to passing a strong … regulatory reform bill this year.”

Fannie Mae is chartered by Congress to keep money flowing into the housing market by buying mortgages from banks and other lenders. Legislation to create a stronger regulator for both companies has been stalled in Congress since last fall because of disagreement over whether to force the companies to shrink their investment holdings of mortgages and mortgage-backed securities. The House has approved a new set of rules that Shelby and the Bush administration consider too weak; a Senate version of the legislation is awaiting a final vote.

The report, prepared at a cost of more than $60 million, portrayed former chief financial officer J. Timothy Howard and former controller Leanne G. Spencer as focused on reaching earnings targets and willing to bend accounting rules to meet those goals. Lawyers for the two former Fannie officers have rejected that finding. While the report found no evidence that former chief executive Franklin D. Raines knew the extent to which his company had strayed from standard accounting practices, it faulted him for creating a “culture that improperly stressed stable earnings growth.” Raines’s lawyer has also rejected the reports’ characterization of his leadership.

A FORECAST “STOOD ON ITS HEAD”

The price of natural gas has been mostly higher over the past decade or so. A few of the winter seasons saw especially dramatic upward spikes (1995-1996, 2000-2001, 2002-2003), though prices then fell as quickly as they climbed. But other winters have seen prices stay flat or go slightly lower (1997-1998, 1999-2000, 2001-2002). These facts notwithstanding, conventional wisdom declares that “natural gas prices rise in winter”. And after Hurricane Katrina, this declaration was shouted from the rooftops. “Natural gas prices may leap 71%” was a USA Today headline on September 28. At the time, most folks thought this sounded plausible – Katrina had done extensive damage to oil and natural gas operations in the Gulf of Mexico and refineries in Louisiana. It shut down the Port of New Orleans, through which 26% of the nation’s oil and gas arrives.

But let us return to the evidence. There is no question that the consumption of natural gas rose this winter, yet that happens every winter, for home heating, etc. The question is the trend in the commodity price of natural gas during this winter season. In truth, the “71%” forecast was nearly stood on its head. Here is a daily chart of natural gas prices for the past eight months. The trend speaks for itself – if it appears like a 50%+ decline from the December high to the February low, that is because it was.

Of course, today’s conventional wisdom regarding natural gas is as interesting as it was back in September. That is why we see natural gas as a potentially strong opportunity.

DOING DRUGS

David Lashmet is an unusual guy who produces an unusual product. Lashmet is not the sort of unusual guy that knits booties for Basset Hounds. Rather, Lashmet is unusually diligent, hence the name of the investment research product that he produces: Diligence. Intrigued by Lashmet’s recent investment successes, your New York editor checked in with him recently to find out what is going on inside the always-intriguing and often-profitable world of “diligence”.

Eric J. Fry (interviewer from Rude Awakening): As you may know, the gang here at the Rude Awakening tracks the performance of the stocks recommended by you and many of your colleagues. So we are always aware of what is hot and what is not. In fact, on the Rude Awakening Web site you can actually find a section that we call “What’s hot, what’s not.” And lately, a few of the medical technology stocks you have been recommending have been popping up on the list of top performers. That is one of the main reasons that I wanted to chat with you.

Lashmet: Yeah, we are pretty excited about what has been happening. We utilize a long-term investment strategy. That is to say, there is always a possibility of a buyout, or that other investors begin buying a stock because they see the same potential that we have already identified and both of those things have been happening with some of our recommendations.

Fry: Before you start telling me what has been happening with your recommendations, why don’t you tell me a little bit about your investment process, because it is quite different and more intense that what most investors do. The research you do is more typical of the type that you find at some hedge funds. So do you mind describing the tactics and processes that you use to identify your opportunities?

Lashmet: We have a lot of ways of honing in on an opportunity. But we tend to think of the process of investing as being similar to the process of medical diagnosis. Before you go into surgery it is a good idea to get a second opinion. The same is true whenever you put your investment capital at risk. When you lose money it hurts. We do not like to lose money. So whenever we think we have a good investment idea, we seek the informed opinion of at least two outside experts. If both of them agree that out investment thesis makes sense, then we move forward. But if one of them disagrees, we do not start shopping for a compatible diagnosis. We simply trust that the expert understands the medical technology in question better than we do. I not only attend many medical technology conferences, but I also drag various experts along with me.

…

Fry: Obviously, your research process has evolved over this period of time. Are you more specialized now than you were six years ago? Within the biotech or pharmaceutical world itself, have you found yourself focusing more on one area than another?

Lashmet: I am looking to make money. So that means I am focusing on cancer treatments and cardiology drugs. That is where the money is. Anybody who finds a breakthrough cancer treatment is going to make a lot of money … and they should. We try to focus on the new drugs and treatments that have the fewest side effects. The best medical product is the one that has the fewest side effects. If you have got something that is really good, but really toxic, compared to something comparable that is much safer, then obviously the treatment with fewer side effects is superior. This one consideration turns out to be an excellent winnowing factor when considering the viability, and thus the investment potential, of new drugs. We already have highly toxic treatments for cancer, for example, so the next generation of treatments must be as effective, but safer. That is the sort of thing we are always looking for.

…

Fry: Okay then, let’s talk about a few trends in the biotech area. … In the last couple of years, how many of the names that you have been involved in have been taken over or struck a major deal with a big Pharma company?

Lashmet: Probably a dozen. …

Fry: It strikes that what you do on behalf of your clients is a kind of public markets venture capital.

Lashmet: Right, with one very big difference. We have got a huge advantage because we can get right back out. The companies we look at are publicly traded. So if we do not like what we see, if the original promise of the stock looks like it is not there, we are not locked in like an angel investor. We can get out. And a lot of times we are able to buy into companies at the exact same prices as some of the late-stage VCs. A while back we bought into one of our names at the very same price that the VCs did three years earlier. So we get the same opportunity, but with a lot of the risk already retired, and we also get the opportunity to exit the name whenever we want. So we are actually in a much better position than the VCs. We do this a lot.

Fry: Let me ask about a couple of specific names. …

ASIAN POLITICS TRUMP ECONOMICS, DEAL WILD CARDS

Anyone mulling the outlook for Asia can disregard the pile of data published by governments. Forget analysts’ predictions. Ignore stock prices and bond yields. More luck will be had looking out the window. It is there, on the streets below, where observers are getting more accurate indications that all is not well in the region. The thousands taking to the streets of Manila and Bangkok are reminding leaders and investors that Asia’s rapid growth is masking cracks in economies and political systems. Far from being just domestic stories, events in the Philippines and Thailand are reminders of how geopolitics in Asia are trumping economics, and will continue to do just that.

In the Philippines, for example, serially embattled President Gloria Arroyo declared a state of emergency on February 24, saying a group of military officials and civilians planned to oust her. Reporters rushed to call debt-rating companies to see if they planned a change in the country’s credit rating. So far, no downgrades seem afoot, but stay tuned. In Thailand, Prime Minister Thaksin Shinawatra was forced to dissolve parliament and announce a snap election for April 2. Amid rising calls for his resignation, Thaksin, who has displayed authoritarian tendencies at times, is under pressure to make political and constitutional changes and avoid a national crisis.

What makes both episodes so troubling is that until recently, the Philippines and Thailand were thought to be on the right track, albeit to varying degrees. What is more, the predicaments of both leaders offer reminders that concerns about the cronyism and corruption of Asia’s past have not gone away. After Thailand’s rebound from the 1997 Asian crisis, leaders throughout the region talked about emulating Thaksin’s economic and political models. His overwhelming victory in last year’s elections only strengthened the 56-year-old’s grip on power. Opponents attacking Thaksin over media freedom, ministerial ethics, education reforms, planned sales of shares in public utilities, and the handling of Muslim unrest got little traction. That was, until Thaksin’s family sold a stake in Bangkok-based telecommunications company Shin Corp. to Singapore’s Temasek Holdings Pte, netting a tax-free $1.9 billion. Suddenly, those arguing for years that Thaksin, a self-made, larger-than-life billionaire, was using public office to advance his private interests had lots of company.

Arroyo’s problems are more about legitimacy. Even before charges of bid-rigging in last year’s election, Arroyo, 58, faced questions about whether she is the rightful occupant of the nation’s top office. She came to power in 2001 after the impeachment of actor-turned-politician Joseph Estrada. He still claims to be president. After barely winning last year’s contest, Arroyo was tripped up by telephone recordings in which she allegedly conspired with election officials to tilt the vote her way. On top of that were allegations of her husband’s and son’s involvement in illegal gambling.

The moral of both stories is that creating credible government policies, reducing corruption and strengthening the legal system are works in progress. They are also a reminder that investors in Asia need to keep a wary eye on political events. When you consider the biggest surprises in Asian markets in recent years, most came from politics, not GDP, inflation or stock prices. Expect more of the same as the year unfolds. Asia’s booming economies are high on investors’ lists of favored destinations. Political turmoil is a bigger risk than many seem to realize. It may help to pay more attention to the buzz on Asia’s streets than to statistics.

N.Z. BUSINESS CONFIDENCE SLUMPS ON RECESSION RISK

New Zealand business confidence fell to a 15-year low in February amid expectations record-high interest rates will crimp profits and may push the economy into recession. About 22% of companies surveyed this month expect sales will improve in the coming year and 26% say they will decline, according to a report released by National Bank of New Zealand. About 47% of the 572 companies surveyed expect no change. Reserve Bank of New Zealand Governor Alan Bollard on Jan. 26 kept the benchmark interest rate at a record-high 7.25% and said there was no prospect of a cut. The gap between optimists and pessimists is the biggest since April 1991, suggesting the economy may contract, said Cameron Bagrie, ANZ National Bank Ltd.’s acting chief economist. Bollard is required by the government to keep annual inflation between 1% and 3%. Consumer prices rose 3.2% in 2005.

OPEN MACRO, CLOSED POLITICS

Economics and markets may be increasingly global but politics remain decidedly local. That contrast has been glaringly obvious in recent weeks in the face of a growing outbreak of Islamic protest, U.S. protectionist backlash, and yet another round of destabilizing events in the Middle East. Meanwhile, the world’s major central banks are pushing ahead on their normalization campaigns, underscoring the distinct possibility of a turn in the global liquidity cycle. The tensions of open macro are building. The key questions are how and when they will be vented.

The open models of globalization continue to produce very powerful macro results. January’s CPI report in the U.S. was yet another in a long string of examples – an outsize spike in energy prices (+25% y-o-y) accompanied by a fractional deceleration in the core CPI (+2.1% versus 2.2% in December). Unlike the closed U.S. economy of the past that was characterized by significant spillover effects from energy shocks, the global price arbitrage of today’s increasingly open economy has produced a very different result. As globalization continues to spread, the powerful forces of secular disinflation in the global economy provide an increasingly greater offset to cyclical inflationary pressures in individual economies. Barring an erosion of the underpinnings globalization – especially those now beginning to transform the vast and once sheltered services sector – I remain convinced that “open macro” is the best way to model the world.

But open macro is not without its potential pitfalls. Frictions have arisen from three key features of the current strain of globalization: The first is technology – namely, the Internet. The rapid penetration of IT-enabled connectivity has brought the world together at an extraordinary speed. With that speed comes a multitude of unintended consequences. For example, ubiquitous access to information creates the potential for resentment at the lower end of the income distribution in rapidly growing developing economies like China and India. Nor can there be any doubt of the role played by the Internet in facilitating the instant dissemination of Danish anti-Muslim cartoons, an incident that set off a firestorm in the Islamic world. Moreover, IT-enabled offshore outsourcing of once sacrosanct white-collar jobs heightens the odds of a politically actionable worker backlash in the rich, high-wage developed world. From the start, the Internet has been billed as the ultimate enabler of a new global democracy. Yet the faster the growth of IT-enabled connectivity, the greater the strains on the entrenched body politic. The Internet may well be the ultimate enabler of a new set of socio-economic tensions.

A second destabilizing characteristic of globalization is its flawed policy architecture – namely, the presumption that the best global policies are the sum of the best approaches of individual nations. Unfortunately, this “new math” of globalization does not add. America’s China-bashing is, in many respects, an example of misguided U.S. saving policies – and the unwillingness of Washington’s increasingly populist politicians to accept any responsibility for their own actions. Moreover, the increased irrelevance of the IMF and the World Bank – the original Bretton Woods stewards of the post-World War II era – is yet another flaw in the policy infrastructure of an integrated world. The longer an open global economy stays with antiquated policies designed for closed economies, the greater the potential for a serious policy blunder.

Globalization has given rise to a third important source of instability – a blurring of the distinction between cyclical and secular shifts in shaping the macro landscape. For the first 50 years of the post-World War II era, the short-term fluctuations of the business cycle were uppermost in the minds of policy makers, investors, and businesspeople. Yet the newly emergent cross-border arbitrage of labor, capital, and financial returns effectively places new limits on the amplitude of such fluctuations – in essence, redefining the balance between cyclical and secular pressures. In my view, globalization is still in its very early stages, as it is only now beginning to spread into the vast services sector. To the extent that is correct, secular forces could continue to swamp cyclical pressures for some time to come. As a result, counter-cyclical stabilization policies framed with more of a traditional perception in mind could be seriously out of sync with macro risks.

The trick for the macro practitioner is to put all this together. The financial market implications must also take account of the current and prospective state of the global liquidity cycle – one of the most powerful forces currently conditioning asset prices. Many of the more elastic results of open macro – namely, low inflation, the real interest rate conundrum, and even the Teflon-like dollar – are outgrowths of years of excess liquidity. So, too, is the sustainability of America’s asset-dependent consumption binge. Absent the tailwinds of the liquidity cycle, there is good reason to believe that the tensions of globalization noted above may have far more actionable consequences for world financial markets.

As always, central banks are in ultimate control of the liquidity spigot. And policy “normalizatio”q is now the over-arching objective for the Federal Reserve, the European Central Bank, and the Bank of Japan. For different reasons, each of these monetary authorities had to run policies of extraordinary stimulus in recent years. With those risks perceived as now subsiding, all three central banks are seeking to end their extraordinary accommodation and put their policies on a more neutral setting. There can be no mistaking the endgame that is now coming into focus: To the extent that a powerful upsurge in the global liquidity cycle has been fueled by extraordinary monetary accommodation, those days are coming to an end.

Of course, a shift in the global liquidity cycle is not the only factor likely to bear on the financial market outlook. The tensions of globalization are also germane to the outcome. In that vein, I would be the first to concede that the role of economics in shaping the outcome may be less significant than we economists would like to think. Social, political, ethnic, religious, military, and security considerations have always been important pieces of the macro puzzle. Perhaps the greatest irony of this strain of globalization is that cross-border integration has unmasked cross-cultural frictions. The closer knit the world becomes through trade flows, capital flows, and information flows, the greater the discomfort level that seems to arise within individual segments of the world.

Throughout history, financial markets have served the useful – and at times, painful – purpose of arbitrating the interplay between economic and non-economic factors. That venting function could take on a very different meaning in today’s era of IT-enabled globalization. A turn in the global liquidity cycle may well amplify the implications of any such venting. Left to its own devices, “open macro” could perpetuate the disinflationary underpinnings of a very bullish financial market climate. The bond market conundrum might endure, as could the resilience of the U.S. dollar. The politics of globalization, however, raise serious questions as to whether open macro ultimately will be left to its own devices. From time to time, economics has its limits in shaping the macro outcome for world financial markets. This feels like one of those times.

A rise in U.S. rates: made in Japan?

Investors are beginning to anticipate that the Bank of Japan (BoJ) will end its decade-long, ultra-accommodative monetary policy as deflation comes to an end in Japan. The first step almost certainly will be a gradual end to so-called quantitative easing, which our resident BoJ watcher believes most likely will come in April. A rise in short-term interest rates probably will not come until later, possibly much later. But BoJ Governor Fukui has been strongly hinting that the time has come to begin the process. As a result, short-term Japanese yields, while still the lowest in sovereign bond markets, rose to 5-year highs last week. With many viewing the BoJ as the global liquidity supplier of last resort, and the yen playing the role of funding currency of choice in global carry trades, what will be the implications of such a development for U.S. financial markets?

There are several reasons to think that a gradual reduction in Japanese liquidity now and even eventually higher rates in Japan will not strongly reverberate here. A BoJ move to renormalize Japanese monetary policy could merely narrow U.S.-Japanese yield spreads in textbook fashion, rather than force up U.S. rates. Moreover, for those enamored of the carry trade, yen short-term rates will remain extremely low for some time, and Japanese investors are still likely to look for higher yields abroad, including in U.S. markets. But context matters, and a more abrupt adjustment is also possible. The BoJ’s prospective moves as I see it come against the backdrop of strong U.S. and global growth and upside inflation risks. So BoJ action while the Fed still has more work to do and the ECB is also beginning to tighten may be a catalyst for changing investor perceptions about U.S. and global yields, and U.S. and Japanese yields in that case would rise together.

Investors should focus on five key implications of these developments, in my view. First, the backdrop of strong Japanese, U.S. and global growth that is prompting the BoJ to move is clearly good for risky assets and credit quality. But investors cannot have it both ways – strong growth and low rates will not coexist. Second, convergence between U.S. and overseas growth will, over time, contribute to smaller U.S. external imbalances, which could weaken the bears’ case to shun U.S. assets. But rebalancing will not happen quickly. And how rebalancing occurs is critical for U.S. rates. Third, to assess the forces affecting U.S. rates, analyzing external imbalances is not sufficient; investors need to look at all components of U.S. saving and investment. In my view, those components taken together point to higher U.S. rates. Fourth, U.S. monetary policy is now less certain than at any time since mid-2004. Finally, the dollar may be caught between the opposing forces of narrower rate spreads and investors’ views of the relative attractiveness of U.S. equities and bonds relative to those abroad. Just as wider U.S.-overseas rate differentials strengthened the dollar in 2005, narrower spreads may mean a weaker dollar today. But if investors now think that, with the Fed close to an end of its tightening cycle, U.S. equities and bonds are attractive relative to those abroad, the dollar could strengthen.

The BoJ’s prospective moves and uncertainty about them mean that risks in financial markets are rising, in my view. To be sure, despite the recent tough talk from BoJ officials, Japanese authorities rightly do not want to move prematurely. So markets may once again have jumped the gun, and it may be a long time before rates in Japan actually rise. But from a global yield perspective, I think the risks lie in the other direction: With global growth improving, and monetary policy tightening, higher U.S. yields are the bigger risk.

Global credit ocean dries up.

One by one, the eurozone, the Swedes, the Swiss and now even the Japanese, are turning off the tap of ultra-cheap credit that has flushed the global system for the past year, keeping the ageing asset boom alive. The “carry trade” – as it is known – is a near limitless cash machine for banks and hedge funds. They can borrow at near zero interest rates in Japan, or 1% in Switzerland, to relend anywhere in the world that offers higher yields, whether Argentine notes or U.S. mortgage securities. Arguably, it has prolonged asset bubbles everywhere, blunting the efforts of the U.S. and other central banks to restrain over-heating in their own countries. The Bank of International Settlements last year estimated the turnover in exchange and interest rates derivatives markets at $2,400 billion a day.

“The carry trade has pervaded every single instrument imaginable, credit spreads, bond spreads: everything is poisoned,” said David Bloom, currency analyst at HSBC. “It’s going to come to an end later this year and it’s going to be ugly, even if we haven’t reached the shake-out just yet,” he said. “People have a Panglossian belief in the march of global capitalism but that will change as soon as attention switches back to U.S. financial imbalances,” he said.

There were early signs of panic this week when the Icelandic krone crashed 8% in two days, setting off dominoes in high-yielding currencies of New Zealand, Australia, South Africa, Hungary and Brazil. The debacle was triggered when the rating agency Fitch downgraded Iceland’s sovereign debt, a move that would not normally rattle markets. The new skittishness comes against a backdrop of ever more hawkish moves by Japan and Europe. “There are several hundred billion dollars of positions in the carry trade that will be unwound as soon as they become unprofitable,” said Stephen Lewis, an economist at Monument Securities. “When the Bank of Japan starts tightening we may see some spectacular effects. The world has never been through this before, so there is a high risk of mistakes.”

It is an open question whether the yen, euro, Swiss franc and Swedish krona carry trades have occurred on such a scale that they have led to over-investment in Latin America and beyond, and compressed U.S. yields, fuelling the American housing boom in 2005 despite Fed tightening. There are other big forces at work: huge purchases of U.S. Treasuries by Asian central banks, and petrodollar surpluses coming back to the U.S. credit markets. Stephen Roach, chief economist at Morgan Stanley, warns that the carry trade is itself, in all its forms, a major cause of dangerous speculative excess. “The lure of the carry trade is so compelling, it creates artificial demand for ‘carryable’ assets that has the potential to turn normal asset price appreciation into bubble-like proportions,” he said. “History tells us that carry trades end when central bank tightening cycles begin,” he said. Ominously, almost every bank other than the Bank of England is now tightening in unison.

Bank of Japan prepares to mop up flood of cash.

For almost five years the Bank of Japan has been flooding the financial market with free money in an unprecedented measure to try to curb deflation. Soon it will tighten the cash tap. The central bank has been preparing financial markets for an end to the current ultra-loose monetary policy sometime within the next few months and most analysts expect a move by April. On Friday the Japanese government is expected to report a third consecutive monthly rise in core consumer prices, clearing the way for the Bank of Japan to end its unorthodox experiment known as “quantitative easing”.

“Japan policy makers stand at a crossroad,” says Jesper Koll, chief economist for Japan at Merrill Lynch. Acccording to Koll, the world’s second largest economy has “snapped out of its deflationary doldrums” after annualized growth of 5.5 percent in the fourth quarter of 2005, making it a “high growth economy” once again. Even the government – which had previously pressed the central bank not to act prematurely for fear of sparking a return to deflation – has now in effect given the green light for a change. Some investors are even betting that the cash spigot will be tightened as early as Thursday of next week when central bank policymakers meet. However, most economists think the central bank will wait until next month – after the end of the current fiscal year – when it has two monetary policy meetings scheduled, on April 10-11 and April 28.

The world’s second-largest economy has been trapped in a deflationary spiral for almost 8 years, discouraging consumption and investment as prices keep sliding, and cutting into companies’ profits. The Bank of Japan has been swamping the banking system with far more liquidity than is actually needed to drive interest rates down to zero, after deciding that rock-bottom lending rates alone were not enough. However, the jury is still out on whether this so-called “quantitative easing” policy ever really had much impact at all. The real question, say analysts, is when the central bank will start hiking interest rates – and this appears unlikely to happen before late 2006.

Financial markets have reacted nervously to signs that a scrapping of the ultra-loose monetary policy is close, sending the yen higher against the dollar and putting the brakes on a stock market rally. This is in large part because foreign investors have for years been taking advantage of rock-bottom interest rates in Japan to borrow here and then invest in other assets such as gold and U.S. government bonds. The Bank of Japan, which has independence in monetary policy, made a blunder in 2000 when it inadvertently helped to snuff out a nascent economic recovery by ending its zero interest rate policy, only to reintroduce it soon after.

Japan’s inflation rate quickens, aiding policy change.

Japan’s consumer prices rose at the fastest pace since 1998 in January, supporting the central bank’s plan to end a deflation-fighting policy as soon as next week. Core consumer prices, which exclude fresh food, increased 0.5% from a year earlier after 0.1% gains in November and December, the statistics bureau said today in Tokyo. The report may persuade the central bank to reduce the amount of cash it pumps into the economy at a meeting next week, a precursor to lifting interest rates from near zero. An end to a 7-year bout of deflation may support corporate earnings, helping wages and loan demand in an economy that will probably grow this year at 3.2%, the fastest pace since 1991.

Bank of Japan Governor Toshihiko Fukui has been preparing investors for a change, saying policy will “immediately shift” once conditions set by the bank are met. The central bank has vowed not to adjust its 5-year-old policy until core prices stop falling for at least a few months and policy makers are sure they will not resume sliding. It also needs to be confident about the overall strength of the economy. Core prices in Tokyo, home to one in 10 Japanese, rose 0.2% in February, the first back-to-back gain since August 1998. Excluding energy and food, Japan’s nationwide consumer prices rose 0.1% in January, the statistics bureau said. This gauge of prices is widely used in the U.S. and Europe to measure inflation. The bank’s policy makers are scheduled to meet next on March 8-9, April 10-11 and April 28.

TIME TO SEPARATE THE ECONOMY FROM CORPORATE PROFITS

For the better part of the last half decade economists and policy makers have struggled to understand the trajectories of U.S. Dollars, GDP growth and corporate profits. For most, the struggle centers on how to paint a picture of health, rebound and strength all the time. These efforts have strained under huge and growing budget deficits, current account shortfall and consumer debt statistics. Skeptics focus on how to reconcile robust consumer spending, stellar corporate profits and decent GDP growth with a sense of foreboding from debt, trade imbalance and successive asset bubbles. Perhaps the U.S. Macro economy, our currency and corporate profits do not affect each other as is traditionally believed.

Critique requires a brief sketch of recent developments. Real wages have gone nowhere in the last 5 years. Spending has surged. BLS data show that real average hourly earnings of production workers increased from $16.10 to $16.35 in the last 5 years. The most recent word form the Federal Reserve Survey of Consumer Finances shows declines in median family income 2001-2004. BEA personal consumption expenditure 2000-2005 reveals an increase of just over $2 trillion in the same period. With wages increasing at or below the rate of inflation, American consumers found the ability to increase consumption by a sum greater than China’s 2005 purchasing power parity GDP at official exchange rates.

Growth in corporate profits and GDP growth are similarly out of alignment. BEA data on corporate profits with inventory valuation and capital consumption between Q12000 and Q32005 shows an increase of $514 billion, or 66%. Unadjusted GDP increased by $3 trillion over the same interval, or 32%. Profits are growing twice as fast as nominal GDP, which has profit growth averaged into its percentage change. Across the same interval the Federal Government racked up official budgets deficits of $903 billion.

Our 2000-2005 trade imbalance on goods and services sums to $2.99 trillion. Across 2004, the U.S. Net International Investment Position went from -$1.5 Trillion to greater than -$2.5 trillion. The trade weighted value of the U.S. Dollar has, across the entire 5 year period been volatile, but little changed in net terms. U.S. real interest rates are and have been historically low. Personal debt has exploded from under 97% of disposable income to more than 115% in 2005. The official U.S. savings rate remains negative for the better part of the last 8 months, having been near zero for years.

What does all the above tell us? U.S. corporate profits have faired far better than the balance sheets of the federal government, international trade, consumers and overall economic growth. This is fueled by debt spending, asset bubbles, wealth redistribution, foreign earnings and borrowing galore. This is clearly unsustainable and will end badly. But if rising GDP, consumer spending and corporate profits are no longer reliable reflections of economic health, what has changed?

The old assumptions of rising tides, displayed by GDP growth, lifting all boats – if some more than others – seems to be fading in accuracy. We now have a rather more internally and externally imbalanced situation. The health of various sectors depends increasingly on availability of cheap credit and access to foreign savings financing. Consumer and state spending, delinked and floating free from earnings/receipts, depends on imported foreign savings. Dominant firms that enable consumption well in excess of declining earnings are well positioned. Capital importers, carry traders, financial engineers and minders of the credit trough occupy an advantageous position. The sectors and firms that enable, finance, assist or distribute foreign goods and savings flowing into the U.S. are also well positioned, for now. Holders of lucrative government contracts are well positioned. With noteworthy exceptions, all others beware.

Taxes are low, interest rates are low, credit is abundant, wages are stagnant and spending from states and households knows no bounds. This is the heady mix that has produced the laundry list of macro data in the paragraphs above. True, no way these factors can continue too much longer. For so long as they do, I suggest the following approach. Since the world has turned upside down your perception must correspondingly adjust. Growth means more debt, more foreign inflow of savings, greater trade imbalance and the further sale of future U.S. earnings, state and private. I would thus suggest that slower growth indicates progress in the present context. Profit deceleration, declining consumer spending and reduced government spending – particularly on pork projects – should be seen as positive. Further increase in bloated house prices, continued dollar strength, rising consumer spending and new government programs should be viewed with fear and apprehension!

THE HIDDEN COST OF OUTSOURCING

Outsourcing customer service may seem like a bargain, but it can cost you some of your most valuable clients.

Dell tried it, then reversed course. Capital One gave up as well, and so did JPMorgan Chase. All came to the same conclusion about their attempts to farm out front-line customer-service jobs to outside contractors: The hidden costs far outweighed the potential savings in labor expenses. With consumers enjoying more choice than ever before, evidence is growing that great service is essential for long-term customer retention. To cite just one example, a recent survey of pension policyholders in the U.K. found that 75% would leave their current provider if they experienced bad customer service.

Meanwhile, the current enthusiasm for outsourcing call centers, IT support, and other “noncore” service functions is not delighting anyone. Two-thirds of the companies that responded to a survey by InformationWeek reported either no change or a worsening in customer satisfaction as a result of business-process outsourcing. A 2005 Gartner study predicts that 60% of organizations that outsource customer-facing processes will see significant numbers of frustrated customers switching to competitors. The costs associated with these defections add up quickly, which helps explain why the same study found that 80% of companies that outsource customer-service functions fail to meet their cost-savings targets. No wonder all three of the companies cited above recently brought some of their customer-support operations back in-house after contracting them out to companies that were not very good at providing help.

There are practical reasons why an outsourcer’s service level is seldom as high as what you will get from your own people. If outside contractors cut costs, it might be because they are more efficient. But it is far more likely that the savings occur because contractors pay their people less, spend less on training, or both. Just as there is no such thing as a free lunch, there is no such thing as a free worker who has been properly trained to do a great job. Likewise, when people do not identify with the organization on whose behalf they are working, their performance typically suffers. It is human nature: Since the name of their organization is not directly associated with the service that contractors provide, there is less motivation to make sure it is done right.

Which is why the backlash against customer-service outsourcing is upon us, and why it is gathering steam. Sure, outsourcing offers short-term cost savings. But contracting out critical functions can never deliver sustainable competitive advantage, because competitors can always hire the same contractors to do the same thing (equally poorly). Real competitive advantage stems from strategies that are not easily imitated – and, sorry, buying services on the open market is not one of them.

WHAT MONEY IS NOT

With the possible exception of international trade, no topic in economics contains more myths than monetary theory. In the present article I address four popular opinions concerning money that suffer from either ambiguity or outright falsehood.

Money represents a claim on goods and services. Although there is a grain of truth in this view, it is quite simplistic and misconceives what money really is. If you own a $20 bill, no one is under any contractual obligation to give you anything for it. Now of course, in all likelihood people will be willing to exchange all sorts of things for your $20 bill. That is why you yourself performed labor (or sold something else) to obtain it in the first place. Nonetheless, if we wish to truly understand money, we must distinguish between credit liabilities on the one hand, and a universally accepted medium of exchange (i.e., money) on the other.

The purchasing power of money equals the supply of real output divided by the supply of money. This too has a grain of truth. Specifically, if everything else is held equal, then the “price level” (if we ignore the problems with measurement and arbitrariness) will go up if the money supply grows by more than real output, and will go down if real output grows by more than the stock of money. However, other things need not be equal, in particular the demand to hold money. As with every other good, the “price” of money (i.e., its purchasing power – or how many units of radios, televisions, etc. people offer in order to receive units of money) is determined by the supply of dollars and the community’s demand to hold dollars. A given stock of money can be consistent with any price level you want, so long as you are allowed to change the demand for money.

Under a gold standard the money is backed by something real, whereas under our present system dollar bills are backed up by faith in the government. Again, I sympathize with this type of view, but when my upper-level students write such things on their exams, I have to take off points for imprecision. Strictly speaking, under a gold standard the money is not backed by anything. The money is the gold. Now if we have a government that issues pieces of paper that are 100% redeemable claims on gold, I would not classify those derivative assets (i.e. the pieces of paper) as money, but perhaps as money certificates. Yet this is a minor quibble.

My real objection to the view quoted above is that it denies that our current fiat currency is really money. Although I fully condemn the monetary history of the U.S., and deplore the means by which the public was forcibly weaned from the gold standard, nonetheless it is simply misleading and inaccurate to deny that the green pieces of paper in our wallets and purses are genuine money. They satisfy the textbook definition: They are a medium of exchange accepted almost universally in a given region. No one is forcing you to accept green pieces of paper when you sell things. The fact that government coercion (past and present) is necessary to maintain this condition is irrelevant.

Deflation is undesirable because it cripples investment. If prices in general are falling, no one will invest in real goods because he can earn a higher return holding cash. Although this last myth is understandable when espoused by the layperson, it is inexplicable that some trained economists believe it. For one thing, the argument overlooks the fact that there were many years of actual deflation in industrial economies on gold or silver standards, and I do not think investment fell to zero in every single such year. So clearly something must be wrong with the argument. Specifically the argument fails because it carelessly assumes that the relevant data for an investor are the spot prices of a particular good from one year to the next. Once we allow for the prices of capital goods and raw materials to adjust to expectations of deflation, there is no reason for falling prices to hamper investment whatsoever.

Most of the myths concerning money are easily exposed when we consider what money is. Some of the more subtle myths, especially those concerning price deflation, are exposed once we consider the intertemporal price structure. On both counts, the Austrian School of economics serves us well.

RUSSIAN ECONOMIC MINISTER WARNS OF STOCK MARKET BUBBLE

Russia’s economic minister warned the government that recent record growth in the local stock market threatens to raise equity prices to unfounded levels, news agencies reported. Economic Development and Trade minister German Gref said that the Russian stock market had shown the best results worldwide, growing by 30.5% in the first two months of the year, and by 83% in 2005 as foreign emerging market funds and local investors poured money into stocks against the backdrop of Russia’s oil-driven economic growth. While the ratio of companies’ capitalization to their profits currently averages 7.8% – “normal” according to Gref – he expressed fears that the market could overheat. “We are very worried about a so-called bubble forming,” he said. Gref noted that the performance of 10 of the country’s biggest companies, which account for 80% of the market’s capitalization, “needs analyzing”.

Nick Mokhoff, a trader at Brunswick UBS in Moscow, agreed that in an environment where investors are piling money into the emerging “BRIC” markets of Brazil, Russia, India and China a bubble may not be far off, but said this was not necessarily a reason for investors to sell. “I’m not worried, we may be entering a bubble phase, but they can last for months or years,” Mokhoff said. “They (government officials) use the bubble term every two or three months. I don’t think we’re in a bubble yet, but even if we are then enjoy the bubble ride.”

LIES, LIES, LIES

The truth is that the feds can control either the quantity of the nation’s money or the quality of it. At the heart of the world’s next – and probably greatest – financial crisis is the sad fact that they cannot do both at the same time. Alas, there is always some catch … some restraint … some skunk in the woodpile. We cannot grow wiser without growing older. We cannot grow richer in the future without forgoing the chance to enjoy our money in the present. We cannot make the Devil’s food cake of an expanding money supply without the gooey spoons and burnt pans of inflation hidden somewhere in the kitchen sink.

Next month, the feds will cease reporting the M3 figure. Thenceforth, it will be harder to figure out at what rate the U.S. money supply is expanding. That is to say, it will be harder to know how much money the feds are hoping to steal from the world’s savers. Yes, dear reader, the great American Empire faces the future, not with grace and resolve, but denial, delusion, deceit, and more debt. Will the Bernanke Fed protect the quality of the dollar, or will it tend to favor the quantity of it? We already know the answer. He has told us himself. He will hire helicopters to drop the green paper all over the country, if it comes to that, just to make sure the quality of the nation’s currency does not improve. In Bernanke’s big, black book of economic alchemy, there is no worse sin for a central banker than to allow deflation – otherwise known as an increase in the value of money. And so, the feds deceive in order to continue their delusions of power, grandeur and mediocrity. Yes, they say that the current economy is nothing special. It is mediocre – just the way it ought to be.

What? Is the yield curve not upside down? Do Americans not spend more than they earn (the savings rate is net negative) for the first time since the Great Depression? Are house prices not at record levels, after more than $5 trillion in appreciation since 2001? Are inventories of unsold houses not also at record levels? Is the country not at war (for the first time ever) with an unnamed enemy? Will the feds not borrow half a trillion dollars in the next fiscal year, while the country buys $800 billion more from foreigners than it sells to them? Did gold not outperform all major asset classes last year? Are all these things not exceptional? Surely, they are anything but mediocre.

We suspect that increases in the money supply will also be exceptional in the years to come – even spectacular. We further suspect that it was to avoid noticing these exceptional increases in M3 that the government decided to stop reporting the figures. Eventually, of course, the inflation news will get out. Government quants created the “core” measure in order to eliminate the volatility of food and energy prices. This would give us a more accurate and consistent picture of inflation, they said. What it really does is persistently understate the actual inflation figure. Lies, lies, lies … and more lies. But, what do you expect, dear reader? Yet, who does not like lies, so long as they are flattering?

TRADE DEFICIT BUBBLE OR CREDIT BUBBLE?

Who was that facetious academician who invented the phrases “trade deficit” and “current account imbalance?” They must have known that, from a theoretical point of view, the words “deficit” and “imbalance” are confusing misnomers in this context. Must be the same person who invented double-entry bookkeeping. There can be no “deficit” in trade, as there is with a budget. By definition, the trade “deficit” and current account “imbalance” are simply statistical measuring sticks, countered on the other side of the plus-minus ledger by corresponding accounting book entries encapsulating the foreign dollar holdings of which that “deficit” or “imbalance” is constituted – which counter ledger entry, by the way, other misinformed or disingenuous experts in one of the White House economics departments have unfortunately taken to calling a “surplus”.

Just to be clear, there is not a “surplus” either, as these “confused” politicians would have you think (giving them the benefit of the doubt.) Statisticians record the total amount of money spent outside the country, both by trade and by investment. The “imbalance” or “surplus” is simply the statement of the difference between the value of goods, services and investment products we have bought from our foreign trading partners on the one hand, and how much or little they have bought in return, on the other. Analysis of the details of the “surplus” tells us where the difference has gone and what the holders have decided to do with it. Sometimes there is an “excess” of exports, and you have a trade “surplus”.

Sometimes, however, some of our trade dollars do not come back and are parked in dollar accounts abroad or used to purchase other investments. Some wind up back in our own country purchasing American Treasury bonds, for example. But the main point is, they end up somewhere in contented hands, and the “deficit” or “surplus” is owed to no one. There is no interest on it, nor is there a minimum balance due. So do not worry about the trade “deficit”, in and of itself. It may look like a dangerous bubble, but it is just incomplete and therefore skewed data. On the other hand, if you want to worry about something, look at the U.S. credit expansion that is behind the data. Now there is a bubble worth its salt.

Here is how it works. Under what was called the gold standard up until the 1970s, all holders of dollars, including exporters to the U.S. who receive dollars in exchange, had several choices of what to do with their money, among which are the following: (1) They could buy goods or services, which in the case of exporters means they could import American goods or services from us; (2) they could buy another currency to buy things or services from a different country; (3) they could just hold the dollars in cash, or pay off a dollar-denominated loan, or buy assets such as a U.S. savings account, stocks, bonds, real estate, or even whole companies; or (4) they could turn their extra dollars back in to an American banking institution for gold at a preset dollar price.

Without going into the mechanics of how it worked, let me just say that the fact of giving dollar-holders that last option had the effect of keeping the purchasing and exchange value of the dollar in line with the purchasing and exchange value of gold. It also vicariously put a brake on any unhealthy credit expansion our financial institutions might have otherwise been tempted to undertake. This same principle applied to all countries. In the 1970s, France and England wanted gold for what turned out to be excessive dollars. We could not give it to them without great havoc, so Nixon closed the U.S. “gold window”, pocketing his marbles and telling them we would not honor our part of the gold bargain. Obviously, the rest of the world soon did likewise. In all fairness, we were not the only country doing the credit expansion – it is just that we lost that particular match point in the game.

Thanks to the world’s blatant disregard for its own monetary standards since the early 1900s, gold’s particularly useful braking effect on credit creation no longer exists. It is the equivalent of a bunch of drivers accelerating over the speed limit in a race down a highway, deciding in tacit agreement to shoot the highway patrolman who is the very fellow they themselves put in place to prevent speeding accidents. The Federal Reserves of the industrial world have now adopted new rules, and each Fed claims to have its own good grip on its currency and credit production. So Americans and foreign exporters to America no longer have the option of obtaining gold for dollars at a set price. This also means that the citizens of the world now have nothing preventing their banks from “printing” as many dollars or euros or yuan as their various Feds may wish to see in circulation – which, by the way, explains why the Feds changed the rules in the first place.

The result in America has been that the Fed has given this nation permission, indeed has encouraged us, to spend every last penny we have earned and then some, in effect signing away tomorrow’s paychecks. Why? To save the economy, in their opinion. To send us all to credit hell, albeit perhaps unwittingly, in mine. It is our own gluttonous fault as voting citizens, but through Fed-instigated, chronic, excessive increases in our money supply since the early 20th Century, we have allowed our economy to become overheated relative to its capacity, and the dollar has lost 98% of its purchasing power. It can presently buy only about 2% of what it bought in 1900, as contrasted to gold, which presently purchases 150% of what it bought in 1900. So much for the Fed’s grip.

As a result of these loose credit Fed policies and of excessive risk-taking by the nation’s banks (for reasons that we will not discuss here), most of us are now addicted to spending beyond our means all across society, whether it be in our personal lives, our businesses, in increased investor speculation or in abusive government debt spending. Some Americans are naive and inexperienced in matters of finance. New generations have known few wars, have forgotten the Depression. The number of people living on the financial edge would make you stop and think. How many stock market players are buying on margin credit? You may not know, but the figures are frightening. How many pension funds and insurance companies are reaching out on an investment limb? Dangerously many. How much debt spending continues at the hands of hypocritical legislators? The answer to that is simple: “Oink”.

On the other side, how many people have saved some money for a rainy day? (Admittedly, easy-credit interest rates do not make it very appealing.) How many have a savings account, CDs, or a non-government retirement fund? What about health insurance, how many are uninsured? How many assume that unemployment compensation and/or disability will fill the bill should they lose their job? Again, the figures are mystifyingly low.

Frankly, if all the precarious financial instruments in existence today were called in at once, billions of over-stretched American incomes and balance-sheet wealth would evaporate instantly. And rightly so, given that empty credit is nothing but hot air swelling fragile bubbles. Thank goodness, the U.S. economy is not threatening to do any such thing, and a credit crunch is not yet upon us. But the danger lies much too close to the surface. Holders of all currencies can no longer keep the controllers of their money in line by demanding the paper-promises’ worth in gold. We now have to take our money on faith. So does every dollar creditor. Are they going to continue taking us at our word? And just how good is our word?

So as to that trade “deficit” ballooning higher and higher from American over-consumption, what are our trading partners doing with the leftover money? Under the new Fed rules, foreign dollar-holders now have only about three choices of what to do with their bucks in today’s fiat (i.e. no gold or other standard) exchange climate: (1) They can buy our goods and services, same as always. (2) They can buy another currency and sell the dollars on the foreign exchange markets at whatever the rate happens to be today, or they can wait and bet on tomorrow. (3) They can keep the cash and/or purchase assets such as U.S. treasury bonds or other American investments. Under the new rules, nations can even use our bonds and investments as their own banking reserves.

Given the amazing confidence in – and inexplicable demand for – the dollar on the international marketplace, they will probably choose No. 3. What does this imply? It means putting up with both currencies’ volatility. To avoid this, an exporter country can “peg” its currency to the dollar. For example, China is presently repressing their own currency’s exchange value and lifting the dollar’s through punctual dollar purchases. This has the effect of increasing China’s dollar-denominated reserves and allowing inflation to incur inside China – which you will notice is the same mistake our own Fed is making.

Other than China’s obvious self-interest, economists are unsure as to why other foreigners demand so many dollar-denominated assets. But the reason for it will not modify the observed fact. So, thankfully or not, and for however long, the world is now buying into the credit-hog American monetary marketplace as though it were itself the latest global bubble. They believe in our stability and productivity, in our credit score, as it were. This would be okay, except they – and we – now hold trillions of dollars worth of claims, i.e., those same dollars we have been “printing”, lending, leveraging, margin-investing and overspending like there is no tomorrow. That is the true imbalance, and the one that deserves the closest study. We must honor their confidence in our dollar with all the respect and gravity it deserves. But are our leaders up to the task?

RADIOACTIVE PROFITS

The Uranium market is one that is like a wild roller coaster, and many of the equities associated with it can make investors queasy from the ride. These equities are no different from many mining stocks – they have to be looked at very closely. Uranium trading was starting to become more stable, or so it seemed. Then, just as fast as it calmed down – bam! – it went right back up. The uranium price surged $5 to $29 in just two weeks last year. After the market woke up and new buying came in, the ultra-precious metal’s price climbed another $4, which set the highest uranium price since the early 1980s. The new speculation was triggered by growing expectations that China, India and Russia were planning to build new reactors and more reactors would cause a run on the limited supply of uranium. This speculation may well be right, if the International Atomic Energy Agency (IAEA) stats are even close to true.

According to a report by the IAEA, 130 new nuclear power plants may be built in the next 15 years. Who are the big players? The usual suspects, of course: China, India, Europe, Russia, etc. Nuclear power provides about 16% of the planet’s total annual electricity generation and 34% of the EU’s needs. Trust me, they need it – a lot. When my wife Katrin and I were in Estonia recently, it was frigid cold. Likewise, people are freezing to death in Moscow, right now. Nuclear power is a key component to economic survival in both Eastern Europe and the EU.

Public ignorance and fear of nuclear power changed the course of nuclear energy, as we have known, it for a very long time. Starting in the 1980s, utilities were canceling plants hand over fist. This resulted in the almost complete collapse of the uranium market. And then, to beat down the market even further, uranium got hit square in the jaw. This second blow came when the Soviet Union fell apart in 1991. Enriched uranium that was removed from Russian bombs was blended down to reactor-grade fuel and put on the market. But, it gets worse. The third punch came when the Clinton administration dumped 55 million pounds of “yellowcake” (uranium in the form of a yellowish powder) on the market, via a government-owned uranium enrichment program. This was what really caused the freefall for uranium prices – until now.

American uranium production peaked in 1980 at 43.7 million pounds, according to the U.S. Energy Information Administration. That was the proverbial nail in the coffin for the exploration of uranium. New research and development ground to a halt, as mines could no longer afford to operate, and exploration was basically a waste of time, energy and money. Wyoming once had eight uranium operations, which produced 12 million pounds per year. Today, things are different – a lot different. Wyoming now has none! I could go through each state and many countries around the world and cite examples just like that from reports I have read. The once-overflowing uranium supply dwindled in just five to 10 years.

During the 1990s the lack of new supply from functioning mines was supported by other sources: excess inventories … the dismantling and recycling of nuclear weapons, especially from Russia. Also, reprocessed reactor fuel was added to the mix. But many of those quick fixes are no longer available. Finally, reality is setting in. The dwindling supply of oil and spiraling high prices of fossil fuels are driving interest in nuclear energy as the possible power source that will be used to meet current and future global demand. Three Mile Island and Chernobyl, unless you lived there, of course, are distant memories to most Europeans and Americans. On their minds are the prices at the pumps and their home heating bills.

Bottom line: New supplies of uranium will come at a much higher cost, which in turn, will continue to put upward pressure on the future price of uranium.

SELL STOCKS, BUY GAS

Whenever you chat with Jay Shartsis, you get the feeling that his mind contains more statistics than the Major League Baseball database. But Shartsis does not track “most hits by a lefty third-baseman during a three-night series on the road.” He tracks financial market statistics, especially the sorts of statistics that indicate short-term trends. At the moment, some of the financial market stats that Shartis tracks are suggesting that the U.S. stock market will soon fall, while natural gas will soon rally. Shartsis, a professional options trader and broker with R.F. Lafferty in New York, monitors a wide – and sometimes bizarre – variety of statistics, indicators and sentiment surveys to divine probable market trends … or reversals of trend.

Presently, for example, he notes that “a near-record number of days have passed since the last 9% correction in the stock market.” He infers, therefore, that a 9% or more correction is overdue. “We are close to an all-time record, going back to 1950, regarding the time that has passed since the last 9% correction,” Shartsis notes. “The longest such stretch came between the 1990 bottom and a 9.7% correction in the first quarter of 1994, a period of 1,280 days. Presently, we are at 1,113 days, the second longest stretch recorded in 55 years. One would think that this condition alone is creating a very high degree of complacency. After all, nothing seems to put a dent in this market – not rising oil prices or gold prices or threatening international situations or breaks in leading stocks like Google. Not yet anyway!

“This one-way market is no doubt responsible for the near record inflows into Schwab equity funds recently reported. January flows were the biggest since February 2000. That is a warning sign that tells us that the inevitable correction is close. It is interesting to note that the prior corrections that followed the five longest periods with no 9% correction came in months other than the infamous month of October. They were February to March 1994 (9.7% decline), January to April 1953 (9.4% decline), May to June 1965 (11% decline) and August to September 1986 (10.2% decline).”

Meanwhile, over in the energy markets, Shartsis is looking for an important new rally phase in natural gas. Curiously, his bullish forecast relies on none of the typical fundamental arguments. He does not predict that cold weather will draw down inventories, or that Gulf of Mexico production will continue to lag behind pre-hurricane levels. Instead, he cites the extreme bearish sentiment of commodity advisors toward natural gas. “The price of natural gas has gone into free-fall since its big top, just under $16, struck on Dec. 13. The low seen a few days ago was accompanied by a 10-day Daily Sentiment Index (MBH Commodity Advisors) reading of 12.7% Bulls. For perspective, this gauge stood at about 80% in the energy frenzy of last summer. The current level is the lowest since 8.4% Bulls were recorded in September of 2004, just before a sharp natural gas rally from near $6.50 to over $9.00 in less than two months.” So far, the natural gas market is stubbornly refusing to rally.

FUEL – THE CATALYST

Whether you are aware of it or not, we are living in a highly inflationary war cycle. The money supply is surging at an alarming rate and nations continue to out-bid each other for natural resources. In a nutshell, the mad scramble for commodities is on. Unfortunately, this dangerous fight may only get worse in the future … glimpses of this are already unfolding with the geo-political unrest brewing in the Middle East. Today, our world faces a unique scenario – the enormous appetite of China and India. Both these gigantic countries have been shopping around the world securing their supplies of natural resources to meet the needs of their 2.3 billion people. And this insatiable hunger does not just stop with oil. Over the past couple of years, Chinese leaders have been busy purchasing all sorts of metals and minerals from Australia, South America and Canada.

The above has not gone unnoticed and the leaders in Europe and America are getting nervous. For decades, these developed regions have enjoyed an endless supply of cheap natural resources. However, this has now changed due to stiff competition from the highly populated emerging economies where demand is growing fast and per-capita consumption is amongst the lowest in world. To complicate matters even more, Iran plans to launch its oil bourse in March 2006, where (for the first time ever) Iran will sell its oil to any country who is willing to pay for it in euros. If Iran manages to set-up its oil exchange, countries around the world may not need to hoard so many dollars, which will seriously undermine American supremacy.

History has shown that each commodities bull-market in the past 200 years has coincided with a major war, without a single exception. So, now we are left with two choices: Either we learn from history and protect ourselves – or we continue to live under the illusion that everything will be okay. “How do I protect myself?” you may wonder. All I can say is that commodities will surely help you to safeguard your wealth. During periods of conflict, countries always embark on the road of massive money printing in order to finance their efforts. Already, America has spent billions of dollars in Afghanistan and Iraq. I hope I am wrong in my assessment, but if the conflict in the Middle East escalates, you can be sure that nations will print a blizzard of paper money. All this money printing and liquidity will cause the price of commodities to go sky-high.

Back in November, I had advised my readers to get back into the energy sector. Since then, oil has risen steadily and surprised most analysts and investment “gurus”. The reason the price of oil continues to go up is because our world is not able to pump enough crude oil from the ground to meet the rising demand. The global oil-production peak is upon us and investors must take action now in order to avoid financial pain.

RETIREMENT: READY OR NOT? NOT, APPARENTLY

This week in Washington, government leaders, retirement experts and financial services executives are meeting to discuss what employers, lawmakers and workers themselves can do to help Americans be better prepared for retirement. Overall, only about 60% of workers over 40 who are eligible to participate in their 401(k)s do, and the number of workers covered by a defined-benefit pension has steadily declined. Meanwhile, young workers have the lowest 401(k) participation rates of all workers under 65. Congress is considering legislation that would encourage all employers to offer automatic enrollment in 401(k)s and set the default contribution rate at 3% of pay, increasing one percentage point every year until 6% of pay is reached. The legislation would also encourage companies to offer a 50% matching contribution or contribute 2% of pay for all employees whether they contribute or not.

Of most immediate concern is the status of Baby Boomers, who are next in line to retire. According to research from Fidelity Investments, Baby Boomers only have enough in savings and other income sources to replace 59% of their pre-retirement income. Of those with 401(k) accounts, the average account balance is just $80,000, and many typically save just $2,750 a year toward retirement. You may think that is because they all have a pension coming to them. Not so. Only 57% of them expect to receive a pension, according to Fidelity. For those who do and who wish to reduce their working hours near the end of their careers, lawmakers are considering changing some rules so that workers could “phase in” their retirement, for example working part-time for their employers from 62 to 65 and collecting a portion of their pension at the same time.

HOW LONG CAN HOUSEHOLDS SUSTAIN NEGATIVE SAVINGS?

Never have so many spent so much and saved so little. The nation’s dismal savings rate is the focus of a sharp debate: This cannot go on forever, some economists say. We spend and borrow too much, we save too little, and in the long run, it spells trouble for individuals and the nation. Nonsense, others say. We might be dipping into our savings, but that is a deep well: Household assets – swollen by rising home equity – stand at $62 trillion, according to the Federal Reserve.

Only a long economic downturn is likely to settle the debate about whether Americans are saving enough. But the low savings rate cannot be entirely waved away. Americans can go on spending merrily until hard times come: a lost job, a recession, a health emergency. Then, assets and income will fall – and those without an emergency fund will be in danger. “We have a real savings shortfall,” says David Wyss, chief economist for Standard & Poor’s. “If you would be wealthy, think of saving as well as getting,” Ben Franklin advised. But now, saving seems to be the exception more than the rule.

Jill Reid, an interior designer in Seattle, is struggling to pay off $6,000 in credit card debt and a car loan. “I haven’t been able to put money away for two years,” says Reid, 32. “All my friends are in similar situations.” The nation’s personal savings rate seems to be saying the same thing. Last year, that rate sank to -0.5%. Households spent $41.6 billion more than they earned. The rate’s last dip into negative territory was in 1933, when banks were closed and breadlines were long. In January, the savings rate fell further, to -0.7%. But we are nowhere near a recession, let alone a depression. Why the dismal savings rate?

One factor is the way the personal savings rate is calculated. To arrive at the rate, the government’s Bureau of Economic Analysis adds income of all types. Then it backs out taxes to get disposable income – a rough equivalent of take-home pay. Next, it subtracts our expenditures: rent, food, clothing and frivolities. What is left, it figures, is savings. This calculation ignores capital appreciation. If you put $1,000 into a mutual fund and it becomes $1,500 in five years, you would consider that $500 part of your savings. The savings rate does not. That rate is a measure of household cash flow, not net worth. It also counts the full cost of purchases made over time – such as cars, computers and appliances. Seen that way, the nation’s savings is not in as dire shape as the savings rate might indicate. Still, however you define savings, many Americans are failing to build up cash reserves that can be tapped quickly in an emergency.

Why is savings slowing? The biggest reason for our poor savings rate is that people have been borrowing against assets – mainly their homes – to get their hands on spending money. Last year, consumers pulled a mammoth $243 billion from their home equity. “Previous years pale in comparison,” says Frank Nothaft of mortgage giant Freddie Mac. A low savings rate troubles some economists because savings is needed to drive the economy. Because the nation is not saving enough, it must rely on foreigners to finance its debt, by buying our bonds. But a chorus of economists say that is not a problem, because the rest of the world is awash with savings looking for a place to park. One problem with that argument, as Federal Reserve Chairman Ben Bernanke noted in February, is that eventually, countries with high savings rates, such as China and Japan, will find investment opportunities within their own borders. Another cause for concern is that without big gains in home prices, consumers will have to start funding their spending out of income – or regular savings.

The low savings rate points to problems on a smaller scale. Workers increasingly must save for their own retirement, as companies phase out traditional pensions. Given the low savings rate, you would suspect workers are not saving enough in 401(k) accounts. You would be right. Nor are people saving for emergencies. A Consumer Federation of America study last year showed that young women were particularly poor savers: 55% of women ages 25 to 34 had less than $500 in an emergency fund. And 42% of all women said they had no emergency fund at all.

If the stock market and the housing market remain in a long slowdown, people will have to rely more on income and less on assets. There is, of course, one way out: to live more simply. “You can live off your income if you lived the way people did in the 1950s,” Wyss says. That means one car in a family, a small home and fewer gadgets.