Turkey Day Readings

Before we get to today’s links, I want to wish everyone a Happy Thanksgiving. While this has been a tough year for many people it is important to reflect on the positive influences in our lives and things we are thankful for.

Tanks or a slow moving train wreck? In his missive this week, John Hussman compares the coming credit losses in home mortgages as Option ARMs reset and prime borrowers fall even further behind on their payments to tanks slowly rolling over a hill to attack villagers. This is very similar to the slow moving train wreck analogy. I think of the impending commercial real estate (CRE) problem as a slow moving train wreck. Everyone is talking about it. Bernanke, Buffett, Elizabeth Warren; you name it. Honestly, the need to refinance billions of CRE debt over the next few years and the associated difficulty based on plummeting property values is the worst kept secret in America today. The conundrum is that there is no way to quantify the damage it is going to cause. Banks are clearly extending and pretending as much as they can. They are putting up a good face but you know that some of the managers are not sleeping at all at night because they know how exposed they are to CRE. (Well, except for at Goldman because it is easy to sleep when God is clearly on your side.)

There are two reasons why I think the market has not reacted more dramatically to the continuing negative impact dodgy CRE loans will have on bank’s balance sheets and capital levels (as evidenced by the huge run-up in banks stocks and levered REITs trading at ridiculous valuations). First, everyone is hoping that markets will rebound before the refinancings are necessary. If you look at previous periods in which real estate lost a significant portion of its value, it has taken many years for prices to reach their prior peaks and in places like Japan it never happened. I actually wrote a piece on this that I think is very pertinent. So, while lenders and borrowers would be much better off if prices went up and cap rates went down, thus causing the properties to no longer be underwater, based on the data I looked at this scenario does not seem particularly likely. Second, the whole process of the unwinding of CMBS and the need to roll over property debt is sort of nebulous. In aggregate the numbers are gigantic but the pain will probably be spread out over a number of years unless vacancy rates continue to go up and lead to more actual foreclosures.

Now, why am I rambling on about CRE when Hussman’s piece was about residential real estate? Because, in contrast to the well known CRE issue, the fact that housing has not yet bottomed is actually a bit of a secret. There have been plenty of people who have called the bottom in housing and have cheered as the $8,000 homebuyer credit and normal seasonality have propped up housing data. But no matter how many RMBS the Fed buys and how much money the government gives homebuyers in an attempt to re-inflate the housing market, job losses, interest rate reset and underwater mortgages are going to cause even more foreclosures and further declines in prices. Throwing money at potential buyers does not fix the underlying problem that people took on too much debt and/or no longer have a stable flow of income. I’ll let Hussman take it from here:

Now, we face a coupling of those weak employment conditions with a mountain of adjustable resets, on mortgages that have to-date been subject to low teaser rates, interest-only payments, and other optional payment features (hence the “Option” in Option-ARM). These are precisely the mortgages that were written at the height of the housing bubble, and therefore undoubtedly carry the highest loan-to-value ratios.

The inevitability of profound credit losses here is unnervingly similar to the inevitability of profound losses following the dot-com bubble. In that event, it wasn't just that people were excited about dot-com stocks in a way that might or might not have worked out depending on how fast the economy grew. Rather, it was a structural issue that related to the dot-com industry itself – those bubble investments couldn't have worked out in a competitive economy, because market capitalizations were completely out of line with what could possibly be sustained in an industry that had virtually no cost to competitive entry. If you understood how profits evolve in a perfectly competitive market with low product differentiation, you understood that profits would not accrue to the majority of those companies even if the economy and the internet itself grew exponentially.

In the current situation, the assumption that the credit crisis is behind us is completely out of line with what possibly could result from the marriage of deep employment losses and an onerous reset schedule on mortgages that have extremely high loan-to-value ratios. A major second wave of mortgage losses isn't a question of whether the economy will post a positive GDP print this quarter or next. Rather, it is a structural feature of the debt market that is baked into the cake because of how the mortgages were designed and issued in the first place…

The past decade has been largely the experience of watching tanks rolling over a hilltop to attack the villagers celebrating below. Repeatedly, one could observe these huge objects rolling over the horizon, with an ominous knowledge that things would not work out well. But repeatedly, nobody cared as long as it looked like there might be a little punch left in the bowl. As a result, long-term investors in the S&P 500 have achieved negative total returns over a full decade. These negative returns, of course, were also predictable at the time, based on our standard methodology of applying a range of terminal multiples to an S&P 500 earnings profile that has – aside from the recent collapse – maintained a well-behaved growth channel for the better part of a century.

An interesting proposal on banking reform: Lately there have been a number of political and financial commentators speaking out about the need to return to a Glass-Steagall-influenced banking model in which commercial banks and investment banks are forced to get a divorce. The thinking, as espoused by Paul Volcker and others, is that investment banks should be free to gamble with their own money but should not be allowed to gamble with taxpayer money provided through the FDIC deposit backstop. If that forced people inclined to risk taking to move to hedge funds then so be it. At least hedge funds risk their own capital and aside from LTCM have failed without taking down the entire global economy. Personally, I happen to like the idea of going back to a partnership structure for investment banks in which the partners are always at risk of losing their own capital. That’s a much better situation than the US taxpayer being at risk when the banks lever up and do foolish things.

With the understanding that something should be done (although it looks less and less likely every passing day) to remove the taxpayer from the above equation, I came across this op-ed article in the Wall Street Journal by the deputy director of financial and enterprise affairs at the OECD that makes the case for what are known as NOHCs (as if we needed more acronyms in our lives):

One proposal, which we now submit for consideration, is that banking and financial service groups could be structured under a variant of non-operating holding companies (NOHCs), in all countries.

Under such a structure, the parent would be non-operating, raising capital on the stock exchange and investing it transparently and without any double-gearing in its operating subsidiaries—say a bank and a securities firm that would be separate legal entities with their own governance. The subsidiaries would pay dividends through the parent to shareholders out of profits. The nonoperating parent would have no legal basis to shift capital between affiliates in a crisis, and it would not be able to request "special dividends" in order to do so.

These structures allow separation insofar as prudential risk and the use of capital is concerned without the full divestment required under Glass-Steagall or in response to the recently-expressed concerns of Paul Volcker and Mervyn King—such extreme solutions should remain the proper focus of competition authorities. With an NOHC structure, technology platforms and back office functions would still be shared, permitting synergies and economies of scale and scope. Such a transparent structure would make it easier for regulators and market players to see potential weaknesses. Mark-to-market and fair value accounting would affect those affiliates most associated with securities businesses, while longer-term cost amortization would dominate for commercial banking. It would create a tougher, non-subsidized environment for securities firms, but a safer one for investors.

If a securities firm under this structure had access to limited "siloed" capital and could not share with other subsidiaries, and this were clear to the market, this would be priced into the cost of capital and reflected in margins for derivative transactions. The result would likely be smaller securities firms that are more careful in risk-taking than has been the case under the "double gearing" scenarios seen in mixed or universal bank groups.

Finally, if a securities affiliate were to fail under such a structure, the regulator could shut it down without affecting its commercial banking sister firm in a critical way—obviating the need for "living wills." Resolution mechanisms for smaller, legally separate entities would be more credible than those needed in the recent past for large mixed conglomerates—helping to deal with the "too big to fail" issue. To protect consumers, deposit insurance and other guarantees could apply to the bank without being extended to the legally separate securities firm…

The structure of organizations and how they compete will be critical to future stability. Going forward, the aim must be to keep the "credit culture" and the "equity culture" separate so that government implicit and explicit insurance does not extend to cross-subsidizing high-risk market activity, and so that contagion and counterparty risk can be reduced. The right balance must also be struck between sufficient size conducive to diversification and strong competition to meet consumer needs at reasonable costs.

I’m sure there are some drawbacks and there would be some unintended consequences from implementing this structure, but given the difficult political landscape and the lobbying power of the banks, if we could kill this many birds (too big to fail, too big to unwind, subsidies for being so large, systemic risk) with one stone, we would be in much better shape than we are right now.

The deficit bogeyman: When people are not talking about gold, commercial real estate, the US dollar or the evil being that is Goldman Sachs, they are talking about the US debt and budget deficit. The Republicans are crying about big government. The Democrats are blaming Bush tax cuts, the 2 wars and the recession for the increased borrowing and spending even as tax receipts have fallen off a cliff. The fear is that either bond vigilantes or our foreign creditors will force interest rates up as they stop buying Treasuries, thus causing the nascent recovery (that I happen to believe is a mirage) to be stifled and the cost of servicing the humungous debt burden prohibitive. Are these just scare tactics or are they legitimate concerns?

As many people have written lately, this was what was expected in Japan and never did happen. Now, I am concerned that Japan may finally have run out of time and luck as a result of the current global recession, but that is not the point. The argument is that the US could run huge deficits and without causing a crippling rise in interest rates. For those of you who are convinced that interest rates are going to go straight up as US creditors become less inclined to hold our debt and inflation starts to pick up, I suggest you take a look at this piece from James Kwak of The Baseline Scenario. I personally have no idea how this will all play out. I think two logical people could argue both sides very convincingly. That is why it is always important to understand events that could kill your investment thesis:

One of the curious things about the debt scare that is building in the media is that it is happening at a moment when long-term interest rates are very low. In other words, it’s based on a theory that the market is wrong in its collective assessment of the debt situation. I’ve heard this blamed on “non-economic actors” (that is, foreign governments that buy U.S. Treasuries not as a good investment, but for political reasons), or on a “carry trade” where investors are exploiting the steep yield curve (free short-term money, positive long-term interest rates), as Paul Krugman discusses here.

Menzie Chinn crunches some numbers. He takes a model that he and Jeff Frankel created several years ago to estimate the impact on interest rates of inflation, the future projected national debt, the output gap (economic output relative to potential), and foreign purchases of Treasuries. That last term is important, because the oft-heard fear is that foreign governments will suddenly stop buying our debt.

Using the future growth in the debt projected by the CBO, this model predicts that real interest rates will … go down by 7 basis points over the next year, assuming foreign purchases of debt are constant. The reason the impact of the debt is so small is that it’s already priced in; since the looming debt is no secret, it should already be showing up in the data.

The counterargument is that it hasn’t shown up in the data because of the “flight to safety” and foreign governments’ irrational purchases of Treasuries. So Chinn also looks at what would happen if foreign purchases of U.S. debt fell to zero, nada, zilch (which is an extreme scenario). In that case, interest rates go up by 1.3 percentage points. That’s not nothing, but it still keeps interest rates at reasonable levels by historical standards. In addition, the CBO is already incorporating higher interest rates into their forecasts; they expect the 10-year Treasury bond yield to go from 3.3% in 2009 to 4.1% in 2010, 4.4% in 2011, and 4.8% in 2012-13, and that’s built into their projections of future interest payments.

So I’ll say again: none of this is good. But if we’re going to make important policy decisions based on fear of the debt, we should have a rational way of thinking about the impact of that debt rather than just fear-mongering.

Why did AIG get bailed out and not the monolines? According to Thomas Adams of Paykin Krieg and Adams, LLP (who is a former managing director at Ambac and FGIC), it may have been due to—you guessed it—AIG’s relationship with Goldman Sachs. In this post on Naked Capitalism, Adams carefully goes through the similarities and differences between the situations facing the monoline insurers and AIG. One major difference? Goldman had little exposure to the monolines. Thus, his conclusion is that a major wild card in the decision to save AIG and let the monolines flail was the amount of money AIG owned Goldman for collateral on credit default swaps on those wonderful ABS CDOs (there are those acronyms again). Clearly there is no way to know for sure and the timing of the AIG blowup (right after Lehman went away and the financial markets were on fire) may have influenced the decision. However, after the recent revelations by Neil Barofsky about Tim Geithner’s refusal to force the banks to take haircuts on their CDS positions, I would not be surprised one bit if Goldman’s exposure to AIG was a swaying factor:

As we have been reading the latest coverage on the AIG bailout from the SIGTARP report and the Treasury Secretary Geithner’s Congressional testimony, a nagging question remains unresolved: why did AIG get bailed out but the monoline bond insurers did not?

The business that caused AIG to blow up was the same that caused the bond insurers to blow up – collateralized debt obligations backed by sub-prime mortgage bonds (ABS CDOs). This was actually one of the few business that AIG Financial Products had in common with the monolines. AIG didn’t participate in municipal insurance, MBS or other ABS deals, which were all important for the monolines.

Certainly, AIG was larger than any of the bond insurers, but in aggregate, the bond insurers had a tremendous amount of ABS CDO exposure, which at the peak was probably over $300 billion. Despite AIG’s claims to have withdrawn from subprime at the end of 2005, we have identified particular 2006 deals with substantial subprime content that AIG most assuredly did guarantee…

I hate to get sucked into the vampire squid line of thinking about Goldman, but the only explanation I can think of for why AIG got rescued and the monolines did not is because Goldman had significant exposure to AIG and did not have exposure to the monolines.

When it became clear that AIG could face bankruptcy, Goldman’s plan to profit by shorting ABS CDOs was threatened. While they had the collateral posted, thanks to the downgrades, this collateral could be tied up or lost if AIG went bankrupt. This was a real crisis for Goldman – they thought they had outsmarted the subprime market with their ABS CDOs and outsmarted all of the other banks by getting collateral posting from AIG when they got downgraded. But if AIG went away, this strategy would have blown up and cost Goldman billions.

In addition, I believe that Goldman and their helpers – including their many connections with the White House and the Fed – pumped up concerns about the systemic risk that the market was facing from a Lehman and AIG failure, so that they could force the government to step in and bail out AIG. This would also explain why Lehman was not bailed out. Lehman didn’t really matter to Goldman. But the fear created by Lehman’s failure served as a good excuse for why they should rescue AIG.

I’m going to keep writing about this until the insanity stops: I have to admit it is a little disconcerting. I have heard ostensibly smart people who work with the financial markets every day argue that stocks could continue to rally because of “money on the sidelines.” Again, last I checked, aside from IPOs and other offerings, for every share of stock bought there is an identifiable seller. So as each dollar comes from the sidelines into the market another dollar leaves the market. Now, of course irrational buyers could pay too much for certain stocks and of course that could drive prices up. However, the argument you hear has to do with liquidity on the sidelines waiting to jump into the markets; not about foolish buying in relation to market valuations. Either I am completely crazy and have lost any and all sense of how markets function or this “truism” is in fact complete hogwash. Please, if you want to buy stocks because you think the valuations are attractive, just say so. I would likely argue that in a lot of cases stocks are discounting returns and margins that are implausible given the economic backdrop, but at least the rationale for buying based on intrinsic value reflects some semblance on investment sanity. If the only reason you are buying is because you think there are other buyers waiting in line (the greater fool theory, maybe?) then I implore you to take a step back and examine the macroeconomic and company specific fundamentals.

Thankfully, I am not alone in my plight. Here is a recent piece from Comstock Funds on this topic (hat tip to The Pragmatic Capitalist):

When making our bearish case for stocks we’re amazed at how often our audience brings up the old “cash on the sidelines” argument as a reason to doubt that the current rally can tank. We have been in this business for a while and don’t remember a time when this fairy tale wasn’t trotted out as a reason to be super bullish. In fact we don’t recall any point where observers ever said that the market was going down because there was not enough cash on the sidelines.

A relatively recent example was the summer of 2007 when a majority of commentators insisted that the availability of huge amounts of global liquidly would never allow the market to retreat. The words were hardly out of their mouths (or word processors) before the ECB and the Fed were forced to pour hundreds of billions of dollars into their banking systems. As we indicated at the time, liquidity is never there when you need it.

The fact is, as John Hussman has so eloquently pointed out, the purchase or sale of a stock is net neutral with regard to cash entering or leaving the market. For every buyer there’s a seller, and for every seller there’s a buyer. When “A” buys stock for $100,000 he/she has $100,000 less cash on hand, but “B”, the seller, receives the $100,000. No net cash has entered or left the market.

The reason stocks go up or down is not a result of cash moving into or out of the market. Stocks go up when prospective purchasers are more anxious to buy than sellers are to sell. If there are more willing buyers than sellers at any given level the market has to go up to equalize demand and supply. In fact, it sometimes doesn’t take any transaction at all to move the market. If Intel reports surprisingly high earnings and Dell reports a disappointment the bid and asked price moves up or down before any transaction even takes place.

Furthermore, if even one anxious buyer of a relatively small number of shares drives up the price, the total capitalization of all the shares of that stock rises. And if the purchases are a result of a real upside earnings surprise in a key bellwether stock, the entire market can rise without a dime of new cash entering the market.

Despite the obvious truth of this case, strategists and the media always bring up the old myth of “cash on the sidelines” to justify their bullish views of the market, particularly when their arguments for the economy and valuation are flawed. If you hear anyone make this case just ignore them—it’s a fallacy. If the market rally continues from here, it will happen as a result of buyers being more anxious to buy than sellers are to sell, not because sideline cash is entering the market. If fundamental and technical conditions deteriorate as we expect, prospective purchasers will become less anxious to buy while sellers will be more willing to sell, and the market will decline by enough to equalize supply and demand.

(Picture courtesy of uvm.edu)

The Weak Dollar vs. Strong Dollar Dilemma

Does the US really want a weak or strong dollar? No matter what the setting or topic, lately just about every discussion between economists, market participants, and government officials turns to the US dollar. Tim Geithner says the US has a strong dollar policy. Unfortunately, that’s about as credible as the International Federation of Bodybuilders saying that is has a no steroids policy. One look at the impressive but clearly unnatural Ronnie Coleman and it becomes obvious that the very large pink elephant in the room is that those body builders are not clean. In a similar fashion, the Fed’s money printing and the willingness of the federal government (both democrats and republicans—let’s not forget that the Bush tax cuts and Medicare Part D were deficit funded) to run massive fiscal deficits patently contradicts the claims of Geithner. So, if the government and Fed are willing to say one thing and do another, what is the point of all the posturing? Have the leaders become resigned to some kind of stealth default on our foreign debts through inflation? Are they just jawboning with that hope that our foreign creditors don’t precipitate a disorderly unwinding of the dollar?

I honestly don’t know. There is no question that a weak dollar makes US exports more attractive. But I’m not sure how to reconcile that the deleterious impact of the falling value of the dollar on the foreign creditors we are desperately going to need to keep financing our massive spending. It was within this context that I came across a guest post on Simon Johnson’s Baseline Scenario that argued that a weak dollar may actually be just what the doctor ordered when it comes to rebalancing the world economy. I advise everyone to examine both sides of this argument because this is going to continue to be a topic that dominates the financial discourse and may eventually affect the results of numerous investment strategies:

A lower dollar is good news for US exporters and foreign importers and bad news for foreign exporters and US importers. However, if policymakers respond appropriately, there is no reason to fear overall harm either to the US economy or to foreign economies. Indeed, a lower dollar could jumpstart the long-overdue rebalancing of the global economy away from excessive US trade deficits and foreign reliance on export-led growth, putting the world on track for a more sustainable expansion.

The fear in economies that are appreciating against the United States is that a falling dollar will choke off exports and hobble economic recoveries. The correct response is to ease monetary policy and temporarily delay fiscal contraction. As I explain here, even in economies with short-term interest rates near zero, there is plenty of scope for central banks to stimulate aggregate demand, and doing so will help to limit the extent to which the dollar falls.

For the United States, the benefits of a falling dollar are obvious: stronger exports and a faster recovery. The fear is that a falling dollar would be inflationary. However, as I have shown in two recent papers, even very large currency depreciations in developed economies have no effect on inflation unless they are caused by policies that attempt to hold an economy’s unemployment rate below its equilibrium level. With US unemployment currently at 10 percent, there is no chance that inflation will rise in the near term. Whether inflation rises in the longer run will depend on whether US monetary and fiscal policy stimulus is withdrawn appropriately as the economy recovers (and tighter macroeconomic policies would tend to support the dollar). Many believe that US policymakers erred in not withdrawing stimulus soon enough in 2003-05, but policymakers now seem to be keenly aware of this mistake and have expressed their determination not to repeat it. Only time will tell, but my own view is that the Federal Reserve, at least, will not allow runaway inflation.

For economies that peg their currencies to the dollar (notably China) the costs and benefits of a falling dollar are the same as those facing the United States and so is the policy dilemma: how fast to tighten macroeconomic policy as the economy recovers? These economies differ on several dimensions, including financial market development and capital controls, strength of economic ties to the United States, and prospects for economic slack and inflation. These differences will determine the appropriate policy stance. To some extent these economies have forfeited the freedom to adjust monetary policy, but they retain the option of adjusting the levels of their dollar pegs. In some cases, a further decline in the dollar may represent an opportune moment to move to a floating exchange rate.

Two quick comments on his analysis. First, I worry about any outcome that is dependent on the Fed being able to withdraw all the potentially explosive liquidity before inflation kicks in. Even if you give the Fed the benefit of the doubt and assume that the members will be vigilant on this front, monetary policy changes are blunt instruments that impact the economy many months after implementation. As such, they are incredibly hard to time and calibrate accurately in order to get the desired effect. Second, we must keep in mind that oil is priced in dollars and dollar weakness that causes oil to increase significantly in dollar terms could put a further strain on consumer spending (as it has in the past—remember $4 a gallon gas?) and stifle any nascent recovery. Since we import far more than we export (note the current account deficit) it is hard for me to see how a weak dollar is a net benefit to the US.

Too bad Q3 GDP growth isn’t actually leading to less suffering: As we assess where the US is in terms of a legitimate recovery, it now appears that there are two very different economies and corresponding realities that both policy makers and investors need to understand. There is the government backstopped, Wall Street and multinational corporation economy that seems to be experiencing a return to prosperity. And then there is the real world economy made up of small business and individual households that is struggling to keep its head above water. Wall Street is about to have a record year. S&P 500 companies have become so lean that bottom line profitability has not shrunk commensurately with sales. When this efficiency is combined with the renewed strength abroad, many companies with significant operations outside the US have hardly missed a beat. Unfortunately, that is not true for small businesses and households. Mortgage delinquencies are at all time highs and foreclosures continue unabated. The overall unemployment rate (U3) is at 10.2%, U6 is at an astonishing 17.5% and the rates in states such as Michigan (15.1%) are downright startling. Further, as discussed in this opinion piece in the NY Times, there is evidence that the recession is having an outsized effect on people who were already not particularly prosperous:

If the elites are correct, if the Great Recession really is over, then these core supporters of the president are being left far, far behind — as are blue-collar workers of every ethnic and political persuasion. Nobody wants to talk seriously about class in America, but the elites are smiling and perusing their stock portfolios while the checklist of Americans locked in depression-like circumstances just grows and grows: construction and manufacturing workers, young men without college degrees (especially young black and Hispanic men), teenagers, and those who were already poor when the recession began.

Now we’re learning that unmarried women are among those being crushed by the epidemic of joblessness. As the Center for American Progress has noted, “The high unemployment rate of unmarried women, and particularly the 1.3 million unemployed female heads of household who are primary breadwinners for their families, is devastating to their financial circumstances and standard of living.”

This was not a normal recession, and we are not on the cusp of anything like a normal recovery. The unemployment rate for black Americans is 15.7 percent. The underemployment rate for blacks in September (the latest month for which figures are available) was a gut-wrenching 23.8 percent and for Hispanics an even worse 25.1 percent. The poverty rate for black children is almost 35 percent.

Wall Street can boast about recovery all it wants, much of America remains trapped in economic hell.

Not that Bob Herbert does this in the article but, honestly, I am sick and tired of people using the Great Depression as a benchmark for this recession. Yes, the current unemployment situation is nowhere near as bad as it apparently was in the 1930s. Great! People are not as desperate as they were in one of the worst periods in this country’s history! That’s not much to celebrate in my eyes and unfortunately the diminished relative severity certainly does not preclude a dangerous situation from emerging. My fear is that people who have nothing more to lose are willing to do things they never would have dreamed of in better times. It doesn’t matter what color or age a person is, we all need to eat. While spikes in crime and widespread social unrest may be on the periphery of proximate concerns, policy makers need to remember that a Wall Street and stock market recovery just leads people who don’t have the means to invest even further behind. So, before we all start celebrating the economy’s apparent return from the abyss, let’s keep our eyes on what is at stake: there is no Wall Street, stock market, or K Street if we disenfranchise every person on Main Street to save the elites from suffering any harm.

How can the US avoid “turning Japanese?” No two countries face the exact same headwinds or tailwinds and thus policy decisions will inevitably have varying impacts depending on the country and the exogenous circumstances of the times. Therefore, comparisons of the current US situation with that of Japan in the 80s may be about as enlightening as the aforementioned benchmarking off of the Great Depression. However, the attempts of the Japanese to extricate themselves from the aftermath of the stock and real estate market crashes of the late 1980s do provide an interesting template to scrutinize as the leaders of the US embark on a similar task. For better or for worse the US has decided to follow the dubious path blazed by the Japanese when it comes to a potentially insolvent banking system cluttered with bad loans and dodgy assets. Extend and pretend was chosen over the Swedish model in which banks were quickly forced to recognize their losses and were then recapitalized. Could it work out differently for the US? Sure. A lot of components of the economy are subject to positive feedback loops in which more confidence leads to increased spending (this link is to an article from Bob Schiller from this weekend’s NY Times on this topic), bank lending and eventually to real growth. If that dynamic played out, the banks (given the incredibly steep yield curve) might be able to earn their way through the cycle and be able to sell their toxic assets at much more favorable prices once the economy had recovered. Having said that, I think there is a compelling argument to be made that we should all be aware of the underlying factors that clearly led the Japanese to fail to reinvigorate their economy and asset markets. In that vein, the following article (hat tip to the Pragmatic Capitalist) discusses some of the elements that did not work in Japan:

The Japanese government’s easing of credit rates, instead of spurring real demand, created artificial demand. Federal loans and stimulus spending were not economically productive, and they vastly increased the nation’s debt and prolonged the economic malaise. Worse, businesses spent critical time on the sidelines, waiting for government bailouts and other centralized actions, instead of speedily consolidating their losses, clearing their balance sheets of bad investments, and reorganizing.

The United States in 2008–09, unfortunately, has started down the same path. Federal intervention and the expectation of additional government action are removing firms’ incentive to clean up their balance sheets by selling “toxic” assets. Why accept pennies on the dollar if a deep-pocketed new bidder (i.e., the state) looms large on the scene? The Japanese experience shows that when the government is an active participant in the market, many firms would rather accept state support than initiate the inevitable financial reckoning. Such a status quo does not provide a sustainable foundation for the economy. Instead, it restricts economic growth and creates a cycle of stagnation…

Capital reserve requirements. In 1988 the Basel I Accord between the Group of 10—which then included the U.S., Switzerland, Japan, Germany, France, and the U.K., among others—set new capital requirements for banks around the world. But the requirements were focused on loan amounts and did not factor in a debt’s underlying risk. In other words, a loan to a sound borrower required the same percentage of capital to be set aside as an equal amount lent to a high-risk borrower. There was already a developing atmosphere of heavy lending and insensitivity to risk, but the Basel requirements rewarded firms for making loans to shaky borrowers because they could earn higher interest rates that way without having to set aside any more capital than they would for loans to safe borrowers.

The chief problem was not that the requirements were too low. It was that the rules created a false sense of security for investors and lenders. Banks were meeting their legal requirements, although it was never clear what kind of debt they were holding capital to cover. Without a standard or competing standards for transparently measuring the value and risks of portfolios, Basel I proved ineffective at preventing systemic rot. (Emphasis added)

Government lending to poorly managed firms. The Bank of Japan tried to ease economic pain by loaning large amounts to businesses. But the attempts to recapitalize the market ignored underlying management problems in the dying firms. It was a costly mistake. Intense lobbying from special-interest groups representing various sectors of the Japanese economy perpetuated the ill-fated loans and funneled government money to zombie businesses. [Emphasis mine—how familiar does this sound]

Conflicts of interests. With all those loans, the Japanese government found itself deeply entwined in the market, skewing its policy incentives. Daniel I. Okimoto, former director of the Shorenstein Asia-Pacific Research Center at Stanford University, points out that Japan’s banking industry and economic bureaucracies were too interdependent. Studies from Okimoto’s center and the Bank of Japan concluded that data revealing the scope of the economic malaise were suppressed and that regulations were developed with governmental interests in mind. At the height of financial industry bailouts, there was little transparency or public accountability. [Cough---audit the Fed—cough]

Short-term, static political vision. You can blame the length of Japan’s asset deflation, recession, and liquidity struggles on an unwillingness to choose hard but necessary policies, such as allowing banks to fail and the market to reset itself. Politicians bent on retaining their power and showing the public they were doing something took actions without regard to their long-term effects.

There was little effort to clean up the banking system or get rid of harmful regulations. The government refused to acknowledge the breadth of Japan’s economic troubles, and the Ministry of Finance went so far as to order banks to hide their toxic loans to create the appearance of success..

Beware of those pesky activists: The reluctance to accept any change when it comes to corporate governance in America is absolutely astounding. Despite the fact that the corporate boards of literally hundreds of financial institutions sat idly as the companies took on extreme amounts of risk, there is still a lot of resistance to any proposals that would make directors more accountable. Interestingly, buried in Senator Dodd’s financial reform bill is a section regarding shareholder rights that allows shareholders who meet certain qualifications to nominate directors. Here is an excerpt from an article by David Reilly on the subject:

The SEC would require that shareholders looking to nominate directors hold a certain percentage of stock depending on the size of the company. Shareholders also would have to show they have owned stock for a period of time, say one year. Nor could shareholders take control of a board.

One caveat: while requiring the SEC to take up the issue of giving shareholders greater say over directors, the Dodd bill doesn’t set minimum requirements for what the agency ultimately adopts.

In spite of the common-sense nature of these proposals, supporters of the present dysfunctional system still argue that the changes will ruin American business.

A memorandum on the legislation prepared by lawyers at Wachtell Lipton Rosen & Katz, and posted in part on a Harvard Law School corporate-governance blog, argued that giving shareholders greater say over boards will only increase short- term pressures on companies from “shareholder activists and hedge funds.”

Is it me or is the fallback of the opposition to any legislation to blame hedge funds? There is no question that there are some activists who are interested in short term gains. However, there are many more firms that are genuinely invested in trying to improve corporate governance, company performance, and returns to all shareholders. As it stands, it is incredibly costly to run a proxy battle and very few funds have the resources, time or patience to wage a war against a company’s board. That is a shame because it has become blatantly obvious in retrospect that directors have not been living up their fiduciary duties and have become nothing more than rubber stampers of CEO initiatives. Reilly makes the very ironic point that no matter how devious the motivations of activist investors are, how could they possibly harm the companies more than the directors have by not diligently evaluating the actions of the management teams?

Here’s something else to consider. Let’s say opponents of greater shareholder democracy are right. And let’s assume that hedge funds and union-backed pension funds run amok, dictating that boards hew to short-term profit goals or ideological agendas.

Would they actually do more damage than has already been inflicted by imperial CEOs backed by obsequious and crony-filled boards? At last count, the U.S. has lent, spent or guaranteed almost $12 trillion to keep banks, Wall Street and the economy afloat, according to the latest Bloomberg estimates.

Even the hedge-fund hordes supposedly waiting to swarm corporate boards won’t stick taxpayers with that kind of bill.

Would contingent capital buffers help to stave off a crisis? Policy makers worldwide are trying to figure out how they can prevent another financial crisis (like the one we have apparently emerged from) from happening again. Some of the options on the table are leverage caps, higher capital ratios, and even shrinking the size of large financial conglomerates to mitigate counterparty and concentration risk. Another interesting idea is to force banks to issue contingent capital that converts to equity at a certain point during uncertain times. One of the problems that a number of firms faced during the depths of the liquidity crisis had to do with not being able to raise equity. If contingent capital had been in place the stressed company would have been able to convert debt to equity and would have enjoyed a larger cushion. However, according to James Kwak of The Baseline Scenario, contingent capital sounds great on paper but has a number of potential pitfalls:

Contingent convertible bonds, a.k.a. contingent capital, are the latest fad to hit the optimistic technocracy in Washington and London. A contingent convertible bond is a bond that a bank sells during ordinary times, but that converts into equity when things turn bad, with “bad” defined by some trigger conditions, such as capital falling below a predetermined level. In theory, this means that banks can have the best of both worlds. They can go out and borrow more money today, increasing leverage and profits (which is what they want). But when the crisis hits, the debt will convert into equity; that will dilute existing shareholders, but more importantly it means the debt does not have to be paid back, providing an instant boost to the bank’s capital cushion. In other words, banks can have the additional safety margin as if they had raised more equity today, but without having to raise the equity.

[Gillian] Tett [of the Financial Times] is skeptical for all sorts of reasons — defining the trigger point (remember, Bear and Lehman were well-capitalized on paper when they collapsed), finding people willing to buy these things, the impact on the market of triggering a conversion, etc.

I’m skeptical for a more basic reason. Contingent capital, like any other type of capital requirement, assumes that we can predict in advance how bad the crisis will be and therefore how much capital will be necessary to avert a bank-killing panic. That means we have to be able to predict (a) just how fat the fat tail is, based on virtually no data points, and (b) how panicked people can get and for how long. That seems to me technocratic hubris of the first order.

So why is contingent capital so popular? (It’s even mandated by section 107(b)(1)(D) of the Dodd bill.) Well, the people don’t matter don’t listen to me or to Gillian Tett. Here is Tett’s explanation:

“Even amid all those hurdles, the CoCo idea currently has many fans, not just among investment bankers touting for business, but some western regulators too. The reason stems from a big, dirty secret stalking the financial world: namely that while global policymakers have spent a year wailing about the ‘Too Big to Fail’ problem, they have hitherto done almost nothing tangible to remove that headache in a credible manner.”

The idea that any clever regulatory scheme we come up with today, which by definition will be untested, can be counted on to come through in the next crisis seems hopelessly naive to me. I think it would be more honest to admit that there are really only two choices:

1. Break up any institution that is too big to fail.

2. Leave them in place (because “big companies need big banks,” or whatever other nonsense justification you want to use) and admit that we’ve done nothing to solve the TBTF problem.

That’s the real choice.

Properly regulating these entities has proven to be just about impossible in the past. Why do we think it will be different next time? Bankers are paid a hell of a lot more than regulators and will inevitably find a way to get around just about any regulation. Is contingent capital better than nothing? Sure, if the goal is to enact reforms that get us as close to the bubble status quo as possible without completely letting the banks off the hook. But, if we want real change and to limit the powers of the banksters, we need legislation that includes options such as contingent capital but is centered on breaking the banks into more manageable and potentially less explosive pieces.

(Picture courtesy of Businessweek.com)

A Sobering Dose of Reality from Economist Steve Keen

Tired of the same old US-based bears such as Nouriel Roubini, Peter Schiff and Doug Kass? Sick of hearing the US is in deep trouble argument from Marc Faber and ex-pat Jim Rogers? Then, for those of you who are not familiar with the most outspoken Australian Nostradamus, let me introduce you to economist Steve Keen. Keen is one person who can legitimately contend that he saw the crisis coming and even warned about the potential impacts extensively on his website. Keen’s writings serve as another example of how nonsensical the claim is that “no one could have seen this coming;” a refrain that you hear from politicians around the world who want to remain blameless for the current economic calamity. Keen is a straight shooter who pulls no punches in his criticisms of other economists, political leaders, and central bankers all over the globe. The reason it is important to listen to him now is that he is still pounding the table about the debt overhang that is plaguing the Anglo-Saxon world. Unlike the bubble-perpetuating pundits you see on CNBC, Keen does not believe economies can recover from the implosion of a debt bubble by printing money or through just the passage of time. As such, he happens to believe that both the US and Australia are on an unsustainable path that may lead to an even larger crash.

I have embedded a video below of a must watch presentation from Keen. Here is a preview of some of the topics covered and associated commentary:

· Amusing and condescending explanation of the fact that Milton Friedman was not a Keynesian economist (as some professor named Joshua Gans had stated the day before)

o In fact, according to Keen calling Friedman a Keynesian is like calling the devil one of God’s angels

§ Calling Friedman a Keynesian is an insult to real Keynesians such as Minsky

· Discussion of the delusional theories espoused by Friedman and the other neo-classical economists who completely missed the crisis and whose ideas do not share anything in common with reality

o Neo-classical models cannot endogenously produce a financial crisis

§ Need a meteor strike or something

o Inability of the neo-classical models to reflect actual market conditions

· Commentary on the prescience of Minsky and how his theories on instability, banking, and crises are essential to understanding what the global economy is facing

o Minsky’s idea of the euphoric economy that leads to instability

o Ponzi financiers failure when the bubble bursts

§ Darlings of the stock market one day and in jail the next

· Reminder of the fact that there were in fact 2 bubbles in the US, a stock market and a housing bubble, both of which were driven by excess debt

o US Debt to GDP before the Great Depression: 170%

o Current US debt to GDP: 300%

§ Same dynamics that existed before the Great Depression are exaggerated now

o Failure to attack the underlying problem (too much debt) and only focusing on the symptoms (limited liquidity) by printing money and enacting stimulus will only prolong the day of reckoning

§ Can’t just paper over the debt overhang that is nothing like we have seen in history

· France is the only country that did not have a debt crisis and that is why it has shown growth

· Foolishness of the Kangaroo Theory of Economics that believes that Australia is different and is not facing a crisis

o But if there is any correlation between excess debt and impending crises the situation in Australia is not as stable as people assume

o Just because Australia’s debt to GDP is less than that of the US does not mean the country is out of the woods

· Helicopter Ben Bernanke’s ignoring of Minsky’s ideas in favor of the idea of the rational investor in his writings

o How scary is that a man who believes that human beings act rationally under uncertainty is the one trying to navigate the US out of this mess?

o Bernanke’s lack of understanding of the credit system and money creation

· Step by step explanation of how money is created by banks

o Suggestion that is better to give money to debtors than banks that just hold money as reserves

· Need for deleveraging in the Australia and in the US

o In Australia, 8% debt reduction occurred in the 1930s

§ Took a world war to get debt levels down

§ Would cause a 12% reduction in GDP if that rate were reached again

§ 4% debt reduction occurred in the 1890s during that depression

· Would take 30 years to get back to 1980 levels at this rate

o America’s problem is even worse due to larger debt load

§ Unemployment is being driven by deleveraging

· $2.5 trillion rate of deleveraging in US this year

o In 2006 the US was adding $4.5 trillion dollars in private debt

o Total demand was $18.5 trillion ($14 trillion in GDP+ $4.5 trillion in debt) so US demand was close to 25% debt driven

(Picture of Steve Keen courtesy of http://www.debtdeflation.com/blogs/)

Are We on the Road to Serfdom?

Appreciation for Hayek continues to spread: As the freshwater and saltwater economists continue their never-ending fight to see who could be more reluctant to consider ideas that fit outside their narrow frameworks, many people are starting to embrace the idea of the Austrian school of economics. After reading some great material on the Austrian school, I wrote an article on Hyman Minsky and now Amity Shlaes has penned on op-ed piece on the Austrian- influenced economist Friedrich von Hayek. According to Shlaes, one of Hayek’s ideas that is most pertinent to today has to do with the loss of personal freedoms at times of national stress. Hayek believed that wars and crises led to national planning, creation of influential special interest groups and an erosion of individual liberties. Hmmm, does that sound familiar? National planning? Well, the government now decides what companies survive and fail and is looking into nationalized health care. Powerful special interest groups? We can’t forget the banking oligarchy that has captured Washington and now imposes its will on Main Street with no repercussions. Loss of liberties? Remember all that wire tapping and other invasive activity that came with the renewed focus on Homeland Security? Sounds to me like the government has used 9/11, the Iraq and Afghan wars, and the financial crisis to become a much bigger influence in our day to day lives.

The problem with this dynamic, according to Hayek, is that the economy suffers due to too much government involvement. Even worse, in the long run he believed that we would all become serfs. I have to admit that in some of my darkest moments I worry that the in recent years the government and the banks colluded and conspired to create a nation of indebted people who would be no more than passive participants in their own lives. Zombie consumers. It’s hard to rise up and question the status quo that includes huge bankster bonuses, crony capitalism, and reduced freedoms when the bank is standing on your doorstep ready to take your house. I hope Hayek was wrong and that Americans will not stand for being trivialized and marginalized indefinitely. One of the few things I have faith in these days is that we are capable of forcing our government to change. I just pray it does not take some kind of point of no return tragedy to wake people up:

As the war came to end, Hayek penned an apocalyptic tract, “The Road to Serfdom.” His thesis was that war gets people used to national planning. So the planners continue to plan, even in peacetime. These incremental expansions of the social- welfare state aren’t benign. They foster the creation of ever- more-powerful interest groups. The economy becomes less productive. Political corruption in turn gives rise to dictators. Foreign-policy tension or economic crisis accelerates the trend.

“‘Emergencies,’” Hayek wrote, “have always been the pretext on which the safeguards of individual liberty have eroded.”

For a number of decades the main thing about Hayek seemed to be that he was wrong. Britain did head to the left, far to the left. After the war, the U.S. also institutionalized government planning in new areas. Yet neither Britain nor the U.S. went socialist or trampled personal freedoms. On the contrary, they eventually turned toward Margaret Thatcher and Ronald Reagan…

But this low estimation of Hayek fails to appreciate his central thought: the economic damage is subtle and is evident only over time…

Hayek understood that a good decade where government expansion seems to stall -- the 1990s -- doesn’t mean government won’t expand when the next crisis comes.

The recent pattern of following a war and a financial collapse with the creation of a new entitlement is a perfect example of the Hayekian dynamic in action…

The U.S. is on the road if not to serfdom then to less growth, less innovation, more rationing and more political corruption…

Brad Delong defends the stimulus: The debate over the efficacy and impact of the $787B stimulus package continues to rage on. Many conservatives have called it a failure because it has not arrested unprecedented job losses. Others, such as Paul Krugman worry that the US will need another round of stimuli because the first allotment was insufficient to repel deflation. Some think it did not focus enough on rebuilding the deteriorating infrastructure in this country. Others wish that it had put more money in the hands of consumers through tax cuts. Curiously, within this cacophony of criticism, the Obama administration has come out with a claim that the stimulus package has saved or created 640K jobs. I am clearly skeptical of government statistics in general. But, in reality, I have no way of assessing the validity of such data. However, this is the same government that continues to claim that small business start ups are adding around 80K jobs a month. To that I say, with what credit and to cater to what demand?

Still, if we give Helicopter Ben credit for bringing the financial system back from the ledge (despite the fact that he was one of the men who allowed it to get so close to the precipice), then maybe we can give Congress and the Obama administration the benefit of the doubt and assume that the stimulus did help prevent a more dramatic initial economic decline. (I say initial because I am deeply concerned that we are setting ourselves up for an even nastier round two) Within this context, I found some interesting commentary from Berkeley economist Brad DeLong. His thesis is that we cannot in retrospect just dismiss the need for stimulus because we automatically assume that “this time is different” and the 54% decline in industrial output that occurred during the 1930s could not have happened again in this crisis:

It is worth stepping back and asking: What would the world economy look like today if policymakers had acceded to the populist demand of no support to the bankers? What would the world economy look like today if Congressional Republican opposition to the Troubled Asset Relief Program (TARP) program and additional deficit spending to stimulate recovery had won the day?

The only natural historical analogy is the Great Depression itself. That is the only time when (a) a financial crisis caused a widespread, lengthy, and prolonged reinforcing chain of bank failures, and (b) the government neither intervened nor passed the baton to a consortium of private banks to support the system as a whole.

It is now 19 months after Bear Stearns failed and was taken over by JP MorganChase with the assistance of up to $30 billion of Federal Reserve money on March 16, 2008, and industrial production stands 14% below its peak in 2007. By contrast, 19 months after the Bank of the United States, with 450,000 depositors, failed on December 11, 1930 – the first major bank collapse in New York since the Knickerbocker Trust failure during the panic and depression of 1907 – industrial production, according to the Federal Reserve index, was 54% below its 1929 peak.

Opponents of recent economic policy rebel against the hypothesis that an absence of government intervention and support could produce an economic decline of that magnitude today. After all, modern economies are stable and stubborn things. Market systems are resilient webs that offer the best possible incentives to people to make deals and use resources productively. A 54% fall in industrial production between its 2007 peak and today is inconceivable – isn’t it?

If so, then the unavoidable conclusion must be that things would not have been so bad if the government had refused to implement an expansionary fiscal policy, recapitalize banks, nationalize troubled institutions, and buy financial assets in non-standard ways. The problem, though, is that all the theoretical reasons to think that depressions as deep as the Great Depression simply do not happen to market economies applied just as well to the 1930’s as they do to today.

But it did happen. And it could have happened again.

DeLong’s point is that doing nothing could have been disastrous and just because it is not 1930 anymore, does not mean the US is immune to that type of a downturn. People reading the newspaper in 1930 did not know that they were about to enter a Great Depression and they probably believed some of the same hype that is being spouted today by the government, banks and media cheerleaders. Obviously, the idea that the stimulus had a part in staving off Armageddon is even harder to prove than how many jobs it has saved. But, despite my skepticism surrounding the Keynesian response that includes unabashed money printing, I grudgingly admit that DeLong may have a point.

A preliminary post mortem on the crisis by Howard Marks: For anyone who is not in the habit of checking Oaktree Capital Management’s website periodically just in case there is a new piece from Howard Marks, I suggest you bookmark the site and set a monthly reminder on Google Calendars. Marks is in the same league as Buffett and Klarman in terms of being able to deliver prescient, articulate and poignant commentary on the financial markets. For value investors especially, his words are pure gold. The latest piece from Marks includes an analysis of what how the US economy, banks and consumers all got into such a terrible mess. It has the feel of an 18,000 foot view of the crisis taken long after the situation had stabilized. Unfortunately, his analysis may turn out to be nothing more than a halftime assessment of what went wrong in the first half. Based on the complete lack of reform and behavioral changes, it appears that we have learned nothing from the bubble years and the subsequent implosion of the global economy. As such, there is little reason to believe that the second half will play out any differently from the first half. Accordingly, I think it is now even more important than ever to understand the biases, greed, incompetence, and blindness that produced such an extraordinarily negative outcome on so many levels. In that case there is no one better than Marks to illustrate where changes need to be made if we are to return to sustainable prosperity:

The recent crisis came about primarily because investors partook of novel, complex and dangerous things, in greater amounts than ever before. They took on too much leverage and committed too much capital to illiquid investments. Why did they do these things? It all happened because investors believed too much, worried too little, and thus took too much risk. In short, they believed they were living in a low-risk world…

Belief that risk has been banished is a key element in allowing people to engage in practices they would otherwise view as risky, and in permitting assets to be bid up to prices that would clearly be too high in a world perceived to involve risk.

Worry and its relatives, distrust, skepticism and risk aversion, are essential ingredients in a safe financial system. To paraphrase a saying about the usefulness of bankruptcy, fear of loss is to capitalism as fear of hell is to Catholicism. Worry keeps risky loans from being made, companies from taking on more debt than they can service, portfolios from becoming overly concentrated, and unproven schemes from turning into popular manias. When worry and risk aversion are present as they should be, investors will question, investigate and act prudently. Risky investments either won’t be undertaken or will be required to provide adequate compensation in terms of anticipated return.

But only when investors are sufficiently risk averse will markets offer adequate risk premiums. When worry is in short supply, risky borrowers and questionable schemes will have easy access to capital, and the financial system will become precarious. Too much money will chase the risky and the new, driving up asset prices and driving down prospective returns and safety…

One of the errors committed in 2003-07 – forming a cornerstone of the crisis – consisted of believing too much in the ability to predict the future. Investors, risk managers, financial institution executives, rating agencies and regulators trusted forecasts, extrapolations and computer models. This made them comfortable with risk, always a dangerous arrangement. The “I know” school of investing has received frequent mention in my memos (e.g., “Us and Them,” May 7, 2004). Its members – money managers, Wall Street strategists and media pundits – believe that there’s a single future, it is knowable in advance, and they’re among the people who know it. They’re eager to tell you what the future holds, and equally willing to overlook the inaccuracy of their past predictions. What they repeatedly ignore is the fact that

(a) the future possibilities cover a broad range, (b) some of them – the “black swans” –can’t even be imagined in advance, and (c) even if it’s possible to know which one outcome is the most likely, the others have a substantial combined probability of occurring instead.

Thus one key question each investor has to answer is whether he views the future as knowable or unknowable. An investor who feels he knows what the future holds will act assertively: making directional bets, concentrating positions, levering holdings and counting on future growth – in other words, doing things that in the absence of foreknowledge would increase risk. On the other hand, someone who feels he doesn’t know what the future holds will act quite differently: diversifying, hedging, levering less (or not at all), emphasizing value today over growth tomorrow, staying high in the capital structure, and generally girding for a variety of possible outcomes.

The unemployment problem in a nutshell: I know Tyler Durden included a portion of this piece from David Rosenberg regarding the unemployment situation in the US. However, I wanted to make sure that everyone had a chance to read it. In just a few paragraphs Rosenberg explains why employment is not going to just turn around on a dime like the bulls will have you believe. I heard financial blogger Mish call it a “job-loss recovery” as opposed to a “jobless recovery.” I happen to think he is spot on because there are structural problems facing this country that are going to preclude companies from hiring and new businesses from forming immediately. Having said that, there are a lot of people much smarter than I am who believe that the jobs will eventually come. Just like we could not have predicted the internet boom, the claim is that some new sector will take the lead and create millions of jobs. It could be from health care. It could be from education. It could be from a green energy or some other form of infrastructure-based revolution. If you ask me I hope it is all of the above. We sure need to rebuild the education system, health care system, energy grid and physical infrastructure of this country if we want to maintain the standard of living we have become so accustomed to. The problem is that it could take years for one or all of these to start creating meaningful jobs. In the meantime, we have to deal with unemployment (both U3 and U6) that will continue to rise until the imbalances that have been created by over-retailing, over-building, over-banking, and over-consumption are eradicated. We should all be thankful that Rosy is here to keep things in perspective and make sure that our expectations for a sustainable job and stock market recovery are realistic:

There are serious structural issues undermining the U.S. labour market as companies continue to adjust their order books, production schedules and staffing requirements to a semi-permanently impaired credit backdrop. The bottom line is that the level of credit per unit of GDP is going to be much, much lower in the future than has been the case in the last two decades. While we may be getting close to a bottom in terms of employment, the jobless rate is very likely going to be climbing much further in the future due to the secular dynamics within the labour market.

But in a nutshell, to be calling for a 12.0-13.0% unemployment rate is meaningless except that it is very likely going to be a headline grabber. The most inclusive definition of them all, the U6 measure of the unemployment rate, which includes all forms of unemployed and underemployed, is already at 17.5%. The posted U3 jobless rate that everyone focuses on is at 10.2% (though if it weren’t for the drop in the labour force participation rate, to 65.1% from 66.0% a year ago, the unemployment rate would be testing the post-WWII high of 10.8% right now). The gap between the U6 and the official U3 rate is at a record 7.3 percentage points. Normally this spread is between 3-4 percentage points and ultimately we will see a reversion to the mean, to some unhappy middle where the U6 may be closer to 15.0-16.0% and the posted jobless rate closer to 12%. This will undoubtedly be a major political issue, especially in the context of a mid-term elections and the GOP starting to gain some electoral ground.

Think about it. We haven’t yet hit bottom on employment but that will happen at some point. Employment is not going to zero, of that we can assure you. But when we do start to see the economic clouds part in a more decisive fashion, what are employers likely to do first? Well, naturally they will begin to boost the workweek and just getting back to pre-recession levels would be the same as hiring more than two million people. Then there are the record number of people who got furloughed into part-time work and again, they total over nine million, and these folks are not counted as unemployed even if they are working considerably fewer days than they were before the credit crunch began.

So the business sector has a vast pool of resources to draw from before they start tapping into the ranks of the unemployed or the typical 100,000-125,000 new entrants into the labour force when the economy turns the corner. Hence the unemployment rate is going to very likely be making new highs long after the recession is over — perhaps even years.

Good luck generating alpha in the herd: Hat tip to Yaser Anwar for providing access to this piece from Dylan Grice of SocGen. Between the work of Grice and Albert Edwards, I think SocGen may produce the only sell-side research worth reading (Just kidding sell-side guys—you know I love you). Having spent my time on the buy-side I think I take a little too much pleasure in seeing data that suggests that for the most part the sell-side analyst community struggles to add a lot of value. I happen to know a number of sell-side analysts who are amazing and have a depth of knowledge regarding their coverage space that I could only dream of. But as whole, they unfortunately comprise a somewhat biased herd and any good contrarian investor knows there is money to be made by betting against the herd. To illustrate this point further, Grice decided to see if there was any relationship between the number of analysts that covered a stock and the relative performance of that stock. I won’t give the secret away as you can peruse his findings below, but let’s just say that the data does not disprove the value investing mantra that it is better to fish where others are not:

It was with all of this in mind that I read Charles De Boissezon, one of our Financial Engineering team’s excellent analysis of sell-side coverage of stocks in Europe. He calculated the extent to which a stock was overbroked by dividing the number of analysts covering a stock to its market cap, and uncovered such gems as Nokia being the most covered stock with 63 analysts “and still it can come up with ‘shocking’ numbers” and Q-Cells (1bn free float) being covered by 44 analysts. Hours of fun.

But it got me wondering whether or not this might be a good proxy for measuring herding within the sell-side research management community. The obvious motivation for hiring a sector team is that there is plenty of commission to be won…

So I took Charles analysis a little further. Let’s call his ratio of coverage to market cap the Banks Aggregate Analyst Herding Index, or the BAAH Index for short (as in the noise bleating sheep make). I used Factset sector classifications with the FTSE World Index and got the results given on the front page. That chart shows herding is most pronounced in the clothing and construction sectors and least pronounced in energy and tobacco. Then, I backtested the strategy on Factset by ranking each sector according to its BAAH index (beginning in 1987) and calculating the subsequent years returns. I rebalanced the portfolio annually. It turns out that a long-short strategy of buying the sectors where herding is less dominant and shorting those where coverage is deepest would have generated around 7% p.a. since 1987…For a given market cap, it seems, the more analysts you see swarming around a sector the more wary you should be of being able to extract alpha from it. (Emphasis added) Leave the herd to its dopamine fix and have another think about the less-crowded sectors.

(Picture of Hayek courtesy of arts.anu.edu.au)

The Investment Case for Zimbabwe & Other Links

The ultimate risk asset: These days investors and market commentators who believe the US is on course to hyperinflation are not necessarily on the fringe. While most people discount the probability of such a disastrous fate for the dollar and our beloved country, the money printing actions of the Fed and the enormous fiscal deficits are prompting people to at least examine the implications of runaway inflation. During such discussions and analysis, the precedential situations in Zimbabwe and/or Weimar Germany are often highlighted as just about the worst case scenario. Personally, despite my general bearishness about the sustainability of US prosperity and global influence, it is hard for me to believe that the economic situation will deteriorate far enough to produce hyperinflation. But for those who disagree and are trying to find a place to park your money before is it debased completely, Ambrose Evans-Pritchard of the Telegraph has just the place for you. Why hold US dollars that will only lose more and more purchasing power when you can invest in the future of none other than the infamous Zimbabwe? That’s right folks, Zimbabwe is back. In this environment where the size of the return is perfectly correlated with the amount of risk (with no limit to the potential appreciation as long as you are willing to accept more risk), there could be no better place for yield hungry investors to speculate on:

"The fundamental change is that we have stopped printing money to cover our deficit," said Tendai Biti, the MDC's finance minister, who shrugs off death threats.

The hyperinflation crisis has in a sense solved itself. The Zimbabwe dollar faded away as the army and then everybody else refused to accept it. The US dollar is now the coin of daily life. Prices have been stable for months. "Forget about a local currency," said Mr Biti.

Zimbabwe's central bank – an arm of state terror under Zanu PF enforcer Gideon Gono – has lost its cash cow. It is no longer able to skim profits from exchange rate arbitrage. The bank has allegedly been involved in the illicit selling of smuggled diamonds from the Marange field (seized illegally).

Harare's stock exchange is humming again. Volume has increased 20-fold, all now in US dollars…They say that Africa is the leveraged way to play China. If so, Zimbabwe is the leveraged way to play Africa. For brave investors, it is the ultimate rebound story.

Damn. Well there goes that idea. The Zimbabwe dollar is dead and now US dollars are the only currency accepted. Now if the dollar gets completely debased they may have to go back to the local currency. Apparently there is no way for Zimbabwe to escape hyperinflation.

The race to a sovereign default: Continuing on the topic of extremely severe but remote outcomes, this week Martin Hutchinson of The Prudent Bear tackles the question of which of these three major countries—US, Japan, or Britain—is most likely to default on its debt first. After reading the comments from Simon Johnson last week regarding Japan, I spent the weekend in Las Vegas betting on a Japanese default. Obviously the chances of a default are relatively small and it is likely that policy changes will be implemented well before there is an imminent risk. However, Hutchinson makes a compelling case for Britain as sort of the dark horse in this dubious race to the bottom:

The worst budget balance of the three deficit countries is in Britain, where the forecast budget deficit for calendar 2009 is a staggering 14.5% of GDP. Furthermore, the Bank of England has been slightly more irresponsible in its financing mechanisms than even the Federal Reserve, leaving interest rates above zero but funding fully one third of public spending through direct money creation. Governor Mervyn King has a reputation in the world's chancelleries as a conservative man of economic understanding. He doesn't really deserve it, having been one of the 364 lunatic economists who signed a round-robin to Margaret Thatcher in 1981 denouncing her economic policies just as they were on the point of magnificently working, pulling Britain back from what seemed inevitable catastrophic decline. King's quiet manner may be more reassuring to skeptics than the arrogance of "Helicopter Ben" Bernanke, but the reality of his policies is little sounder and the economic situation facing him is distinctly worse.

Britain has two additional problems not shared by the United States and Japan. First, its economy is in distinctly worse shape. Growth was negative in the third quarter of 2009, unlike the modest positive growth in the U.S. and the sharp uptick in Japan. Moreover, whereas U.S. house prices are now at a reasonable level, in terms of incomes (albeit still perhaps 10% above their eventual bottom), Britain's house prices are still grossly inflated, possibly in London even double their appropriate level in terms of income. The financial services business in Britain is a larger part of the overall economy than in the U.S. and the absurd exemption from tax for foreigners has brought a huge disparity between the few foreigners at the top of the City of London and the unfortunate locals toiling for mere mortal rewards. A recent story that the housing market for London homes priced above $5 million British pounds was being reflated by Goldman Sachs bonuses indicates the problem, and suggests that the further deflation needed in U.K. housing will have a major and unpleasant economic effect.

A second British problem not shared by the U.S. is its excessive reliance on financial services. As detailed in previous columns, this sector has roughly doubled in the last 30 years as a share of both British and U.S. GDP. In addition, the sector's vulnerability to a restoration of a properly tight monetary policy has been enormously increased through its addiction to trading revenue. The U.S. has many other ways of making a living if its financial services sector shrinks and New York is only a modest part of the overall economy. Britain is horribly over-dependent on financial services, and the painful if salutary effects of London costs being pushed down to national levels by a lengthy recession are less likely to be counterbalanced by exuberant growth elsewhere.

If this analysis is correct, Britain is facing many of the same challenges that I think will hamper growth and prosperity in the US, but on an even larger scale. Crippling budget deficit? Check. More room for housing prices to decline? Check. An outsized financial services industry that has become a drain on the entire economy? Check. Continued quantitative easing as even the US is beginning to ease off? Check. An economy that doesn’t produce anything and that relies on rent seeking? Check. Ladies and gentlemen, I think we may have a new contender in our midst!

Breaking news: The US financial sector is too large and may not contribute to growth: If the events of the past 2 years haven’t made the accuracy of these previous statements obvious and even intuitive, in a recent article Justin Fox highlights some data that backs up what most of us already know is true. Fox is the author of The Myth of the Rational Market, a book that attempts to further debunk the efficient markets hypothesis and promotes the idea that irrationality explained by behavioral finance is likely a better predictor of market fluctuations. I haven’t read the book yet, but for any of you who share my disdain for the efficient markets and the rational actor theories, I have heard it is very good. In any case, in this recent piece in Time Magazine, Fox cites a study done by Thomas Philippon of NYU Stern that calls into question Lloyd Blankfein’s contention that gigantic financial firms contribute to growth:

If there were a simple correlation between financial-sector growth and economic growth, Philippon reasons, finance's share of the economy would stay constant. But when he examined data back to 1860, he found that finance's share of GDP varied widely. It ballooned in the late 19th century, shrank, ballooned again in the 1920s, shrank and stayed low for decades, then began to grow again in the 1970s, reaching unprecedented levels earlier this decade. The measure Philippon uses is the economic value added of the financial sector as a percentage of GDP, which was at about 4% in the 1960s and hit almost 8% in 2006. An easier-to-understand metric — financial-sector profits as a share of overall corporate profits — followed an even more dramatic trajectory, from 12% in the mid-1960s to almost 41% in 2002.

The 1960s were by most measures the best decade ever for growth and widening prosperity in the U.S.; the past decade has been a bust. Yet the financial sector was relatively tiny in the 1960s and huge in the 2000s. Could this mean that good times for finance are bad for the rest of us? Philippon says it isn't that simple. The 1990s, for example, were good for both Wall Street and Main Street. His theory, which fits the historical evidence well, is that the financial sector's share of the economy should increase when there are fast-growing companies needing outside funding, like railroads in the late 19th century, manufacturers in the 1920s and tech firms in the 1990s. If financing wasn't in great demand in the booming 1960s, perhaps that was a warning sign of stagnation to come rather than evidence of the uselessness of financiers.

Over the past decade, though, reality took a detour from Philippon's theory. Corporate America's need for outside financing fell, but the financial sector refused to shrink; it pumped out ever riskier products until the system nearly collapsed. Why the refusal? Maybe the pay was too good. Philippon and the University of Virginia's Ariell Reshef have found that, starting in the mid-1980s, financial-sector paychecks began to outstrip those for jobs in other sectors demanding similar skills and education levels. Since the late 1990s, Philippon and Reshef estimate, 30% to 50% of financial-sector pay has amounted to what economists call rents — windfalls that serve no economic purpose. They may even hurt the economy by pulling highly skilled workers out of other, potentially more productive fields.

In other words, according to Philippon there is no clear evidence that the size of the financial sector has anything to do with GDP growth. In fact, high wages and bonuses as well as the stature associated with being a banker may have been enough to steal workers away from other, more productive industries. That is on top of the fact that the size, concentration, and interconnectedness of the financial system as a whole ALMOST BROUGHT DOWN THE ENTIRE GLOBAL ECONOMY. Sorry, I just wanted to make sure you hadn’t forgotten this somewhat trivial fact. Now that Goldman is making $100M a day trading, bonus payments are going to set new records this year and bank stocks have risen from the ashes, it is easy to overlook the fact that the financial sector is even more concentrated now and appears to be more focused on rent seeking and fee extraction that ever before. I guess the point of all of this is that when a banker comes to you saying that the entire world will end unless his firm is bailed out, you should remember that there is no guarantee we would all not be better off without such a company in existence.

Buffett paid what for BNI? It’s amazing how many Buffett haters come out of the woodwork whenever he makes a major investment. Recently people have harped on the fact that many of the companies Buffett has invested in (both of late and in the past)—Goldman Sachs, GE, Wells Fargo, American Express—have received some form of government bailout of subsidy. Apparently, they view this as a sort of an unfair handout to Buffett and Berkshire. Maybe he saw the writing on the wall that the government would step in to stabilize the stock and financial markets and thus made a very prudent investment. Those Goldman warrants sure look nice right now, huh? Look, I am not a Buffett apologist. He is a shrewd investor with an unsurpassed track record who uses his position, influence and stature with the media to obtain better deals and further his financial interests. In other words, he is a capitalist through and through. Such people used to be revered and admired. Now, even people who give billions to charity are criticized as if they were banksters.

It is within this backdrop that the naysayers have once again emerged to criticize the large premium paid for Burlington North (BNI). According to these geniuses The Oracle no longer follows the principles of value investing and has overpaid for BNI. I know for a fact that the first assumption is patently false. As for the second, only time will tell if the price was too rich. However, I think people should remember a few things before they prematurely pass judgment. First, with over $20B in cash on the balance sheet, Berkshire has to do large deals if it wants an acquisition to have any meaningful impact. As a result, Buffett has admitted that it will be harder for BRK to generate the returns it has in the past. Big deals are not cheap and sometimes the control premium is substantial. Further, despite Buffett’s initial training with Ben Graham, since he shut down his partnership all those years ago he has focused on buying great companies at a fair price as opposed to fair or bad companies at a great price. I happen to believe that BNI is a great company, but maybe not for the reasons you automatically assume. I thought Simon Johnson of The Baseline Scenario explains the long term positive secular story that may end up justifying the price (and reminds me of when Buffett bought Coca Cola) as well as anyone:

Buffett’s big investment in railroads looks like a shrewd way to bet on growth in emerging markets – which is where most incremental demand for US raw materials and grain comes from. It’s also a polite way to bet against the dollar or, even more politely, on an appreciation of the renminbi.

When China finally gives way to market pressure and appreciates 20-30 percent, their commodity purchases will go through the roof. You can add more land, improve yields, or change the crop mix of choice (as relative prices move), but it all has to run through Mr. Buffett’s railroad.

Of course, Buffett is nicely hedged against dollar inflation – this would likely feed into higher inflation around the world, and commodities will also become more appealing.

And Mr. Buffett is really betting against the more technology intensive, labor intensive, and industrial based part of our economy. If that were to do well, the dollar would strengthen and resources would be pulled out of the commodity sector – the more “modern” part of our production is not now commodity-intensive…

By betting on commodities, Mr. Buffett is essentially taking an “oligarch-proof” stance. Powerful groups may rise to greater power around the world, fighting for control of raw materials and driving up their prices further. As long as there is growth somewhere in emerging markets, on some basis, Mr. Buffett will do fine.

If everyone is cheating, is it wrong? Clearly the politicians in Washington and the banksters in New York are setting poor examples for the rest of us. Between not paying their taxes, orchestrating secret bailouts at the expense of the taxpayer, and awarding themselves enormous bonuses in the midst of a terrible recession, it is understandable that an outside observer would conclude that there are no laws governing these folks. The question is how does this affect the actions of others? According to one of my favorite behavioralists, it might make us all a little more prone to gaming the system any way we can:

Trickle down really does work. Consider these inspired words, from an online reader of USA Today, reacting last week to news that Americans were lying, cheating and law-breaking to get their hands on an $8,000 tax credit for first-time homebuyers:

“The system is scamming you, so why not scam back a little,” wrote the reader, using the name “None in 08.” “You’ve seen what crooks in Washington and on Wall Street can get away with.” So “it’s time to get yours.”

There is also the simple matter of bad examples: The more people observe bad guys getting away with it, the more they cheat, says Dan Ariely, author of “Predictably Irrational: The Hidden Forces That Shape Our Decisions.”

Ariely worries about what he calls “the Madoff effect,” a swine-flu-grade virus that causes people who witness corruption to conclude that cheating has become acceptable, and to wind up cheating, too. When Mom and Dad are putting their tots’ names on the income-tax forms to scam $8,000, Ariely says, “we’re seeing the aftershock of all this dishonesty on Wall Street.”

Fixing the problem is unlikely in an era when the saving of one guy’s bonus is of such crucial importance that it motivates a few-hundred-million-dollar corporate transaction. Averting future financial crises requires entirely new banks in which compensation runs in the hundreds of thousands, not millions, of dollars a year, says Ariely.

Fantastic. Another way in which Wall Street proves its overall worth to society. Not only do banksters set bad examples for our impressionable children, but their firms also apparently (see above) may not even contribute to growth. So why do we need such a large financial industry? Oh yes, to further increase the gap between the rich and the lowly middle class and poor. I am with Bernie Sanders: break ‘em up!

(Map of Zimbabwe courtesy of usaid.gov)

A Set of Unusually Cheery Links

Peggy Noonan pulls no punches: In one of her latest missives in the Wall Street Journal, Peggy Noonan poses a very simple question. Do today’s leaders of America really care about the future of this country? I often worry that the re-election cycle has gotten so short and the incentive to pass the burden onto future lawmakers is now so pervasive that we can do no better than short-sighted, even foolish near term fixes to current problems. Extend and pretend when it comes to financial companies and kick the can down the road when it comes to the bulging deficit seem to have become the official policies in Washington. Clearly, no one wants to force any more pain on already strained American households. But at what point do the consequences of the actions being taken actually become magnitudes worse than the painful rebalancing and restructuring we could choose to face today? It is within this context that Noonan posits an interesting theory. Her premise is that the current leaders have lived in a period of such US prosperity that they are essentially too arrogant to even contemplate the idea that country could be in the midst of a lasting decline:

When I see those in government, both locally and in Washington, spend and tax and come up each day with new ways to spend and tax—health care, cap and trade, etc.—I think: Why aren't they worried about the impact of what they're doing? Why do they think America is so strong it can take endless abuse?

I think I know part of the answer. It is that they've never seen things go dark. They came of age during the great abundance, circa 1980-2008 (or 1950-2008, take your pick), and they don't have the habit of worry. They talk about their "concerns"—they're big on that word. But they're not really concerned. They think America is the goose that lays the golden egg. Why not? She laid it in their laps. She laid it in grandpa's lap.

They don't feel anxious, because they never had anything to be anxious about. They grew up in an America surrounded by phrases—"strongest nation in the world," "indispensable nation," "unipolar power," "highest standard of living"—and are not bright enough, or serious enough, to imagine that they can damage that, hurt it, even fatally.

We are governed at all levels by America's luckiest children, sons and daughters of the abundance, and they call themselves optimists but they're not optimists—they're unimaginative. They don't have faith, they've just never been foreclosed on. They are stupid and they are callous, and they don't mind it when people become disheartened. They don't even notice.

Has Japan’s luck run out? When I hear people say that one of the worst case outcomes for the US in terms of the current recession is a Japan-like lost decade (or two), I usually am not so worried. Yes, the fact that the stock and the real estate markets are still massively below their late 1980’s peaks is not a particularly positive outcome. Additionally, years of dubious infrastructure building certainly has led to outsized fiscal deficits. However, so far, while growth has been understandably tepid for a long time, the Japanese economy has seemed to find a way to muddle through. Before you start to think I have lost my mind, you have to consider the alternatives. From what I know Japan has not experienced any meaningful deleterious social unrest. There have been no violent overthrows of the government. Interest rates have remained incredibly low without sparking inflation. My point is that while the circumstances in Japan during the past few decades have been far from ideal, the world has seen much worse. Unfortunately, this current financial crisis may have sent Japan over a tipping point. With a gigantic fiscal deficit, a scary imbalance between older and younger people, and an export-dependent economy that is being crippled by the strong Yen, suddenly the situation in Japan does not look sustainable. As a result, there are numerous financial commentators and economists sounding the alarm. Here is a recent piece in the Telegraph from Ambrose Evans-Pritchard:

Simon Johnson, former chief economist of the International Monetary Fund (IMF), told the US Congress last week that the debt path was out of control and raised "a real risk that Japan could end up in a major default"…

"The debt situation is irrecoverable," said Carl Weinberg from High Frequency Economics. "I don't see any orderly way out of this. They will not be able to fund their deficit. There will be a fiscal shutdown, a pension haircut, and bank failures that will rock the world. It is criminally negligent that rating agencies are not blowing the whistle on this."

Mr Hatoyama inherited a country that was already hurtling into sovereign "Chapter 11". The Great Recession has eaten up 27pc in tax revenues. Industrial output is down 19pc, even after the summer rebound; exports are down 31pc; the economy is 10pc smaller today in "nominal" terms than a year ago – and nominal is what matters for debt.

Tokyo's price index fell 2.4pc in October, the deepest deflation in modern Japanese history. Real interest rates have risen 300 basis points in a year. It reads like a page from Irving Fisher's 1933 paper, Debt Deflation Causes of Great Depressions.

Is the “New Normal” really playing out? Bill Gross and Mohamed El-Erian of PIMCO have been the major proponents of the idea of the “New Normal.” For those of you who aren’t familiar with this phrase, it refers to a US economy in which growth will be subdued for a pretty long time, the government will be more involved than ever before, and unemployment will remain stubbornly high. The New Normal unequivocally does not imply a V-shaped recovery. Now, we know PIMCO has been recommending bonds, especially US Treasuries, that would benefit relative to stocks if the New Normal scenario plays out. So there is definitively a possibility that the co-CEOs of PIMCO are talking up their book as they advance this concept. But Doug Noland of The Prudent Bear argues that New Normal is only a slight modification of the bubble-influenced period that led up to the crash and may not fully describe what the US economy is actually experiencing:

From my perspective, the “New Normal” appears more like the old than something new: I'm thinking more “The Newest Abnormal”. To be sure, there have been some popped Bubbles. But we remain trapped in the same old Bubble-inciting paradigm of activist central banking and government intervention. I have expounded the view that a “government finance Bubble” emerged with the bursting of the Wall Street/mortgage finance Bubble. I would argue that Bubble dynamics have taken firm hold in China, throughout Asia, and in the “developing” economies more generally. New Normal reminds me too much of “muddle through.”

“Deleveraging” is at this point overrated. Our federal government issued about $1.9 TN of additional debt over the past year. In my book, that’s “leveraging.” The Fed’s balance sheet has become much more leveraged. The mortgage businesses of Fannie, Freddie, Ginnie and the FHA have become much more “leveraged.” The Newest Abnormal is about massive synchronized global government Credit expansion and extreme monetary looseness. The Newest Abnormal sees massive “private” Credit expansions in China, India, Brazil, and the “developing” markets. The Newest Abnormal is fueling historic Credit and economic Bubbles in China.

The Newest Abnormal has seen a major resurgence in the global leveraged speculating community. The Newest Abnormal is acting with great speed to impair the dollar as the world’s reserve currency - taking unfettered financial “globalization” to a whole new level. The Newest Abnormal has animal spirits that could give the old ones a run for their “money”.

Mr. Gross’s New Normal – constrained by “deleveraging and reregulation” - seems to imply a more subdued and therefore stable Credit landscape. Such a backdrop would be consistent with lower average economic growth and lower investment returns. The Newest Abnormal – with varieties of newfangled Bubbles, excesses and uncertainties – would point to ongoing financial and economic volatility. The “averages” may indeed be lower going forward - but it may be the divergences that prove most noteworthy (hard asset returns vs. securities; non-dollar vs. dollar; China GDP vs. U.S., for example).

The New Normal implies more monetary order, while the Newest Abnormal suggests unrelenting Monetary Disorder. The proponents of the New Normal would tend to view extreme government intervention as a stabilizing force appropriate for a (deflationary) post-Bubble landscape. From the Newest Abnormal perspective, massive government deficits and market interventions inaugurate a dangerous new stage of global inflationism. Newest Abnormal analysis posits that a more stable New Normal backdrop would, at this point, likely arise only after a major government debt crisis.

What could global central bank tightening mean for equities? Well, we now know that there are a number of countries out there that are not going to wait to raise interest rates until the US is ready. Australia, for example, has not been shy about increasing its rates despite the fact that the US is still engaging in zero interest rate policy. While the Fed communiqué released today did not give any indication of plans to boost rates any time soon, the actual minutes apparently included meaningful discussion regarding the appropriate exit strategy from all of the current liquidity backstops. As a refresher, I am a member of the deflation and inflation camp. I think the lack of credit and slack in the labor force will continue to make deflation the most near term risk. However, it is hard for me to believe the Fed will be able to unwind its facilities, unload its balance sheet, and deal with bank reserves without creating inflation at some point down the road. Considering this point of view, the idea that the Fed is considering pulling the punch bowl away now is somewhat startling. I don’t know if we need more stimulus or increased quantitative easing, but what I do know is that any economic improvements are incredibly tenuous and allowing certain markets to function on their own might be disastrous in the short run. Additionally, given the fact that Fed liquidity has been a major driver of the stock market rally, my guess is (and according to this piece in the Telegraph) that central bank tightening and abandoned stimulus are not going to be good for stocks:

Teun Draaisma, Morgan Stanley's equity strategist, said investors should move with care as central banks awaken. A study of 19 "bear market" rallies over recent decades shows that bourses tend to tip over as the US Federal Reserve starts tightening. Equities fall back 25pc over the next 13 months on average. It is unlikely to be better this time.

"Given the amount of leverage in the economy, little changes in rates can have a disproportionate impact. The poor state of government finances, the high supply of bonds, and the fear of inflation could further exaggerate a bond market sell-off once tightening starts," he said.

Timing is tricky. Stock markets began to fall four months before the first rate US rise in 2004, but they did not tip over until the tightening started in 1994.

Japan's Nikkei index in the 1990s slumped each time Tokyo drained fiscal stimulus, most notoriously by raising VAT from 5pc to 9pc in 1997 - a warning for Britain as the VAT cut expires in January.

Yet another instance of why the government should not be backstopping large banks: In an article from this weekend, James Surowiecki of The New Yorker identifies some additional structural advantages that the largest US banks have over smaller ones, especially those with an explicit (sorry Tim Geithner, implicit) government bailout guarantee. First off, switching banks is costly and time consuming, particularly if you have multiple accounts or products with the same bank. Plus, inaction is especially attractive when you know the government won’t let your big bank fail. Similarly, Surowiecki argues that as a result of the government backstop, the brands of even the most troubled and controversial large banks are still intact because relative to the small enough to fail banks, the behemoths are viewed as safer. This is truly perverse but it makes complete sense from a customer’s point of view. Even more disturbing is his argument that the banks reputation among corporate business has not been meaningfully impaired. Despite the fact that these institutions could not even manage their own business well enough to make it through the recession without taxpayer support, for some reason businesses continue to want their advice on M&A and may even trust them to handle their IPOs. While none of this is surprising based on what has transpired over the last two years, it is hard not to be struck by the resiliency of these institutions even in the face of nationalization:

So why aren’t customers and clients moving on? In the case of ordinary consumers, “switching costs” have a major effect. It’s a serious hassle to shut down a bank account and transfer money to a new one, especially with direct deposit, automatic bill payments, and the like. The same is true of refinancing at a different bank from the one that currently holds your mortgage, or trying to persuade a new bank to give you a business loan. These costs aren’t trivial: a 2001 study showed that the cost of switching a loan came to about a third of the loan’s annual interest rate. Even if people are dissatisfied with their bank, it’s usually cheaper not to fight than to switch. If you’re a restaurant or a retailer, you have to work hard to insure that your customers keep coming back. But once banks get a customer he’s pretty much theirs for good.

The big banks have the further advantage of their brands, however tattered the brands may be. It’s nearly impossible for consumers to evaluate how healthy a bank is. So, at a time when banks are failing with some regularity, the size and ubiquity of these big banks is reassuring. It seems improbable that they will simply vanish (the way a bank like IndyMac did), because the government won’t allow it. It’s possible, in fact, that the crisis, instead of eroding the reputational advantages of the big banks, ended up bolstering them. In times of uncertainty, people are inclined to shun experiment for the safe choice.

Reputation arguably plays an even bigger role in the competition for corporate business. A major part of what Wall Street firms do for their clients is, in effect, to vouch for their financial prospects: when a bank underwrites a company’s bond offering or an I.P.O., it is essentially certifying that company in the eyes of investors. Companies hire high-profile firms to advise on mergers not just for the advice but for the public signature of approval. The more powerful the bank that’s giving the advice, the better the cover it offers. Success, then, feeds on itself: having a big market share today makes it easier to win business tomorrow.

(Map of Japan courtesy of lonelyplanet.com)

Britain to break up the taxpayer owned banks: Citigroup Beware

The Telegraph is reporting that Britain will follow through on its promises to break up the banks that are taxpayer owned in order to dampen the banking monopoly that dominates that market. The two semi-private banks slated for gutting are Royal Bank of Scotland and Lloyds Banking Group, both of which were saved by taxpayer bailouts in the last year or so. In addition, Northern Rock, which is completely owned by the state, looks like it will be split into a good bank and a bad bank, with the good portion to be sold off as soon as possible:

Many of their assets will be sold off in deals which ministers will present as fulfilling Gordon Brown's promise that the taxpayer would get "pay back" for the multi-billion pound Government bail out of the sector last year.

Assets to be sold could include Cheltenham & Gloucester, currently owned by Lloyds, and RBS-owned NatWest branches in Scotland.

The three new-look banks, all of which have their roots in smaller-scale high-street operations of the past, will be:

* The TSB, the old Trustee Savings Bank whose branches were bought up by Lloyds. These will now be resurrected across the UK.

* Williams & Glyn's, which had a brief period of operation in the 1970s and 1980s. Owned by RBS, it will be formed of hundreds of the Scottish group's English branches.

* BankCo, the "good bank" portion of the entirely state-owned Northern Rock, which will include retail deposits, mortgages, and branches. Ministers are keen to sell the operation off as soon as possible.

So, while the US banking system continues to consolidate and the too big to fail problem increases exponentially with each additional derivative contract, our colleagues across the pond are enacting the type of reforms that are desperately needed in the US. Both Paul Volcker and Mervyn King have in the last 2 weeks called for a separation between commercial banking and proprietary trading. In one of his emails this past week, fund manager Whitney Tilson of T2 Partners advocated the same split. James Kwak of The Baseline Scenario has directly addressed the topic of whether bigger banks are better and has come to the conclusion that “[t]his whole argument, that global companies need massive banks, is one of those things that sound plausible until you actually start thinking about them.” Additionally, I have also read a compelling counterpoint to the idea that if the US breaks up the banks or regulates them too severely (with capital requirements or leverage caps) the banks will leave the US for less restrictive locals and as a result we will all be worse off. I am paraphrasing but the gist of the argument was that we should be willing to let the banks leave if that means that they take their unabashed risk taking with them and we are left with a more stable banking system and economy.

Accordingly, there is a chorus of very distinct voices rising up on the side of breaking up the banks and separating the risk-taking functions from the plain vanilla lending operations. But where do the US Treasury and Fed stand on this topic? Maybe the better question to ask is where the bank lobbyists stand. Clearly, the banks have no interest in the perceived logistical nightmare of splitting up or the potential loss of monopoly power. So, my guess is that if the lobbyists have their way there is little hope of the US following in the shoes of its British counterparties. What is probably the most amazing aspect of the plan coming from Alistair Darling is that the government is putting in provisions to protect against further consolidation. The Brits seem to believe in “never again” while Geithner and Co. believe in “let’s go back to 2007.”

Officials said the move would increase competition on the high street and would mean a better deal for customers looking for mortgages or current accounts which did not charge fees.

They added that the announcement would mean the break-up of the established "monopoly" over retail banking of the high street giants – whose numbers also include Barclays, Santander (owners of Abbey) and HSBC…

Under the deal, the new institutions will not be allowed to be taken over by any purchaser which currently owns a British retail bank. Ministers will stop this happening using their powers as controlling shareholders in Lloyds, RBS and Northern Rock, rather than by new regulations.

Channeling my inner Nassim Taleb: less opacity and reduced concentration within the financial system leads to robustness and minimized fragility. (You can tell I have listened to way too many Taleb presentations.) As an added benefit, the more competitive nature of the mortgage and credit markets could lead to lower fees for consumers and businesses. Obviously, these actions in the UK provide minimal solace for those lucky Citibank customers who now have to pay 30% or more on their credit card balances despite their solid credit ratings. But I do think this is positive step and there is a ray of hope. Remember how quickly the SEC moved to ban short selling in US financial stocks after the FSA did so? It was like once someone had bitten the bullet the US regulators were willing to jump on board. Now, banning legitimate short selling was a terrible idea and all it did was temporarily halt the decline in the shares of the financial companies on the very dubious list. However, if all the Treasury, Congress and Fed need is some precedent, then maybe this announcement by the Brits will lead to a concerted effort to reduce the dangerous concentration of our financial system that continues to generate exorbitant profits at the expense of the taxpayer.

(Picture of Alistair Darling courtesy of thesun.co.uk)