Monday, October 5, 2009

The best articles of the weekend

Peter Schiff’s prescription for what ails the US: Hat tip to The Pragmatic Capitalist for posting the link to this commentary from Peter Schiff of Euro Pacific Capital. In this piece the newest candidate for Congress in Connecticut lays out exactly what he thinks needs to happen to get the US back on the road to prosperity. Whatever you may think of his politics, it is hard to quibble with his very pragmatic suggestions. Let the market do what it does best without all of the continued government bailouts and subsidies: clear out excesses and set asset prices and interest rates.

To really recuperate, the government must allow market forces to restructure our economy. The government and individuals must rein in their spending; we must replenish our stock of savings, allow interest rates to rise, asset prices to adjust to economic reality, insolvent businesses to fail, and wages to reflect productivity. To accomplish these goals, subsidies that distort market forces must be removed and regulations that undermine our competitiveness must be repealed.

None of this can be accomplished without a degree of short-term economic pain. However, if we endure it, the payback will be a real recovery with plenty of new jobs that don't rely on government stimulus money. If we refuse to allow the economy to experience a real recession, we will never have the benefit of a real recovery. Instead, we get the "jobless recovery," a veneer of apparently positive indicators that merely obscures the underlying rot.

Over the last few decades, our industrial job market has atrophied while service- and public-sector jobs have grown unsustainably. We must restore balance. New jobs will have to come from areas that produce goods; bloated service and government sectors must be allowed to shrink. By propping up the sectors that need to contract, and running staggering budget deficits, the government cuts off the capital necessary to fund sectors that need to expand.

I have to admit that I am dubious when I hear people say that the US economy needs to get back to being production-based and therefore much less consumption-dependent. It’s not that I don’t think we would all be much better off if financial and service companies played a smaller role in the economy. I just don’t know what we would produce or make competitively. I’m sure we could make quality products but without creating new tariffs on imports, how could US-based production compete with emerging market-centered production? The difference in cost of labor is just night and day. Thus, I worry this solution is a bit pie in the sky. I think it is much more likely that the US takes the lead in green energy and in an unrelated shift, consumption becomes less of a factor due to higher savings rates.

Some insight from the previously prescient Meredith Whitney: There is no doubt that Meredith Whitney has been able to parlay a couple of somewhat logical, but gutsy and contrarian calls into a significant amount of respect from investors. While I might not pay too much attention if she were discussing monetary policy, I do think she has credible insight when it comes to credit. She currently seems to be in the deflation camp with people such as Albert Edwards and Steve Keen. Why? Because no matter how much money the Fed is trying to pump into the economy, credit is still contracting. Banks are not lending. The shadow banking system is dead. According to Whitney, what all this lack of credit means is that new small businesses will not be formed and existing ones will not be able to grow or fund innovation. As a result, with as important as they are to employment and GDP, it is hard to see how the economy and especially employment recover in a robust manner:

Anyone counting on a meaningful economic recovery will be greatly disappointed. How do I know? I follow credit, and credit is contracting. Access to credit is being denied at an accelerating pace. Large, well-capitalized companies have no problem finding credit. Small businesses, on the other hand, have never had a harder time getting a loan.

Since the onset of the credit crisis over two years ago, available credit to small businesses and consumers has contracted by trillions of dollars, and that phenomenon is reflected in dismal consumer spending trends. Equally worrisome are the trends in small-business credit, which has contracted at one of the fastest paces of any lending category. Small business loans are hard to find, and credit-card lines (a critical funding source to small businesses) have been cut by 25% since last year…

Why do small businesses matter so much? In the U.S., small businesses employ 50% of the country's workforce and contribute 38% of GDP. Without access to credit, small businesses can't grow, can't hire, and too often end up going out of business. What's more, small businesses are often the primary source of this country's innovation. Apple, Dell, McDonald's, Starbucks were all started as small businesses.

Interesting guest post on Zero Hedge: I’m not sure what qualifications the writer of this piece (Grant Dossetto) has, but I thought his commentary was extremely insightful and articulate. In this guest post he distinguishes between asset deflation and demand pull deflation. Commodities, equities and bonds have rallied thanks to the Fed’s injections of unbelievable amounts of liquidity, but wages and final goods are continually facing deflationary pressures. The problem with falling prices of goods and rising input prices is that margins and profits are getting squeezed at a time when businesses are not particularly strong already. So, what does this dynamic mean for unemployment? Nothing good is my guess:

The government has rationalized that its unprecedented steps have staved off deflation. This is only partly true. It has staved off asset deflation, it has not ended the threat of demand pull deflation. Since the lows of last winter, commodities and financial assets have rallied seemingly without interruption. Oil has doubled from the low thirties to nearly seventy dollars a barrel, copper has doubled in price, silver has recently exploded as high as seventeen dollars, and gold now stands north of one thousand dollars per ounce. The stock market has increased nearly sixty percent with the S&P now around 1,020, a far cry from the ominous intraday low of 666. The Nasdaq has proven even more resistant to sluggish fundamentals and the Dow Jones Average has also yielded healthy six month returns. Equity strength should portend bond weakness but that has not been the case. Bonds also remain highly priced pushing the 30 year yield to below four percent…

The government reflation experiment has ensured that company costs cannot reach equilibrium with weak final goods markets. This is similar to the Great Depression except that artificial wage inflation has been replaced by artificial commodity inflation to create the disequlibrium. To cut rising costs, the only option is to reduce salaried employees, or shut down completely due to losses in core operations. Rising unemployment will create further weakness in final goods. This portends continued macroeconomic performance below trend for a length of time not seen since the Depression. Asset prices will eventually fall to the market solution, government intervention aimed at avoiding this harsh reality will only delay the inevitable and probably assure a more painful destination in the process.

Review of a much anticipated book on the economy: This Time Is Different: Eight Centuries of Financial Folly by economics professors Carmen M. Reinhart and Kenneth S. Rogoff is finally on book shelves. Investors will recognize the first part of the title as some of the most dangerous words imaginable when describing any asset or economic situation. Over the last 15 years we periodically heard the argument that both tech stocks and US housing prices no longer had to be valued based on past metrics because there was a new paradigm at play. In hindsight any such contentions obviously seem incredibly foolish. History may not repeat itself, but it may very well rhyme as Mark Twain so famously quipped. This is precisely what this book is about. While each financial crisis is unique in certain ways, according to the authors there are a number of similarities that should tip off investors and government officials to the dangers long before any potential bust:

The authors use copious amounts of data — well, actually, numbing amounts — to make the compelling case that any well-informed person should have seen the Great Recession coming. The essence of their book is that while financial crises come in different varieties, they are not mysteriously born of undersea earthquakes, but frequently occurring events that can be spotted and even controlled if politicians and regulators know what to look for.

“Our basis message is simple: We have been here before,” the authors write. “No matter how different the latest financial frenzy or crisis always appears, there are usually remarkable similarities with past experience from other countries and from history. Recognizing these analogies and precedents is an essential step toward improving our global financial system, both to reduce the risk of future crises and to better handle catastrophes when they happen.”

These academics have found the same disturbing patterns in economic data from more than 66 countries: A nation’s political leaders loosen regulations governing the financial system. Banks use the new freedom to borrow money and earn juicy returns. Soon, these sovereign states are awash with money from foreign investors. But beware these torrents of outside wealth. They are accompanied by bubbles in stocks, commodities and real estate.

Just follow the steps. It’s almost as if they could have called the book “Creating Financial Crises for Dummies.” Obviously, I am being facetious and the situation is much more complicated. However, going forward it would be nice to know what specific factors (if any) can be identified before things get out of control.

The too big to fail subsidy: In this weekend’s piece in the NY Times, the irreplaceable Gretchen Morgenson reviews a study from Dean Baker of the Center for Economic and Policy Research regarding the implicit subsidy that the TBTF banks get when it comes to cost of capital. You see, when creditors know that the government will have to bail out a bank, they are willing to lend that bank money at rates that are lower than those they would charge non-systemically important institutions. Talk about irony. The more likely you are to take down the financial system if you fail, the cheaper you get to borrow money. Meanwhile a well capitalized community bank that is trying to support small businesses has to accept onerous terms from creditors. So many things about the financial system in the US are backwards it is mind boggling. In any case, even with the difficulty in estimating the exact subsidy, it appears that at least on a nominal basis it could be pretty substantial:

Using data from the Federal Deposit Insurance Corporation, Mr. Baker’s study found that the spread between the average cost at smaller banks and at larger institutions widened significantly after March 2008, when the United States government brokered the Bear Stearns rescue.

From the beginning of 2000 through the fourth quarter of 2007, the cost of funds for small institutions averaged 0.29 percentage point more than that of banks with $100 billion or more in assets. But from late 2008 through June 2009, when bailouts for large institutions became expected, this spread widened to an average of 0.78 percentage point.

At that level, Mr. Baker calculated, the total taxpayer subsidy for the 18 large bank holding companies was $34.1 billion a year.

Mr. Baker is the first to note that the expanding gap may not be attributable solely to the too-big-to-fail policy. Banks’ cost of money has risen during other times of economic uncertainty, like the recession of 2001. After that downturn, the cost-of-funds spread between small and large banks rose to 0.69 percentage point.

Given that increase, Mr. Baker said, one could calculate a more conservative assessment of the too-big-to-fail subsidy. Using the difference between the spread during the last recession and the current figure, which is 0.09 percentage point, the annual subsidy for the large banks reached $6.3 billion.

Mark Hanson on why a foreclosure tsunami is coming: The chart below and associated commentary do not need much explanation. Hanson, the country’s housing guru, does a better job than I could ever do. However, as a quick summary he believes that loan modifications (he calls them mods) will not work to stem foreclosures in the long run because so many of these attempts fail. He also explains what people mean when they claim that there is a shadow inventory of houses waiting to be foreclosed upon. With cure rates (people who fall behind becoming current again) as low as they are, late stage delinquencies are moving towards foreclosure at an amazing clip and the attached chart highlights the potential supply coming online. The takeaway? Don't count on a new housing bubble any time soon:

The chart below really highlights the growing spread between late stage foreclosures (blue) and actual foreclosures (red). Unless all those loans that make up the spread result in a successful mods, foreclosures will jump again in the near-term.

The gap between late stage (NTS) and actual foreclosures (highlighted in red circle) represents almost a half million foreclosures ready to go. This foreclosure-ready inventory, much of which is on HAMP trial, represents a clear and present danger to the housing market at any time.

Australian economist Steve Keen on the AU housing market: As a result of the research I did on the Australian banks and housing market, I have continued to follow the space to see if my conclusions turn out to be accurate. As a reminder, my thesis was that the Australian and New Zealand housing markets looked a lot like the US market did in late 2006, just before the crash began. Consumers are over-levered and prices have risen dramatically over the past 10 years to the point where the valuations are no longer justified by the rent they can generate. Apparently people are arguing that Australia is different and that the country will not experience a housing bust like the one that has decimated the US and the UK. But, if you listen to Keen and look at the data, it is hard to imagine that the “this time is different” argument will hold water in this case:

I doubt that most people realise just how different Australia has to be to the rest of the world to sustain the bulls’ expectations of yet another explosion in house prices in 2010. Not only do we need to defy a worldwide trend of falling house prices, we need to sustain that on top of a house price bubble that has already exceeded the best the rest of the debt-driven world has achieved in the last 20 years.

Australian house prices rose by a factor of five since the 1987 Stock Market Crash, far more than even US house prices. Even adjusted for inflation, Australian house prices increased by over 250 percent from 1987 levels. The best the US’s housing bubble could manage, before it burst in 2006, was a meager 180 percent rise.

(Picture of Peter Schiff courtesy of