Finance Digest for Week of July 24, 2006

WHAT IF GOVERNMENTS HAD NOT DESTROYED MONEY?

What would the world economy and financial markets look like had government controlled central banks not followed a course of relentless increases in credit and fiat money supply? Any attempted answer to this question is sure to trigger a heated debate. In any case, however, answers would clearly depend on the alternative monetary systems that had been available at the time such decisions were taken./

Before the “Great Inflation”, seen between the late 1960s until the early 1980s, began to destroy monetary values in many industrial countries, Ludwig von Mises, one of the 20th century’s most important libertarian thinkers, put forward a monetary regime that is diametrically opposed to what has become the standard monetary system used today. Mises went to great lengths to rationalise and preserve a monetary system that would be compatible with the ideals of a free market society. It is important to note that from Mises’s perspective, preserving “sound money” was not an end it itself, or a principle defended on ideological or moral grounds, but a necessary (pre-)condition for maintaining a free market order: “It is impossible to grasp the meaning of the idea of sound money if one does not realise that it was devised as an instrument for the protection of civil liberties against despotic inroads on the part of governments. Ideologically, it belongs in the same class with political constitutions and bills of right.”

Under Mises’s constant money supply regime, U.S. prices would have, on average, declined as output increased, and the short-term volatility of prices would have corresponded to cyclical changes in output growth. An ongoing, and random, rise in the price level as a result of discretion on the part of the central bank – as is the case in today’s government-controlled paper money system – would not have been possible. In general, the real market interest rates would have reflected the expected (trend) increase in production. With the change in the purchasing power of money reflecting the negative of the latter, nominal interest rates would have been fluctuating around zero. Certainly, with nominal zero rates, savers could have earned a living from holding deposits with banks and buying bonds in capital markets. The compensation for savers and investors would simply be the real return as implied by the growth rate of total output – as the price level declines as output increases, the value of each money unit deposited and lent increases over time.

A constant money supply would clearly have strengthened the principle of the free market economy, given the increased need for prices to respond to changes in demand and supply. Producers could not have relied on inflation to restore equilibrium of relative prices, but would have to step up efforts to provide goods and services that meet customers’ demand. Indeed, the required decline in the price level, in line with productivity gains of the economy, would have affected consumer goods prices as well as asset prices. For instance, stock and housing prices could have shown (marked) increases over time. However, such a development would have been accompanied by an over-proportional decline in prices elsewhere – which would be a necessary factor in causing the economy’s price level to decline over time.

Under a constant stock of money, the financial sector could of course have been active in all kinds of businesses: lending, deposit taking, M&A, foreign exchange and bond trading, etc. The crucial difference, however, would be that banks were no longer in a position to increase the stock of money through lending as they do today under the fractional reserve system. With the nominal transaction volume remaining constant over time, the real rather than nominal credit supply would have expanded.

Clearly, with a constant money supply there would be no monetary policy. As a result, monetary-policy-induced booms and busts would be prevented. Monetary policy-induced swings, boom and bust, in the economy would no longer be possible. This contrasts with the status quo, under which central banks are regularly called upon to lower their interest rates to below the economy’s “natural rate”, thereby stimulating additional demand for (bank) credit. As an increase in the stock of credit and money “out of thin air” is bound to induce misallocation of capital, additional money-induced booms and bust would not have occurred.

The constant money supply regime would presumably entail another important implication as far as societal organisation is concerned. It would have made the de facto build-up of government debt by stealth much more difficult, perhaps impossible. This is because under a given stock of money, any increase in government bond supply would have tended to push up market yields, thereby directly and noticeably affecting the funding conditions of private households and firms (“crowding out”), which are competing for a given stock of payments.

To Mises, stopping any increase in the money supply would be just a first move (which was presumably not intended to last for long), followed by a second step. Mises called for a re-establishment of a functioning gold market, to ultimately allow the workings of the free market to freely adopt gold as the means of payments: “The classical or orthodox gold standard alone is a truly effective check on the power of the government to inflate the currency. Without such a check, all other constitutional safeguards can be rendered vain.”

In sum, there should be little doubt that had the gold standard been upheld, world economies had been spared many of the severe fiat-money-induced economic, social and political crises experienced seen in the latest decades, from which resulted the growing disenchantment with the idea of a free market order.

GOLD SHOWING WEAKNESS

Gold is showing weakness despite the tension in the Middle East. As a matter of fact, Gold is showing very few signs of short term strength. First, before I describe why, I want to say I am a long term gold bull. I bought gold and silver bullion last week at higher prices than now because of my philosophy of buy and holding gold. I bought last week even thought it looks like gold could go below 600. I have this philosophy of buying gold regardless of local time price movement. So, please just take this paper as research about gold.

The largest bearish force on gold temporarily is rising interest rates. When the BoJ raised its discount rate by 0.25%, gold dropped just as predicted. Gold has given back all of the flight to safety gains since India and Lebanon within a week of those latest events. Rising world interest rates are going to push gold down. That is just going to give me more time to buy bullion, which I am doing, as I have advised taking this opportunity to buy bullion on its way down. (Notice I did not say buy it at the bottom?) Quite interestingly, gold has dropped this week along with the USD weakness. That is a very gold bearish factor. Normally this is an inverse relationship, and the fact that both are dropping this week is a very unusual event. I believe this is very suggestive of strong gold bearish forces and possibly a big sea change on the world financial horizon.

Commodities are showing weakness, with the exception of oil. I believe that metals like copper are over bought. Speculators have ridden the copper mania and other commodities manias of late. Time for them to take money off the table. As a matter of fact, if I was to characterize the entire world financial situation, it is time for a lot of taking of money off the table in everything – which is why gold is going to drop with all these markets. Weakening commodities are gold bearish short term.

Rising interest rates are going to kill every major world stock market. I will reiterate that world stock markets and gold are synchronized. The last week they were not. Aside from these temporal flight to safety incidents, more of which are to come, overall gold and financial markets are liquidating and the world is going to cash. This is dollar bullish, and yen and euro bullish. People want dry powder now, that includes hedge funds, for their next speculations, which is probably going to be shorting markets quite soon.

$100 OIL SURE BET, ROGERS SAYS; OTHERS CONCUR OR DEMUR

Jim Rogers says oil prices will reach $100 a barrel, possibly this year. Merrill Lynch’s Francisco Blanch says no way. “Unless somebody discovers something very quickly and very accessibly, we’re all going to be dumbfounded at how high the price of oil will go, including me,” Rogers said in an interview in Singapore. Fighting in Lebanon between Israel and Hezbollah forces, backed by Syria and Iran, helped send New York crude oil for August delivery to a record $78.40 on July 14 on concern the violence may spread through the Middle East, the region that produces more than 30 percent of the world’s crude.

Not to worry, says Blanch, the head of commodities research at Merrill, the world’s biggest brokerage. Oil supplies would have to stop from a country such as Iran, the second-largest Middle East oil producer, to drive the market higher, he said. “It’s unlikely we will see another price rally from here, unless the current conflict expands beyond its current borders,” Blanch said in a July 17 interview in London. “You’d need physical disruptions, and large ones, to bring the price to $100. You’d probably need to lose Iran.”

A growing number of Wall Street traders are siding with Rogers. Bets on futures contracts for $100 oil tripled in the past three months, helped by demand for fuel from China. Oil has tripled in four years to more than $74 a barrel and gasoline pump prices reached $3 a gallon in the U.S., threatening to damage economic growth. Rogers says the rally will accelerate as supplies decline from aging fields and reserves become more difficult to find. Philip K. Verleger, an economist who founded PK Verleger LLC, an energy consulting firm, said only a U.S. recession can stop the advance to $100 a barrel before the end of next year.

Oil at $100 a barrel is “a very low probability,” said Tim Evans, an energy analyst at Citigroup in New York. The $100 level became a market benchmark in March 2005, when Goldman Sachs analyst Arjun Murti wrote that “we believe oil markets may have entered the early stages of a ‘super spike’ period, which we now think can drive oil prices toward $105 per barrel.”

“$100 oil is not a ridiculous idea,” Paul Horsnell – the second-best oil-price forecaster surveyed by Bloomberg last year – head of commodities research at Barclays Capital in London, said in a July 17 interview. Louise Yamada, an analyst who correctly predicted in July 2004 that oil would reach $67 within “months to years,” said she expects oil to reach $84 a barrel in the “short term,” then keep rising. “I wouldn’t be surprised to see oil in excess of $100,” she said. Oil was near $40 when she made her 2004 prediction. Adjusting for inflation, oil exceeded $86 in early 1981, when Iranian production collapsed following the country’s 1979 Islamic revolution.

Rogers said declining supplies from existing fields and a lack of new oil discoveries will drive prices higher. “The bull market has about 10 or 15 years to run,” he said. “How high it’s going to go I don’t have a clue during that time, certainly over $100 a barrel or over $150 a barrel before it’s over.”

Oil, oil everywhere.

There is an alarmist theory that the world is running out of oil. Quite the contrary. There is plenty of oil in the ground, and high prices are just what is needed to tap the earth’s vast reserves. For two decades low prices have discouraged the search for new resources in areas with the largest deposits of crude. Over time this has thinned out global production capacity and virtually eliminated the safety margin needed to provide a cushion against sudden crises. Today spare capacity is a mere 2% of world consumption, holding the price of oil hostage to every kind of political or climatic crisis, and fueling rumors and speculation.

Starting in the mid-1980s and continuing until the early years of the new century, the price of oil mostly oscillated between $18 and $20 a barrel, held down by oversupply. In 1986 and again in 1998-99 prices dipped below $10. In this environment oil producers, terrified by the specter of overproduction, held back on the search for new oilfields. Some countries limited production to already active fields. The scope of this phenomenon is extraordinary but barely understood outside the industry. During the last 25 years more than 70% of exploration has taken place in the U.S. and Canada, mature areas that probably hold only 3% of the world’s reserves of crude. The Middle East, on the other hand, has been the scene of only 3% of global exploration, even though it harbors 70% of the earth’s reserves.

Looking back over a longer time frame, you find the same lopsided ratios. In Saudi Arabia only 300 oil and gas wells (including developmental wells) have ever been drilled, as opposed to several hundred thousand in the U.S. The contrast is even more striking with respect to Iran and Iraq, and Russia is still paying the price for the technological backwardness and poor management of its fields during the Soviet era. Even today it is scarcely expanding its productive base, although its recent groping toward Western capital and expertise may change that picture. Venezuela could double its production of crude in 10 years with the help of foreign capital and technology, but political considerations drive it in the opposite direction, and its production is falling. In fact, the vast majority of prime producing countries get their oil from old fields, most of which have been in production since their discovery in the first half of the last century. And in many instances they are operated with 50- and 60-year-old technology and equipment.

While the industrialized world is concerned with future energy supply security and price, the producing countries have been driven by concern over future demand. Will consumption of crude hold up in the future, they ask, or is the current scenario only a bubble, bound to explode as it has done so many times before? Only relatively high prices for oil can provide a painful but effective antidote for the current situation. The process has already begun, but the cure will take time. Thanks to high prices, investment in oil exploration and development has exploded during the last two years worldwide. If global production continues at present rates, it could grow by 12 to 15 million barrels per day by the end of the decade. In other words, there is more than enough oil in the ground.

HOUSING: GRIN AND BEAR IT

The first stage of the grieving process is denial. That is the state the few remaining housing bulls seem to be in. Even the scant good news is tinged with bad. According to RealtyTrac, foreclosure activity dipped 5% across the nation in June from the previous month, although it is still up 17% over last year’s pace.

But the real news, sending shivers down the spines of speculators who have yet to exit stage left, was from Nevada and California, where foreclosure postings spiked. In Nevada, foreclosures rose 13% over May, nearly double the national rate. In California, foreclosures were up 15%, boosting the Golden State to No. 2 in the nation, ahead of Florida. The best news came out of Texas, where foreclosure postings plunged 22%. That said, the level of postings remains so high that the Lone Star State retains its status as the No. 1 foreclosure state for a 7th straight month. And those figures speak solely to the existing stock of homes.

Although it has taken some time to catch up with the stream of builder warnings, the National Association of Home Builders’ housing market index for July finally reflected the gravity of what is facing the hammer-and-saw crowd. Last week’s release put the index at 39. To put that into context, 50 is the cutoff point between expansion and contraction. July’s level is the lowest level in nearly 15 years. Even the usually gregarious NAHB chief economist, David Seiders, could not muster the levity to mention a “soft landing” in the press release. Instead, he spoke of “growing builder uncertainty on the heels of reduced sales and increased cancellations” and builders’ concerns of “more monetary tightening by the Federal Reserve that could drive interest rates, and thereby homeownership costs, even higher.”

For the coming quarter, Merrill Lynch equates the current housing market index with 1.5 million housing starts a year, down from January’s 2.27 million unit peak level and the current 1.85 million rate. “We still think that homebuilding stocks should be avoided,” wrote Merrill chief investment strategist Richard Bernstein. “With energy prices rising, inflation measures at cycle highs, and the Fed potentially continuing its tightening cycle, we think that homebuilding stocks may be a classic value trap.” A “value trap” stock appears undervalued to the naked eye but defies logic by becoming cheaper yet. But that is just one sector. The bigger issue is housing’s growing influence on the broader economy.

Lights Out in Georgia

Following is a set of posts from a real estate broker who goes by the name “Sonnypage” on The Motley Fool. This synopsis is with his permission. Follow the progression from 2006-01-04 through 2006-07-20.

2006-01-04: “Many of you know by now that my wife and I are both REALTORS and associate brokers. … We are seeing an extremely high level of relocation activity. Our business last year was very solid, we closed 26 transactions. So far this year, days into the year, we have two transactions pending, booked in the fourth quarter, plus 25 prospects. If only two-thirds of those prospects close, then we already have 18 or so deals. They are evenly split, buyers and sellers, but much more importantly, 19 involve relocations. This is a very high level of relocation activity, the highest we have seen in years.”

…

2006-07-20: “It’s been a character-building year, as another agent in our office put it the other day. What makes it more stunning, at least to me, is that it started out so well. We ended the first quarter with nine deals pending or closed, which is a very solid start. Then we hit a brick wall with only three deals in the second quarter and that would make it our worst second quarter ever in our 12 years. … Then it got worse. … So here we are with 10 deals and needing a total of about 20 to meet our cash flow needs: personal and business, plus taxes. The last year we failed to ‘make a living,’ so to speak, in real estate was about 1994. Without a strong finish, we just may be looking at that again. … What do you do if you owe more on your home than you can sell it for? Apparently, you just decide to sit on it and hope for a better market, at least for now.”

For one reason or other, REALTORS across the country thought, “It’s different here.” “We are unique.” “Real estate is local.” “It won’t happen here.” “There is no bubble.” Look at all the reasons given:

• Demographics – Florida and California
• Strong jobs – California
• Relocations – Atlanta and the Southeast
• Retirement – Las Vegas, Phoenix, Florida
• Strong economy – Everywhere but the Rust Belts
• This place is unique – Damn near everywhere.

And in every case, my set of answers was the same:

• Home prices have outstripped wages by 4-5 standard deviations from normal
• Home prices have outstripped wages by 4-5 standard deviations from normal
• This cannot continue
• What cannot continue will not, by definition, continue.

One by one by one, all of the local experts who said, “It’s different here,” are finding out, “It’s NOT different here.”

The “strong economy” was (and still remains) an illusion. What we had was an economy totally propped up by homebuilding and real estate transactions. 40% of all homebuying in both 2004 and 2005 was for second homes, or for “investments”. In addition, people were all too quick to spend that increased “wealth” from home price appreciation (and then some), going deeper and deeper in debt.

The economy has not crashed (yet), because homebuilders are still building. That supports jobs. But when those houses do not sell (and they won’t – without enormous discounts), all this “paper wealth” of homeowners is going to vanish overnight. As soon as someone drops their price by $100,000, every house in the neighborhood will be repriced. Comps will drop like a rock. Consumers used to seeing nothing but rising prices are in for a rude awakening. Their house will no longer be an ATM. Consumer spending is 75% of the economy, and it has only one way to go, and that is down. There are going to be a lot of people hurt badly in the recession of 2007.

It will be interesting to see who the scapegoats will be: Realtors … the Fed for hiking rates too far … homebuilders for slashing prices … neighbors for slashing prices. Where does the blame really belong? On the Fed, not for raising rates, but for cutting them to 1% in the first place and flooding the world with dollars in the biggest liquidity experiment the world has ever seen. On banks and Fannie Mae for loose lending standards. On themselves for getting caught up in bubble madness, just as they did with stocks in 2000, then taking cash-out refis and spending like drunken fools, further fueling a runaway economy.

Glut of unsold new homes across U.S. hits record high.

The glut of brand new unsold homes for sale across the U.S. hit a record high in June, a government report showed, as some economists warned of a worsening market in coming months. The latest data appeared to confirm a cooling trend in the housing market, following a boom and sky-rocketing prices of recent years that have priced many hopeful new home owners out of the market. In recent months, a steady rise in interest rates hikes has prompted a downturn in home buying.

Sales of new U.S. homes declined 3% in June to a weaker-than-anticipated annualized rate of 1.131 million units. Analysts also zeroed in on the inventory of unsold new homes which leapt to a record high last month. The government said the inventory of unsold new homes on the market rose 0.7% in June to a record 566,000, representing a 6.1 month supply of brand new homes at the June sales pace. Most of the unsold new homes are located in the south of the country, the report showed. Apart from a slight one month drop in the inventory in May, the stock of unsold new homes on the market has risen steady over the last 12 months.

“Many individuals, who signed a (purchase) contract in what they had believed was a booming housing market, may now be backing out of those contracts,” said Phillip Neuhart, an analyst at Wachovia Securities. “Thus, the new home market is likely weaker than new home sales reflects. We expect both existing and new home sales to continue their slide throughout this year and the next.”

Will housing illness infect other sectors?

In a recent report, Northern Trust Co. chief economist Paul Kasriel wrote, “There is no question that the housing sector has entered a recession. Will the rest of the economy follow?” His first conclusion was based on building permits, which were down 12% in the second quarter, the weakest showing since 1991. Answering the question he posed is a bit trickier. “Our bet is that the economy is losing altitude faster than what the [Federal Open Market Committee] says – what the FOMC says publicly, that is,” Mr. Kasriel added.

Goldman Sachs chief economist Jan Hatzius is not quite as bearish, but he is concerned enough to use his strongest language yet. His latest missive on housing is titled “On Track for a Large Housing Hit”. Mr. Hatzius’s calculations, based on the homebuilder index’s steepest annual fall in its 20-year history, predict inflation-adjusted residential investment could drop by a 15% annualized rate or more in the second half of this year. This would shave 0.9% points off real GDP. And that is just the direct impact of housing on the broad economy. “In contrast to the direct effect, which if anything is occurring more quickly and more violently than expected, the jury on the indirect housing effect is still out,” Mr. Hatzius wrote.

After 5 years of growth, home prices drop in D.C. area.

In what may be the most telling sign yet that the real estate market here has shifted downward, median prices of homes in several parts of the Washington area have declined when compared with the same time last year. In Loudoun County, for example, the median price of homes sold dropped 1.2% last month, compared with June 2005, according to Metropolitan Regional Information Systems, the area’s multiple listing service (MLS). In Fairfax County, prices fell by half a percent in May and a tenth of a percent in June. And in the District, the decrease was 0.8% in March and 1.2% in May, compared with the same months last year, even though prices in the District in June were higher than the year before. The median is the point at which half of the houses cost less and the rest more.

The declines are small, and certainly not universal. Prices continue to rise in some areas, most notably Prince George’s County, where houses are still relatively inexpensive. But the drops are significant because they mark the first time in half a decade that home prices have fallen in a 12-month span, illustrating just how much the real estate landscape has changed after five years of double-digit growth in home prices.

The areas with declines have some things in common: swelling numbers of houses for sale, slowing sales and lots of new houses on the market. In Loudoun, where developers have put up acres of new subdivisions in recent years, nearly 5,000 properties are for sale via the MLS, which includes mostly resale homes. That compares with 1,800 a year ago. Homes there now take an average of 75 days to sell, compared with 21 days a year ago. In the District and Fairfax County, the number of unsold homes and time on the market has also increased, boosted by a large supply of condominiums. What has happening is part of a national trend in which regional markets that led the country during the boom are seeing prices flatten or decline as the number of unsold homes on the market mushrooms.

The question for many local buyers and sellers is whether the small declines foreshadow big price reductions in the months ahead. Economists are split. One view is that any declines will be insignificant or temporary because of job growth and the strength of the local economy. “Could it be a 5 percent drop in prices? Could it be 10 percent? Whatever it is, it will be short-lived, because demand is right there on the sidelines,” said David A. Lereah, chief economist of the National Association of Realtors.

But others see a steeper, prolonged downturn in prices because of overbuilding in some areas, speculative buying and a run-up in prices that has outpaced affordability. Prices, they added, have actually declined more than the MLS statistics indicate because sellers have been offering such incentives as help with closing costs. Peter Morici, an economist at the University of Maryland, said prices could drop 10% by the end of the year, and perhaps by 20% “by the time it’s all over.”

Foreclosure filings in Massachusetts jump 66%.

Foreclosure filings in Massachusetts increased 66% in the second quarter, a trend that is expected to continue over the next year. Mortgage lenders filed 4,292 notices of foreclosure against homeowners in Q2, up from 2,585 a year earlier, according to ForeclosuresMass Corp., which compiles the data from Massachusetts Land Court. That 66% surge compares with a 30% rise in first-quarter filings.

The state’s rate of past-due mortgages – the number of homeowners more than 30 days behind in their payments, as a percent of total mortgages – is 3%, compared with 4% nationwide, according to the Mortgage Bankers Association. Lenders have filed for foreclosure on 0.6% of Massachusetts mortgages, below the 1% national rate. But, ForeclosuresMass president Jeremy Shapiro said he was alarmed about the pace of Massachusetts’s sharp recent increases. “The foreclosures in Massachusetts right now are skyrocketing,” he said. “This is a problem that’s going to extend through 2007 and 2008.”

Kevin Cuff, the executive director of the Massachusetts Mortgage Bankers Association, said these are “big increases.” However, the total number of mortgage loans also has ballooned. For example, just 315,000 mortgages were extended to Massachusetts homeowners in 2000. By 2002, loans had doubled and hit a record 870,000 in 2003. Lending activity has slowed recently, to 535,000 mortgages in 2005. It “would seem logical” that the total number of foreclosures statewide would rise, Cuff said, because there are more total loans outstanding.

Foreclosure filings do not mean the imminent loss of property for a homeowner. Once they receive notice from a bank or mortgage company, homeowners may be able to work out a refinancing plan with their financial institution or sell the home and pay off the loan, averting foreclosure. That strategy is increasingly difficult, because home sales are down sharply from a year ago, particularly in the suburbs. The strategy may be impossible for homeowners with little equity in their homes or homes that have declining value.

Sharpiro and Cuff both cited the popularity of adjustable-rate mortgages as a cause of homeowners’ financial problems. Those who stretched to buy high-priced homes with these loans, which offer lower rates than 30-year, fixed-rate mortgages, now face payment increases as the interest rates mover higher. Adjustable-rate loans are “a big driver now and will be more so going forward,” Shapiro said.

Mortgage rules get tougher as housing cools.

Downward momentum in the housing market is leading some of America’s biggest mortgage lenders to adapt business plans for even softer demand. They are launching new cost cuts and risk-reduction strategies that suggest growing concern for the $9.5 trillion home mortgage industry. “I’ve never seen a soft landing in 53 years, so we have a ways to go before this levels out,” Countrywide chief executive Angelo Mozilo said. “I have to prepare the company for the worst that can happen.” Countrywide, the nation’s biggest mortgage lender, plans to cut as much as $500 million in costs in the next year.

At New Century, one of the nation’s biggest subprime lenders, chief executive Brad Morrice said the company has tightened some credit requirements as it puts “more thought into loans you want to make or don’t want to make.” While lenders tighten credit requirements to reduce expected defaults, they are taking new risks elsewhere. Countrywide, New Century, and Thornburg Mortgage Inc. are wading deeper into more lucrative payment-option adjustable-rate mortgages, products increasing in popularity since borrowers can defer all principal and portion of interest for a period. The lenders conceded the loans have unknown risks as their payments reset higher, but for now are relying on data including credit scores to manage their default exposure.

Fed showing concern over housing slump.

Nothing has been more important in driving the U.S. economic expansion that began nearly five years ago than housing. It could be just as vital as growth slows. Federal Reserve officials are watching warily to see whether the housing retrenchment that began late last year will remain modest or turn into a rout that could damage the economy severely.

The Fed raised interest rates 17 consecutive times over the past two years to keep inflation under control, and the officials have understood that at some point that would sting housing. What has only become evident in recent months is that, perversely, the big decline in housing affordability – due to the combination of double-digit housing price increases year after year and higher mortgage-interest rates – would cause a surge in core inflation. Would-be homeowners – either priced out of the market or simply fearful that the value of a home purchased now could fall in coming months – are renting instead. As a result, rents of residences and the so-called owners’ equivalent rent components of the consumer price index have shot up this year. Together, those carry such large weights in the CPI that their increases accounted for almost two-thirds of the full percentage point increase in the core CPI in the first half of this year. From December to June, the core rose at a 3.2% annual rate, up from a 2.2% rate in the second half of last year.

As for the links among rising interest rates, a cooling housing market, increasing rents and the surge in core CPI, Bernanke said that the high weight rents carry in that index is one reason the Fed prefers to focus on the core personal consumption expenditure price index. The PCE index “puts a much lower weight” on rents, he said. In addition, Bernanke said, “the increase in inflation we have seen is a much broader phenomenon than that single component. If that single component was the only issue, I would think twice.” Presumably, the Fed chairman meant that he would think twice about raising the Fed’s target for the overnight lending rate if rents were the only issue.

Even if rents are not the only issue, the causes of why they are rising so much mean that Fed officials do regard them somewhat separately from the other inflationary pressures at work. Essentially, the surge in rents is seen as a transitory phenomenon that will ease gradually. That process has begun in the Washington metropolitan area, according to recent stories in the Washington Post. Rents are rising because of an extremely low vacancy rate, partly because many potential homebuyers have turned to renting instead. Tens of thousands of new and existing condo units are on the market, and thousands more are under construction. At least 4,000 upscale condos that were to have been sold will be leased instead, the Post said. In other instances, some older apartment complexes, which were to be converted to condos, will be renovated and remain on the rental market. The number of unsold homes on the market rose to 3.725 million units, almost 40% more than a year earlier.

“This implies that we are only at an early stage of home sale problems,” economist Ken Mayland of ClearView Economics told his clients. “At some point along the way, prices could crack big time.” Fed officials recognize that possibility. It is probably their greatest single worry about growth right now.

Homebuilders start fessing up.

Several of the homebuilders have reported second quarter earnings over the past week. During the first quarter, most homebuilders started experiencing a challenging market. At the time they were not concerned because the winter is normally a slower period and felt that activity would rebound during the spring selling season. It has not quite worked out as planned. Orders have continued to drop, while cancellations have increased. Most homebuilders have reduced forward earnings guidance and the tone of the conference calls have definitely changed. I have included sections of the various conference calls below.

Home builders’ bonds take tumble.

Bonds of U.S. home builders, profitable through April, have turned into the biggest losers this year in the market for debt with ratings below-investment grade.

How U.S. homes are hurt by rising energy prices.

Soaring energy prices have literally hit home. Although it was not always true in the past, crude-oil and gasoline prices, along with higher financing costs and decreased affordability, may have pushed the U.S. housing market into a palpable decline. Rising fuel costs often translate into higher mortgage expenses as the Federal Reserve raises short-term rates to squelch inflation. As energy prices have spooked consumers, Federal Reserve Chairman Ben Bernanke has noted how higher household spending on gasoline is slowing the overall economy. At what point do rising energy prices start to directly depress home sales?

Those who are furthest from their jobs are most vulnerable to energy-cost run-ups. As home prices rose in the frothiest areas, homebuyers mainly have done two things to augment house affordability: They financed with risky, interest-only loans to ensure the lowest-possible payments and moved farther out from employment centers, where prices are lower. It is not unusual for commuters to drive more than 60 miles (97 kilometers) one-way in southern or northern California or for New York-bound workers to live in eastern Pennsylvania. This has happened where houses were already priced well above the national average. Four-hour commutes are not unusual now around several large cities.

Because of the bruising cost of the commute, it becomes dearer to live in the home on the edge of the metropolis that was initially more affordable. With some exceptions, the vast American vehicle fleet has shown little progress in improving fuel consumption. The average 2006-model car achieves 21 miles per gallon, while many gluttonous sport-utility vehicles favored in suburbia get less than half that.

It is also costing more to own a home if you are playing the increasingly roiled bond market through your mortgage. Homeowners with the shortest-term, adjustable-rate loans are on the edge. One in three respondents in a recent survey by the Realtors association said “rising monthly payments – especially property taxes and energy costs – will force them to sell their home and buy a less expensive one.” Over the past two years, even with rates rising, home prices have often seemed to defy gravity. Now, rising finance costs and energy concerns are unwelcome residents under the same roof.

FORMER GOLDMAN EXECUTIVE KVETCHES ABOUT INVESTMENT BANKERS’ POST-BOOM TURPITUDE

Autopsies abound of the Internet and telecom bubble that drove the Nasdaq index past 5,000 points in 2000. “Much less has been written, however, about the investment banks’ own bubble,” writes Jonathan Knee, who spent almost 10 years engineering mergers and acquisitions for Goldman Sachs and Morgan Stanley. In The Accidental Investment Banker, Knee chronicles his decade, concluding that “the culture that emerged during the boom undermined the integrity of these institutions in a way that will make it difficult if not impossible for them ever to regain the role they once held.”

Knee’s arguments come across, though, as a yearning for a bygone age that may or may not have really existed. There is little insight into how either the allocators or the consumers of capital might have behaved differently, and not much originality in what amounts to a diatribe against modern capitalism. Liar’s Poker, which remains the classic of the genre of investment banking exposes, has a lot of Salomon Brothers and not much Michael Lewis. Knee’s book has too much Knee, not enough anecdotes to illustrate his assertions – possibly because Knee’s role as an adviser to publishing companies kept him in a backwater and away from the front row of the investment-banking industry.

INTERNET BUBBLE MAY BURST – AGAIN

Is the bubble about to burst, again? Investment in Internet companies has climbed so steeply since the dot-com crash of 2000 that some Silicon Valley veterans worry that too much money is again pouring into too many unproven, unprofitable ideas – setting the stage for another high-tech shakeout. Watching venture capital firms invest billions of dollars in new companies last year, longtime Internet executive Richard Wolpert branded the upswing “a mini-bubble”. But “about a month ago,” he said, “I started dropping the word ‘mini’.”

In the first three months of this year, venture investors funded 761 deals worth about $5.6 billion. That is up 12% from the same period last year and the highest first quarter since 2002. One sector in particular is heating up fast: media and entertainment. The $254.9 million invested in blogging and online social networks in the first half of the year already exceeds such spending for all of 2005, according to Dow Jones VentureOne. The $156.3 million pumped into online video is also on pace to surpass last year’s investment.

The popular success of social-networking site MySpace, bought last year by Rupert Murdoch’s News Corp. for $580 million, and video-sharing site YouTube has inspired a spate of imitators. In online video alone, there are nearly 180 new companies – not to mention big players such as Yahoo!, Google and CBS – vying to be the next YouTube. There is also VideoEgg and Video Bomb, Blinkx.TV and Blip.TV, Guba and Grouper. But MySpace and YouTube have yet to make big bucks. And if neither of the industry leaders is profitable, some skeptical investors are wondering what hope there is for the scores of copycats. “YouTube has been a cultural phenom,” said Mike Hirshland, a general partner with Polaris Venture Partners. “But how many YouTube knockoffs have been funded in the last six to nine months? The market has capacity for a certain number of successful winners. Whether it’s one, two or, if it’s really exciting, three – you can debate. But eight?”

Venture capitalists say they are being more responsible this time. The current run-up does differ from the implosion that began in 2000 and, within two years, wiped out $5 trillion in paper wealth on Nasdaq. Nasdaq’s market value peaked at $6.7 trillion in March 2000 then plummeted to $1.6 trillion by October 2002. (It has since recovered to $3.6 trillion.) For starters, venture investment remains dramatically below the first Internet boom’s height. The first quarter of 2006 saw less than 20% of the $28.1 billion spent in the first quarter of 2000. Also significant is the lack of investor appetite for initial public offerings. Unlike the last round of online exuberance, small investors are not buying shares in an online pet store with a sock puppet as its public face. And the range of companies sprouting this time is narrower. In the 1990s, entrepreneurs tried adapting any number of business ideas to the Web. Now, they are more sharply focused on free services that can be supported by the growing demand for online advertising.

Some investors argue that there will not be another dot-com implosion, that the investment boom in online media companies is part of the natural ebb and flow of venture capital: Money plows in to unproven start-ups, winners emerge and the investors move on to the next opportunity. Nevertheless, overinvestment carries potential consequences. If Silicon Valley again disappoints the pension funds and college endowments that bankroll venture capital, it could find itself spurned next time, stifling the next round of innovation.

With the public markets soft, money managers are desperately seeking other ways to get the returns needed to fund their pension plans, including hedge funds, buyouts and venture capital. The prospect of finding the next Google when it is still young holds great appeal, and they are willing to fund 10 venture-backed fledglings in hopes that one hits it big. To veterans like Wolpert, former president of Disney Online who now serves as an adviser to RealNetworks and Accel Partners, it all seems familiar. “If you screw up once, it’s an accident. If you screw up twice, it’s a trend.”

NANOTECH LURES BANKERS, VC’S WITH PROMISE OF $1 TRILLION MARKET

Venture capitalists, lured by potential breakthroughs in electronics, medicine and textiles, are heading to the labs in search of inventions based on nanotechnology, the study and manipulation of particles smaller than 100 nanometers. A single nanometer is equal to one-billionth of a meter. After decades of hype and false starts, the National Science Foundation forecasts that $1 trillion worth of nanotechnology-enabled products will be on the market by 2015. This year, corporations and governments will spend more than $11 billion on nanotechnology research, according to Cientifica, a London-based consulting firm.

VCs are hovering, eager to create startups and then shepherd them to the public markets. Last year, venture firms invested $496.5 million in nanotech-related companies, 21% more than in 2004, according to Lux Research, a New York-based firm that studies nanotechnology. “Nanotechnology is no longer just a novelty,” Lux Chief Executive Officer Peter Hebert says. “It’s working into the industrial food chain.”

Wall Street is wading into nanotech. Investment banks are hiring Ph.D.’s to scout developments and advise clients. In March, San Francisco-based Global Crown Capital LLC started a $250 million nanotechnology-focused hedge fund, the first of its kind. Indexes are sprouting up to monitor publicly traded nano companies such as Hillsboro, Oregon-based FEI Co., which builds microscopes for nanotechnology-minded scientists. The Lux Nanotech Index of 26 companies has gained 53% from its inception. The index has fallen 1.6% this year, compared with a 6.1% drop in the Nasdaq Composite Index. In October 2005, PowerShares Capital Management LLC initiated an exchange-traded fund to track the Lux index. The fund had gained 4.8% so far.

Experiments using nanotechnology may yield new ways to tackle everyday annoyances such as ketchup stains or lead to the creation of microscopic devices that detect and treat cancer. VCs are investigating oil-eating molecules that clean up spills, fabric fibers treated with tiny particles to repair rips and cheap solar panels made of newly invented materials. But the route from science project to viable business can take years and suffer twists and turns. Investors have been waiting for almost five decades for nanotech to catch fire in a meaningful way. Richard Feynman, who won the Nobel prize in physics in 1965, described nanotechnology’s potential in 1959 in a lecture at California Institute of Technology.

That tricky balance between gee-whiz science and the art of building a viable business is why few venture capitalists are able to sniff out research projects that will generate helpful products and then stick with them, says JoAnne Feeney, an analyst at Punk Ziegel. The VCs, hedge funds and Wall Street firms wading into nanotechnology are banking on the decades of research in making things tiny finally adding up to something big.

TECH BEAR SMELLS FEAR

With yesterday’s 41-point run-up in the Nasdaq reminiscent of the 37-point bounce last Wednesday that was eliminated – and then some – by week’s end, there is no way around it: We are officially sliding back into a tech bear market. By “officially”, I mean that old rule of thumb that says when stocks in a market or market sector drop more than 20%, it stops being a correction and starts being a bear market. Many of the most closely watched stock indices have moved close to losing a fifth of their value – if they have not done so already – from the high points they reached since the last bear market a few years ago. Some have already lost more.

The Nasdaq 100 – watched by some as a large-cap tech index even though there are plenty of non-techs in it – closed down 18% Friday from its 2006 high. Sector-specific indices, like the Amex Internet and Morgan Stanley High-Technology, were down 19% and 20%, respectively. By the end of this week, they could find themselves squarely into bear territory. Once there, they will find familiar company. By Friday, the Nasdaq Telecommunications Index was down 26% from its recent highs, and the Philadelphia Semiconductor Index was down 31%. The sense that this may be something darker than a chance to buy on dips took root after a week of bad earnings news. Dell was down 11% Friday after warning – yet again – of disappointing earnings. PMC-Sierra and Packeteer were down more than 20% in one day on disappointing earnings -- joining Yahoo! in the goat parade on Wall Street.

The term “bear market” seems to have been creeping back into popularity for a few months. Take a look at the Google Trends (a helpful analytical tool to chart how search queries of a particular term have grown more or less popular over time). Starting in May, the number of people typing “bear market” into Google’s search engine started to grow, and it accelerated as the month wore on. That is just around the time when many of the tech titans started the declines that they seem unable to pull themselves out of. Of course, the 20% selloff mark is really an arbitrary point. But whenever major indices drop below it, it tends to have a crystallizing effect on the thinking of investors. Some pare back their long-term holdings. Some see it as a contrarian chance to buy into an oversold correction.

Who is right this time? The way many tech stocks declined last week suggests there is still a good deal of fear in the air. Companies like AMD, with strong earnings but weak revenue, got whacked. Some of the week’s gainers, like Apple and Microsoft, won out by beating previously lowered forecasts. Microsoft and eBay tempered uninspiring guidance with news of buybacks – a move that tech companies often take when their own financials are not buoying up the stock price. As a whole, money managers seem to be giving up on a tech rally at least for the rest of the year. As Jim Cramer pointed out on his radio show last Tuesday, institutional investors are pouncing on any sign of strength as an opportunity to sell – a classic bear market mentality.

They might no longer be tech giants.

Strike up the Wagner. It is time for the third and calamitous act of that epic, sprawling opera Twilight of the Tech Gods. It has been nearly four years since the curtain came down on the first act, when the Nasdaq plunged to 1108 and all seemed dire. The second act was not nearly as dramatic, with giants like Microsoft, Dell and Intel scrambling to right themselves and take advantage of a changing landscape and lay plans for their resurgence. This year, it is growing increasingly clear that these companies are not heading for a resurgence, but a tragedy. If you had bought them four years ago when the Nasdaq was nearing the bottom of its trough, you would have lost money on all three. Microsoft is down 4.7% over four years, Dell is down 4.6%, and Intel is off 3.7%.

Those declines are not exactly votes of confidence. Investors are valuing these companies today below where they did during the Nasdaq’s darkest hours, when typical headlines read “Investors are Sick of Tech”, “What’s Holding Back the Economic Revival?”, and “Nasdaq Declines 3% on Gloomy Forecasts”. Each of these companies has unique explanations as to why they are seriously lagging every major stock index (the Dow Industrials are up 18% over four years, the S&P 500 is up 25% and the Nasdaq has gained 45%). But there is a common element to all of them: The tech world evolved away from the personal computer, and they failed to adapt.

Four years ago, a new generation of tech gods was emerging, tech companies that did not rely on PCs for their revenues, but relied on the Internet itself. Amazon.com, eBay, Yahoo! and, later on, Google returned life to the technology sector. This graph plots out how dramatically they ascended even as the older tech giants were flagging. But more recently, even these Internet gods are looking winded. Take a look at these same stocks over the past six months, and it is harder to tell the new tech gods from the old. With the exception of Google, every one of these stocks is having a terrible year in 2006.

Four years ago, Microsoft, Intel and Dell ran out of tactics to keep their stocks rising. The same thing started happening to Amazon and eBay a year and a half to two years ago. Google, and possibly Yahoo!, may yet have some life in them, thanks to the strong demand for search-related advertising. The search-growth story still has to play out, but investors have been worried for a couple of years about what new products and services Google will devise to keep its growth rate up. Without them, Google may soon join the others.

If and when that happens, who will be there pick up the baton? It is certainly not clear today. Despite all the hype over how the Internet is evolving into Web 2.0, how social networks and streaming video and wireless zones are going to take tech to the next level, what Wall Street is telling us is that there are not any leaders on deck to take us to that next level. And that is a big change. It used to be the savvy tech investor could simply surf from the stock of an aging giant to one on the rise. But for the first time, there may be no tech name for investors to turn to should Google’s rise come to a halt.

Instead, the tech industry may turn into a gerontocracy, guided by a bunch of graying old geezers, short on new ideas and big on indigestion – the way the Japanese consumer-electronics giants, which once ruled the tech world, have looked for the past 15 years. And that would be an ending tragic enough to depress even Wagner.

THE BANK OF JAPAN IS NOT TO BLAME FOR RISK ASSET DECLINE

In recent weeks, some investment commentators have unfairly tried to lay the blame on the Bank of Japan for the recent global decline in risk-bearing assets. The BoJ, however, has simply removed from its system vast excess liquidity, built up over several years to stimulate a stagnant, deflationary economy. It is no longer necessary or desirable to maintain this liquidity now that the Japanese economy has recovered and its financial system stabilized. Notably, most market commentators have cheered this unorthodox liquidity build-up since its inception in 2001 and few have argued against its demise this year.

Furthermore, the BoJ has loudly broadcast since early this year that it was going to end this system of “quantitative easing”. So when it happened in March, the only people who were surprised were those who thought the BoJ might have waited slightly longer. As for whether the BoJ caused disruption in a “yen carry trade” – in which investors borrow cheaply in the yen to invest in high-yielding foreign assets elsewhere – it is unclear how much yen carry trade was actually being funneled into risk markets. Even if the amount of the carry trade was large and there was some effect on risk markets, this is not the fault of the BoJ but of those who took such risks. Rather, should we not congratulate a central bank for diluting the alcohol content of the punch bowl when risk assets seem too overheated?

More likely, the decline in risk assets since mid-May was due to the fact that commodity prices were moving in parabolic fashion and that investors realised that global central banks, especially the U.S. Fed, would need to tighten further to arrest it. Central banks around the world have indeed increased their hawkish rhetoric since then and raised interest rates more (or earlier) than the consensus previously expected.

“JUST WONDERING” DEPARTMENT: GREENSPAN WAR CRIMES?

Here is an intriguing question: Could Greenspan (and the Bank of Japan) be at least partially responsible for the commodity boom as well as the liquidity bubble? Could the commodity boom (or bubble if you like) be a direct function of the liquidity bubble?

Oil at $70, $3 copper, and sky-high base metals are a function of massive developing world demand at the margins. Developing world demand for crude at the margins has also stimulated geopolitical tensions by putting pricing power in the hands of bad guys (Iran, Venezuela, etc.). Developing world demand was artificially juiced by the Bretton Woods II arrangement, i.e., China et. al would not have ramped up capex investment in factories, roads, machinery, plants etc. nearly as quickly if not for the gaping maw of the American consumer willing to consume all the “stuff” China produced.

The housing bubble was essentially a giant ponzi scheme that masked the true role of foreign creditors. Consumers, feeling richer and fatter on real estate, bought more stuff with their inflated gains, not realizing they were actually spending borrowed money. In turn, stocks gained on fat corporate profits, ostensibly traced back to a flush consumer, but actually are traceable further back to borrowed money.

So, look what happens when you remove the initial Greenspan/BoJ stimulus from the equation. No willy-nilly consumer spending ramp up. No mercantilist debt ramp-up masked by ponzi housing profits. No massive capex build-up in Asia and elsewhere to respond to artificial demand .No $75 oil, $3 copper … no raging commodities boom. What if developing world demand had ramped up more slowly and naturally in the absence of massive liquidity stimulus? Could all (or most) of these painfully sharp imbalances have been avoided, including $3 copper and $75 oil?

If China’s growth in recent years has been drastically above trend due to the mercantilist-driven, liquidity-fueled Bretton Woods II arrangement, would that explain Asia’s perplexing disconnect between thriving export economies and struggling domestic economies? What happens, then, in the aftermath of liquidity withdrawal? Does China go back to trend with a thud, with ugly nationalist antics (saber rattling at Taiwan, etc.) to follow?

And – last but not least – if Iran Kicks off World War III, and Iran’s clout is a product of $75 oil, and $75 oil is Easy Al’s indirect doing, does that mean we can prosecute Greenspan for war crimes?

CHINESE ECONOMY: KAA … BOOM?

Despite how well things have been going for China’s economy, there has been a huge thorn in the paw of Asia’s new “powerhouse” – the stock market. The Chinese government had been very concerned about its poor health, and for good reason. After hitting an all-time high in mid-2001, the Shanghai Stock Exchange Composite index (SSE) lost more than half of its value in 2001-2005. The glaring disparity between the Chinese economy – which at the time was adding an average of 8% a year, vs. the depressed position of the SSE was so disconcerting for Chinese officials that last summer they even considered creating a “$15 billion fund to help bail out the nation’s ailing stock market” (New York Times). But mid-summer last year, Chinese stocks rebounded – and have rallied for over a year.

Curiously, after the SEE began its rally, the Chinese economy also picked up pace. Already one of the fastest-growing economies in the world, in the first half of this year it posted a staggering annualized growth of 10.9%. Yet do you not find it peculiar that there was a rebound in the stock market first – and then one in the economy? After all, the conventional economics says the opposite should have happened. “Everybody knows” that it is the strong economy that drives the stock market, not the other way around. Right?

Wrong. Fans of Elliott wave analysis know that in any country with a free market system, what drives both the stock market and the economy is the social mood of that society. Social mood changes for its own, endogenous, internal reasons, and it does so according to an Elliott wave pattern. The stock market signals those changes first: When stocks rally, it means the country’s collective psychology is improving. When stocks fall, the opposite is true.

And here is the crucial point: The stock market usually signals changes in social mood before the economy does. Stocks are a liquid, quick barometer of how a society “feels”. The economy is a much more complex system (hirings, firings, credit applications, purchases, productivity, inventories, etc.) that needs more time to reflect the shifts in collective psychology – which is why the economy usually lags the stock market. Just as it did in China. In the 1990’s, rallying Chinese stocks were first to show that the country’s mood was fast improving. The Chinese economy followed. Then in 2001-2005, stocks fell hard, exposing a negative shift in China’s social mood. The economy stayed relatively strong, a residual affect of the former mood – but its growth had slowed in 2003-2005. And now that the SSE has rebounded again, so too has the economy – albeit with a delay. If China is your darling, though, do not break out the bubbly yet. The SSE so far only exhibits a 3-wave pattern from the bottom in June 2005.

THE U.S. DOLLAR: SURPRISE, SURPRISE

The dollar sure knows how to surprise, does it not? In December 2004, for example, it stood at an all-time low of $1.356 against the euro and ¥102.58 against the yen. Yet by the end of 2005 the USD had defied all the “crash and burn” forecasts, to gain 14.6% on the EUR and 15.2% on the JPY. This was its best performance “against the euro and yen since 1999 and 1979 respectively” (WSJ).

Despite last year’s stellar comeback, most analysts still expected trouble ahead for the buck. A majority of the forex analysts polled by Reuters back in January, for example, said that some time in 2006 the buck’s upward trend would certainly, well, buck. Why? Simple. “Bad fundamentals.” The chief one of those, of course, is America’s growing trade deficit. Oddly, though, when the U.S. government reported two weeks ago that the U.S. trade gap grew some more in June, that did not stop the dollar from hitting “three-month peaks against the yen and Swiss franc” shortly after the report was released (Bloomberg). Hmmm.

The dollar’s latest “surprise” came on Wednesday, July 26, when it was reported that the Ifo “business climate index for Germany fell to 105.6 in July from 106.8 in June, a worse-than-expected decline” (AFX News). You would think the dollar would rally on the news – but no. It lost against the euro instead, sending the EURUSD some 180 pips higher towards the end of trading on Wednesday.

Try counting such “surprises”, and you will quickly run out of fingers. From an Elliott wave viewpoint, the explanation for them is simple, though. What moves the forex markets is not robotic reasoning – it is traders’ emotions, their collective psychology. “Fundamentals” are useless when trying to predict them.

INTERNATIONAL DEBT CRISIS

There is some dispute as to what exactly set off the tremendous expansion of debt to developing countries in the 1970s. A rather typical explanation runs something to the effect that after the first major oil price hike touched off by the Yom Kippur War of 1973, the OPEC countries faced real limits to where these “petrodollars” could be effectively invested. As they sought more lucrative investments, they turned increasingly to Western banks to absorb the windfall. Dollars flowing out of the industrialized countries in payment of costly oil shortly came flowing back in the form of credit. The banks of the industrialized nations were obviously pleased to be the recipients of this windfall, but it did present them with a challenge. The same oil hikes which had served the OPEC countries so well had caused (or at least exacerbated) an economic contraction in the major western countries, and it was difficult to find sufficient commercial and industrial interest in taking new loans. In order to put these petrodollars to use, many of the restrictions and requirements on lending were over­looked. It became a true “buyers market” for loans among the poorer nations.

This all sounds quite plausible, however in his book Manias, Panics and Crashes, historian Charles Kindleberger points out that the rush to loan to developing nations had already begun several years before the outbreak of the Yom Kippur war. In his view it was largely due to a “serious mistake in monetary policy” that had caused the sudden rush to provide loans to the developing world. The error was “cheap money initiated in the United States to help with Nixon’s presidential reelection campaign” at the same time “the Deutsche Bundesbank was tightening money to curb inflation.” (p. 21)

This, too, is probably somewhat simplistic. Though I would not deny the importance of monetary factors, I seldom think they are uniquely causative. More valuable than this particular explanation, I believe, is his general thesis that manias are normal, relatively predictable phenomena which are an integral part of economic history. I believe the essential “mania-revulsion cycle” pattern outlined by Kindleberger fits the sudden expansion of debt to developing nations quite well.

TURNING BACK THE CLOCK ON OPTIONS BACKDATING

On a Friday night five years ago, a technology executive named Dave Rickey appeared on Maria Bartiromo’s weekly television show and delivered one of the more amazing performances in the history of CNBC. Like a lot of companies in early 2001, the one Mr. Rickey ran – a silicon chip maker called Applied Micro Circuits – was going through tough times. Its customers were canceling orders for new equipment, and its stock had sunk from a high of more than $100 in the summer of 2000 to just $29 when Mr. Rickey sat down with Ms. Bartiromo. He started the interview by being upfront about the state of the industry, predicting that things might get worse before they got better. But within a few minutes, he was making his pitch. His company’s products were not low-priced commodities, he said, and the long-term prospects looked as good as ever. “The demand for bandwidth,” he explained, “is not only insatiable, but it’s in its infancy.”

At this point, Ms. Bartiromo reminded him that about a year earlier, he had dared investors not to own Applied Micro stock, and Mr. Rickey quickly reissued the challenge on CNBC. “You know, Maria, I am very bullish about the company. I think we’re in the right space,” he said. “I dare you not to own my stock now. But, you know, I’m kind of a gutsy guy, and I have a lot of confidence in what we’re doing.” What made this so amazing was that Mr. Rickey had already come very close to accepting his own dare. Ms. Bartiromo never asked him about his own holdings of company stock, and he did not volunteer the information, but it turns out he had sold more than 99% of his shares over the previous two years, for a profit of $170 million. He was unloading the same stock that he was urging investors to buy.

Mr. Rickey stepped down from Applied Micro last year, and now – with the stock trading at $2.37 – he is in the news again. As part of the growing inquiry into the backdating of stock options, the Justice Department and S.E.C. are investigating whether the company improperly altered the dates on option grants to benefit employees. On February 10, 2000, for instance, Applied Micro filed public documents claiming that Mr. Rickey received 1,000,000 options on January 19, a day the stock briefly dipped below $36 before shooting above $50 in the three weeks that followed. The next grant, of 800,000 options, had even better timing. “He looks very, very lucky,” said Nejat Seyhun, a finance professor at the University of Michigan. “This is very unlikely to have happened by chance, but it doesn’t prove by itself he has done anything wrong.”

In fact, the publicly available evidence against the company is not as clear as in some other backdating cases. A couple of Mr. Rickey’s later grants look perfectly normal. But this makes Applied Micro a useful case study in an odd way, because backdating is really part of a larger problem that will not go away even if some people end up going to jail. Despite all the post-Enron rules, executive pay is still a rigged game, and going after backdating will not change that.

Mr. Rickey’s accomplishments do not look so good in retrospect. His CNBC predictions turned out to be spectacularly wrong. The company has not made an annual profit since 2000, and its work force has been cut by a third in the last few years. To recruit new management, the current chief executive moved the company from the San Diego area up to Silicon Valley. Yet the board at Applied Micro had bestowed so many options – backdated or not – on Mr. Rickey, now 50 years old, that he was able to walk away with a fortune. With it, he has retired, bought homes in Southern California, put his name on the Rickey Science Center at Marietta College in Ohio and endowed a professorship at Columbia.

Amazingly, the company has appointed one of the men who sat on the compensation committee from 1999 to 2004 – Harvey P. White, a Qualcomm founder – to lead the company’s internal investigation into backdating. For the government, obviously, the question is not whether Mr. Rickey’s pay was undeserved. It is whether he and the board broke the law by secretly changing the date on his option grants, after the fact, to make sure the grants came with the lowest possible exercise price. But the rest of us would do well to focus on how somebody could have become so rich while running a company so poorly.

The people who own the company – the ones whose money is being used – need to have control over the purse strings. The problem with executive pay is not that it is high. The problem is that pay often is not based on a real negotiation between an executive and a board. It is more like a friendship in which the board kindly gives the executive a big pile of the shareholders’ cash and then claims it is actually paying for performance. As Mr. Rickey said to the Marietta College class of 2005, while delivering the graduation speech there, “It’s all about money, until you have it. Then it was never about money at all.”

INFLATE OR DIE

Stock and commodity markets around the world have hit an air pocket on the tough talk by central bankers. Their fears of CPI inflation and inflation expectations spiraling out of control are the stated reasons for the current round of global monetary tightening. Hope springs eternal that a soft landing can be engineered in asset markets without touching off a liquidity crisis. Yet these synchronous tightening initiatives have repeatedly stood out as the catalyst for Long Term Capital Management-like blowups and stock market meltdowns over the past decade. It amounts to removing the stimulus that set into motion the stock and housing market malinvestments in the first place. This potential market-disrupting event is on the minds of many. Especially those who respect the lessons of history.

Whatever may happen this summer as this tightening campaign plays out, the fact remains that the developing world is industrializing at a rapid pace. 20+ years of perfecting a comparative advantage in financial engineering in lieu of investments in tangible wealth production will grow to haunt the U.S. The Asian “Money Migration” is not dependent upon the fed funds rate, but instead reflects the outsourcing of real wealth production capacity. A hedge fund blowup or a rise in the cost of capital will not end this gradual process.

This line of thought infects many modern academic economists who seek to explain the growth of an enormous credit bubble that is rooted in excessive consumption. The credit bubble will deflate under its own weight as the household savings rate drops further into negative territory. Those who promote government intervention in free markets will be itching to “clean up” the mess left behind by this spending contraction, because there will not be another housing bubble on deck to provide a bailout on the scale we have witnessed in recent years. What we have, after decades of evolution, is a monetary system whereby the debt created by every previous credit bubble must be papered over in true Ponzi fashion in order for the real economy to function at a level that provides full employment.

Credit that is self-repaying out of investments is one thing, but credit that is taken out in return for a pledge of future payments out of a 30-year household income stream is quite another. Consumer credit and mortgages are financed through a combination of two options: house price inflation or pledging a percentage of future household income toward installment payments. Lately, the servicing of this debt has been accomplished by option one. Now that this option is near its point of exhaustion, option two must become a larger part of the payment mix. The share of household income devoted to paying down debt must go up in the long run.

For reasons of simplification, not to mention the fact that its case has been successfully argued by the most proven economists in history, I define “inflation” as the Austrian school of economics does: an increase in the supply of money. Prices for goods and services can rise and fall for a variety of reasons: labor strikes, wars, OPEC actions, Hurricane Katrina, recessions, overcapacity, etc. But the ultimate root of inflation is the money that the Fed prints in the course of its open market operations to monetize short-term government securities. CPI inflation ensues when the growth rate in the money supply exceeds the growth in supply of goods and services. The current CPI does not resemble that of the 1970s, because U.S. dollars are flowing overseas at a rate of $2-3 billion per day. If this fire hose of foreign-bound liquidity decelerates, the pressure on the recently accelerating CPI numbers will increase. If it reverses, it is lights out for the dollar reserve standard.

When the Fed lowers rates, it prints money and buys up Treasury Bills in the banking system, effectively raising the amount of loanable cash on bank balance sheets. Banks are not in the business of holding cash with no yield, so they become more aggressive about loaning out the newly printed cash on their books. This is the crucial step where malinvestments often originate. Easy monetary policy inevitably aggravates boom/bust cycles. Consider how many hundreds of thousands of bad mortgages have been written over the past three years. The coming wave of defaults will exacerbate a housing/credit/consumption correction that is long overdue.

To complicate things further, rookie Fed Chairman Ben Bernanke brings to the FOMC his ivory tower “inflation targeting” theory – using backward-looking, highly doctored statistics like core CPI to conduct open market operations that raise and lower short-term interest rates. These rates clearly work their way into the economy with a lag. Therein lies the serious flaw in this theory. In the time between when the doctored core CPI stats are crunched and the policy works its effect on the economy, recessionary conditions may approach quickly. We are in the midst of such a time. Credit addicts are fast approaching withdrawal symptoms.

Central bankers can talk down markets with their rhetoric, and may even go so far as to cause a financial accident, but every developed economy around the world is dependent on an edifice of credit and derivatives that makes future policy a foregone conclusion: Inflate or die. Before the housing market enters a tailspin, you should remain confident that the Fed and Congress will team up, do a marvelous job at printing money at no cost, and providing it to debtors who are clamoring for it. There is legal precedent for this behavior in the savings and loan crisis and the New Deal.

RUSSELL 2000 SET TO RISE 30% … IS IT POSSIBLE?

“Over the next six months, don’t be surprised if the Russell 2000 rises 30% or more.”

I almost choked on my coffee when I heard those words come from Steve Sjuggerud’s mouth. Surely, I heard him wrong. “There is no way the Russell 2000 is going up 30%,” I thought to myself. “That’s absurd.”

According to Steve, 58% of individual investors (as polled by the American Association of Individual Investors) think stocks are set to fall. He went on to say, “More people are bearish stocks today than during October 1987 – the month of the greatest stock market crash of our generation. Back then, only 33% of investors thought stocks were headed lower. In fact, this is the strongest bearish sentiment reading since early 1990 – during the middle of the only ‘real’ recession in the last 24 years. And it is equal to the sentiment at the end of February 2003.”

Guess what happened in 1987, 1990 and 2003, when bearish sentiment was so prevalent – when so many people were so certain the market was headed lower? Stocks rose big over the next six months. Especially small-cap stocks on the Russell 2000. In 1987, the small-cap index rose 37%. In 1990, the Russell 2000 rose nearly 50%. And in 2003, small-cap stocks rose about 40% in six months.

FOOL-ISH NONSENSE

Someone recently sent me a set of articles that appeared on the Motley Fool and asked for comments. All three were written by one Mike Norman.

The first article is called “Tune out the Debt Doomsday Crowd”. Following are a few snips: “Have you ever seen one of those debt clocks? They show our national debt, with the numbers ticking away at the end so fast you can’t even read them The debt is a source of popular conversation again, now that it has hit a new high of $8.4 trillion. And of course, it’s never been out of favor with the Debt Doomsday crowd. I’m sure you know those folks. They’re the ones who have been predicting a debt-driven collapse of the U.S. economy for decades – yet it’s never happened … When you look at that as a percentage of GDP, however, it comes in at a very comfortable and manageable 38%, which is well below the post-World War II average of 43%.”

I hardly know where to start. The chart above shows the debt-to-GDP ratio was higher under Truman. But this was in the wake of World War II and with the baby boom just starting. The debt-to-GDP ratio is now close to a peacetime record high (if one calls this peace) and far exceeds the Vietnam era debt-to-GDP ratios under LBJ and Nixon. Will there be another baby boom to bail us out? I think not. When the baby boomer time bomb triggers, there will likely be nothing comfortable at all about government debt, especially if current deficit spending continues and there are fewer workers supporting each retiree. To this I will add that every year, the government attempts to hide more and more expenses (such as the war in Iraq) off the balance sheets. Furthermore, estimates of U.S. GDP are total fabrications of reality. For those who want to tout GDP and U.S. growth compared with the rest of the world, I suggest reading “Grossly Distorted Procedures”.

Monetary nonsense is running out of hand, yet people believe what they want to hear. What people want to hear are the “free lunch” ideas that Norman is spouting. Yes, “It hasn’t mattered yet.” All I have to say is, “How comforting.” Until the Great Depression happened, such a thing had not happened on a worldwide scale ever before, either. Until the Nasdaq collapsed by 75%, that had not happened. Until gold rose from $35 to $800, that had not happened. Arguments that suggest something cannot happen because it has not happened yet are silly. Moreover, it has happened in Japan.

In Norman’s next article, he proclaims, “America IS Fiscally Responsible”: “While it’s true that the nominal figures have grown, it’s a mistake to examine the deficit and debt numbers without some frame of reference. That frame of reference is how big the economy has grown. To ignore the growth in inflows (or the asset side of the balance sheet) gives a totally lopsided view. … When it comes to the government, however, the Debt Doomsday crowd doesn’t want you to know about the income and asset side of the balance sheet. All they want you to see is that big, scary debt figure … [A]ll the worries about the Social Security and Medicare ‘time bomb’ are misplaced. Do you realize that those dire forecasts have been around almost since Social Security’s inception back in the 1930s? Yet they have never come to pass.”

Once again, we see the same reasoning that it has not happened yet, so ignore it. Of course, it has not mattered yet. The condition that triggers the Social Security problem is a massive baby boomer retirement, and that has not yet happened. But it is about to. In 2004, there were about 30 beneficiaries for every 100 workers. By 2030, there will be about 46 beneficiaries for every 100 workers. As bad as Social Security looks, Medicaid/Medicare looks worse. Those interested in real facts should see what the comptroller general of the U.S., David M. Walker, is worried about. Norman may not be worried, but Walker seems worried, and you should be too.

As for ignoring the asset side of the equation: Heading into the Nascrash of 2000, assets were high. What happened to those assets? They plunged, right? Did debt go away? No, it did not. We are in the same situation now, only worse. Greenspan and Bernanke replaced one bubble (in the stock market) with multiple bubbles (housing, stock market, debt). When assets rise 100% and debt rises 100%, what has really happened is that leverage and risk have increased exponentially. What happens if home prices fall a mere 20%? What happens if the stock market falls 40% from here? What happens if real estate prices fall for eight consecutive years? Remember, they fell 18 consecutive years in Japan. Of course, people like Norman say, “It can’t happen,” or, “It can’t happen here,” even though such things have already happened.

In effect, Norman is suggesting, “It’s different this time.” That argument has a historical 100% failure rate. I do not buy it. Nor should you, given that home prices are in many places 4-5 standard deviations above normal compared with both rent and wage increases. Time and time again that housing prices have reverted to the mean. When that happens, it will make a mockery of those touting the “asset side of the equation.” We are now facing the housing equivalent of the “mother of all margin calls”" for leveraged debt backed up only by housing prices expected to rise forever. The ramifications of that margin call will be enormous. Consumers have never been in worse shape from a debt standpoint or so dependent on rising house prices. When home prices plunge, asset values will be wiped out, but the debt will remain. Compounding the problem is the “Bankruptcy Reform Act” – an attempt to make people debt slaves forever.

In July 2006, the St. Louis Fed dared to raise the question, “Is the United States Bankrupt?” Their conclusion? “Countries can and do go bankrupt. The United States, with its $65.9 trillion fiscal gap, seems clearly headed down that path.” Let us now consider Norman’s third article in the series. This one is entitled, “How Big Is Your Trade Deficit?”: “I’ve already written about the budget deficit and the national debt, and I hope you now have some better perspective on those issues, so that the next time you hear the typical one-sided commentary, you’ll be better equipped to analyze the arguments. Today, I’d like to discuss the trade deficit … Although we had a $710 billion outflow because of our big import tab, foreigners pumped a whopping $1.2 trillion in investment into our economy. … The $1.2 trillion figure more than covered the $710 billion trade deficit, but as usual, the media and the so-called ‘experts’ focused only on the red ink, and not the good stuff happening on the financial side. … Nobody forces foreigners to invest in America. … But they put it here because the U.S. economy is the world’s engine of growth. Foreign nations … have been growing their economies and creating jobs for their citizens by selling products to America. … All they’ve done is gain an advantage in exports, but it comes at a tremendous cost to their citizens’ standard of living. … Another way to state it is that imports are a benefit, while exports are a cost.”

For the third time, we see arguments that equate to “It’s different this time.” This one suggests that outsourcing of jobs to India and China is a result of strength in the U.S. economy. I strongly disagree. Outsourcing of manufacturing jobs that are replaced with jobs at Wal-Mart can hardly be a good thing. In the classic sense, savings are what are left over from production after consumption. Given that the U.S. is now a nation of consumers, as opposed to producers, any idea that equates consumption as opposed to production as a position of strength is fatally flawed. The U.S. savings rate hit a negative 1.7% the lowest since the Great Depression. Is that strength? Is it remotely sustainable? The fact that U.S. consumers must grow increasingly indebted to maintain their lifestyle is ample evidence of the unsustainable nature of the current trend. It seems that Norman, like others before him, is making the classic mistake of confusing “savings” with unwarranted asset price inflation caused by “bubble economics” and reckless expansion of credit.

The idea that the standard of living in China and India is falling is absurd. The fact is the middle classes in China and India are rising exponentially, while ours is, arguably, shrinking. Real (inflation-adjusted) wages have been falling in the U.S., while rising elsewhere. That is unprecedented in an “economic recovery” and is proof that purchasing power in the U.S. is falling. An increase in jobs and wages elsewhere (in conjunction with a falling U.S. dollar) suggests that purchasing power outside the U.S. is rising, not falling. The idea that “imports are a benefit, while exports are a cost,” is unsound thinking. It overlooks the destruction of real capital at a rate nowhere near sustainable.

Foreign governments are buying Treasuries because they do not know what else to do with the balance of trade dollars – no more, no less. Anecdotal evidence of that statement is easy enough to establish: China tried to buy Unocal, but Congress interfered. Foreign governments have been trying to buy U.S. port operations, but Congress blocked those too. So exactly what are they supposed to do with those dollars? Buy oil, you suggest? OK, if China uses those dollars to buy oil, what does Saudi Arabia do with those U.S. dollars? The bigger the U.S. deficits are, the more U.S. assets foreigners are going to buy (or try to buy). So foreigners eventually do have to buy U.S. assets (or the balance of trade has to reverse), which is in stark contrast to the statement, “Nobody forces foreigners to invest in America.” Eventually, the U.S. is going to be selling off more and more assets to foreigners, whether we like it or not. We have no choice. That fact that we are selling off the U.S. piece by piece because we have to (not because we want to) is further proof that our current consumption binge is not sustainable.

For now, foreigners have been willing to finance our deficits for a mere 5% interest rate. While I suspect this can continue for a while, it is a big mistake to assume this arrangement will last forever. The only solution will be to sell off more U.S. assets, to stop spending, or to hope to God the rest of the world gets as crazy as we are about buying stuff on debt. The latter will only help us if we have a manufacturing base in the U.S. The imbalances that Norman says do not matter are about to. A consumer-led recession is coming our way regardless of what we do now, but the real price to be paid will come later, when China and India no longer need U.S. consumers to grow.

I fear for people who take Norman’s message to heart. On the other hand, perhaps I should thank the Fool, and Norman as well, because the “no problem yet” viewpoint is so pervasive in current thinking that rebuttals like this need to be heard. On that basis, I them for those posts.

THE UNITED BANKRUPT STATES OF AMERICA?

The word “bankruptcy” is often misused. It is not uncommon to hear someone say, “So-and-So is bankrupt” when what they really mean is that “So-and-So cannot pay his bills.” In this latter situation, if So-and-So cannot pay his bills, then he or she is technically “insolvent”. Insolvency means that you cannot pay your bills as they fall due in the ordinary course of business. Insolvency can also reflect a situation in which someone’s total assets, if made immediately available, would not serve to pay off all of the liabilities. It is an important distinction.

What prompts me to write about bankruptcy is a recent report by economist Laurence J. Kotlikoff, professor of economics at Boston University. Kotliloff wrote of his conclusion that the U.S. government is “bankrupt” insofar as it will be unable to pay its creditors, who, in his use of the term, “are current and future generations to whom [the U.S. government] has explicitly or implicitly promised future net payments of various kinds.” Later, Kotlikoff notes that “Unless the United States moves quickly to fundamentally change and restrain its fiscal behavior, its bankruptcy will become a foregone conclusion.” Kotlikoff takes note of what he calls a total net “fiscal gap” that looms in the future of the nation – the present value of the difference between the federal government’s future income and expenses, as calculated using relatively optimistic assumptions, not including any contingent liabilities such as natural disasters or wars.

I agree with the criticism of U.S. fiscal policy that is embodied in Kotlikoff’s report. By shining a spotlight on the long-term indebtedness of the U.S. government, Kotlikoff is doing a good service. He is highlighting the immense level of federal liability. But I have to take issue with Kotlikoff’s use of the term “bankrupt” in this context. Can the U.S. government really be financially “bankrupt”? There are implications of sovereign debt and potential future government default that go far beyond the government simply not being able to pay its bills on time. I want to take the opportunity to explore some terms and revisit some history.

The concept of bankruptcy is quite old. The word itself comes from two Latin words, bancus and ruptus. In ancient Rome, the bancus was a tradesman’s counter, across which almost all transactions were conducted and money was exchanged, not unlike the merchant’s counter today (except without the cash register). You can see old banci in, for example, the ruins of Pompeii, preserved for almost two millennia beneath the ash of the Vesuvius eruption of A.D. 79. And the word ruptus means “broken”. So literally, bancus ruptus translates as the breaking of a tradesman’s counter.

The ancient roots of both the concept and the term for bankruptcy deal exclusively with personal and commercial financial failures. There are no real historical roots for sovereign financial failure. When Alaric and successive groups sacked Rome, for example, they did more than just smash the banci of the merchants. They tore the nation to ribbons. Thus, the use of the word “bankruptcy” in connection with unpayable U.S. federal financial obligations may be inapt. It would probably be better to label the U.S. situation as one of “insolvency”.

Rome conquered the British island as far north as Scotland, and Roman law governed parts of Britain even after the Roman Empire fell. The historical records are sketchy, but point to the existence of some form of bankruptcy procedure in medieval Britain. Early American law closely followed English law. Hence, the legal process of bankruptcy was available during the first days of American colonization. Bankruptcy proceedings and remedies followed the English template and occurred from the British Maritime provinces of Canada to the Massachusetts Bay Colony to the Virginia settlements. English bankruptcy procedure spread wherever English colonization carved a trail. The State of Georgia was founded as a “debtors’ colony”, to which English debtors were sent in lieu of debtor’ prison in England.

The concept of “indentured servitude” became established in the Colonies, as both a means of emptying the English jails and of populating the New World with a labor force. Indentured servitude was a means by which debtors could work off their debt through physical labor to benefit the creditor. Many individuals in England, looking for a way out of a system stratified by class and rigid economic limits, booked passage to the New World by signing up as indentured servants to pay the fare. One of the most famous indentured servants in American history was a young man named Benjamin Franklin, whose later views on avoiding and staying out of debt were very much formed and informed by his early indentured experiences.

France, too, had many poor people and not a few debtors who owed quite a bit of money to creditors. But instead of adopting a national policy to send its poor and indebted to the New World, France sent Jesuit priests (and some explorers and traders) to its territories in Canada. Apparently lacking an understanding of the use to be made of indentured servants in overseas colonies, France kept much of its debtor class at home. After a century of such divergent immigration patterns, France was confronted with a populous group of English-speaking, British-controlled colonies to the south of its own holdings in Quebec, Ontario, and beyond Michigan and Wisconsin to as far west as the Rocky Mountains. Thus, there came a time when French interests came into direct conflict with the expanding colonial and demographic interests of Britain. Not a few formerly indentured servants in Colonial America “bought” their freedom with service to the English king during the Seven Years’ (“French and Indian”) War (1756-1763).

The French Revolution was an outgrowth of the need for the French government to confront its national debt. This revolution was truly an example, writ large, of the ancient Roman concept of bancus ruptus, except that in this case, the French people smashed the entire national system of governance and a whole lot more. The national debt of France was a result of a long series of efforts by the monarchical government to gain and hold empire. Yet the French effort to gain and hold empire did not include a national policy of “exporting” large numbers of the nation’s poor people to distant lands where they could find some hope, if not make trouble for others.

The French Revolution gave rise to Napoleon. And in 1803, Napoleon found himself badly in need of funds and facing an indefensible situation in North America. So Napoleon sold France’s Louisiana Territories to a young and rising U.S.A. and its ambitious and prescient President Jefferson. The price for the Louisiana Territories was all of 3 cents per acre. For France, this was truly a national bankruptcy sale.