Sunday, November 23, 2008

The Return of Bretton Woods

I believe it might be escaping all of us why the US cannot deflate without deflating the world. There is a lot more than trade deficits, bonds, interest rates and connects or disconnects involved here. There is the existence of currency worldwide at stake, something that could be possibly eluding all involved in speculation as to what each country might do. It appears to me that the nature of Bretton Woods is not only intact, but in full force.

For all those that are confused, what would make a dominant power like the United States totally lose its productive industry, especially when looking at the power of its financial structure and its domestic resources? One couldn't point to the behavior of the people, as the US gained economic prominence in the early 1900's with 8 million drug adicts and an alcohol problem so bad that it was banned in the 1910's. At the same time, what causes the world to bend over backwards to finance their exports to the United States and when these exports fall, their economies come to a screeching halt? The entire game defies logic.

What is going on when an economy like Russia goes from claiming over $1 trillion in foreign reserves to sweating default in a matter of a few months? The entire world has been made flush in cash only to suddenly be short of it. The whole idea of the matter makes one sit up and wonder what is going on.

Because none of us are educated in the international creation of money, it may be something that needs to be figured out by observation. I am sure someone in this world knows what is happening here or the system wouldn't be set up the way it is set up, but then again are the people that know the people that are running the game?

Here is what I propose is happening and has happened since 1944. Bretton Woods was set up to allow for the fixed exchange of currencies around the world with the reserve currency, the dollar, being exchangable at $35 an ounce in gold. What this did is put the onus on the United States after the world had recovered from the war, to keep producing money for the world. Once the French decided they would be better off making a run on the gold behind the dollar than holding dollars, that system fell apart and was replaced with a floating system. What wasn't replaced was what collateralized the money around the world, the dollar. Thus the game switched from hard money to strictly bank credit. The dollar had been exchangable on an international trade basis at $35 an ounce since FDR effected devaluation in 1933. Prior, the dollar was gold and silver and only represented by currencies. For those that don't understand, the gold was the money, the currency the receipt or note.

I believe it is beyond theory that once all money in circulation becomes bank credit, the only real purchasing power in the economy comes from new money being created and the failure to create new money greatly diminished purchasing power for goods and services. The old money is used to collateralize what collateralizes it, assets. Thus the more money piles up, the greater the asset base. But this game comes with a penalty, that the supply of money and the weight of interest grow faster than the economy as a whole and eventually the engine that supplies the power becomes too small to propel itself forward. In the old days, it was never the money supply that imploded, but the credit system that was representative of the money supply. In the current sense, there is no money supply, as the real property of the world is now the money and the credit the recepits for it. This gives the dollar more credence because the US is one of the places around the world where real property is property and can be owned outright subject only to taxes and liens and in some cases use restrictions.

Here is my theory and it explains why the talk of the Chinese or Japanese are going to sell their US Treasuries, that the dollar is going to zero and all the other crap is not only wrong, but so far in error that nothing could be farther from the truth. It is far from the truth because the world set sail on the dollar back in 1944 and there isn't a lifeboat sufficient to get off the dollar. The European market would like to believe they could do it with their new currency, but truth be known, this currency needs the flow of dollars for collateral and should they attempt an exit, they would find money to back their exit lacking. In short, the world money supply is created by the Federal Reserve of the United States.

You might note how many emerging markets tied their currencies to the dollar in an effort to ride the game. The ones that weren't in shape to attract export business, like Argentina, ran into deep trouble, but those that succeeded in attraction export business like China, prospered. The stability allowed them to mirror the US without the liabiity of being the US. This game works as long as a country can continue to attract dollars in sufficient amounts to allow their own banking system to work.

There are 2 examples of what happens when the amounts aren't sufficient that come to mind, Japan and Argentina. In the case of Argentina, the export business never developed and they used their anchor as so many consumers in the US use it, as an advantage to consume. In the case of Japan, they used inflows to develop internal bubbles in real estate and banking and when the US slowed down after 1990, their bubbles broke. The inflows of dollars haven't been sufficient since for the reflation of the system, as their own system can't reflate what is not actually based on its own value. The Japanese banking system, to the surprise of many of you, may be totally supported by their supply of American dollars. Its bank credit is supported by domestic collateral, but the yen itself is not. Thus the capacity of the domestic central bank has to be able to expand at an exponential rate or the system runs into trouble. In this case, the US cannot slow down or the rest of the world collapses.

This is why they never sell the bonds. The dollar and its collateral are the only chairs available for other currencies. It is also why the US is stuck in an ever ending system of expanding debt and diminishing output. The US can't quit consuming because there is really no exchange that can be made to create the currencies the rest of the world need. In fact, not a country in the world is really interested in collateralizing their own currencies because it would expose them to the same financial looting that has wiped out the US. Most of them would have to give up their industrial growth and face the prospect that their major industries take on the look of General Motors. Plus, few could stand the continued drain that goes with supporting their money with their own assets.

Here is the rub of it. The world is addicted to US trade deficits in the $500 billion range and the US consumer has finally run out of its capacity to take on more debt. No more than the rest of the world can get off its credit collateral, neither can the US. We are stuck in an end game situation and the result of this end game is clearly the shrinking value of assets we are seeing around the world. Remember, the existing money isn't here to spend so much as it is to value the assets in the market place. So we have 3 problems to support, debt devaluation, economic growth and asset return support. In order to keep the game going, more than enough money has to be borrowed into existence to keep the majority of debt being serviced, so the system can at least claim current solvency. The assets have to have enough return to justify their prices and allow for the support of the collateral values attached to them.

If you take China, for instance, in order that their economy expand 5%, they need to expand the monetary base by 5%, plus they need enough extra money to pay the return on the money already in existance along with the stream of income to the investments made around the country. Some of this money recycles back through the economy, but most of it accumulates. If they need to encourage loan solvency as well, they will need even more money. This means they need to attract enough dollars to expand their monetary reserves by maybe as much as 15% or more in order to run in place. To do less would expose the economy to deflationary forces that threatened the value of the asset base of the country and the capacity of the system to pay its debts. I am sure this is behind them not wanting to let the yuan appreciate, as this would lessen the number of new yuan they could issue.

One might recall what occurred in Japan in the late 1980's. For one, the yen apprecited to the point that I believe they could only issue about 90 new yen for every dollar they got in trade. This was down from 200 earlier in the decade and 300 in the 1970's. The yen was definitely deflating and their asset bubble was inflating as money flowed to Japan to take advantage of appreciating currency and rising asset prices in stocks and real estate. Japan started buying sizable investments in the US as well, when the US caught cold from its own financial problems and its incapacity to generate enough new credit to pay the high interest rates of the Volker Federal Reserve regime.

As strange as this may seem, the trade deficit of the US cannot be balanced and the US cannot be treated as a normal debtor nation. People over and over again differentiate Japan from the US by saying Japan was a creditor nation but not the US. What they miss is that the US owes Japan its entire monetary base, which means that if the US paid Japan off, Japan would need to find something else to use as money. Thus the Japanese economy would literally cease to exist.

Truthfully the only way the US can solve this problem is to allow consumers to pay down their debt load, if this actually could be accomplished. The problem with this is that to do so would deflate every country in the world, as the US consumer would have to earn back what the rest of the world is using as money. This would of course cause the collapse of banks around the world.

I am going to develop this idea forward, but I do know enough to know that the outline of the system is as I described it, that there is little chance the Chinese or any other outfit sells off their US bonds and for that matter, that the oil producers leave the dollar, as to do so would immediately collapse their business and the world economy. Of course, if they should wish to bring down the west, this would go a long way to doing it.

Saturday, November 15, 2008

Should they bail out GM?

The Bush administration has balked at bailing out GM and now GM hopes to make it to Santa Claus' administration. This is going to be one of the great economic debates of all time and if GM makes it after a bailout, it will be used as proof that it should have been done. But, if you put your life savings on a roulette wheel number and win, is that proof you should have done it or is it merely the fact that luck separated a fool from a genius?

I know I don't understand what is going on when the statement prevails that if GM falls to $12 billion in cash they are out of business? That really doesn't make sense to me, but maybe I have lived on the edge for too long. If a company with $12 billion in cash is broke, then what is a family with $200 to make it until a week from now? This isn't the primary problem though.

The primary problem is that the figure of $25 billion that has been tossed around appears to not amount to much in this case. It is true that the loss of GM would be devastating, but a bankruptchy might work as well as a bailout from where I sit. It would force some changes in a company that is clearly broken. It isn't like they were blindsided with this economy, as they have known for the past 50 years that auto sales at the level we have witnessed for the past 15 years are an abnomoly and not the norm and that eventually something bad was going to happen, like a real recession.

My first instinct is to save GM. Mom, apple pie and Chevrolet, the symbol of American power and the backbone of many a local economy to boot. Then, the question moves to, what do you do with Ford? Do you save them as well? I don't see why not. It is clear that over the short term losing these operations would devastate the US and most likely roil the financial system more than anything that has gone down so far. Who has the CDS's on GM? Are we up for another bailout if they go down? It might be a good idea to walk them pst the window these swaps cover, if for no other reason than to disarm a devastating situation.

But, can you blindly save a company that has seen the handwriting on the wall if they continued to operate as they are? What are they going to do different than they have done over the past 20 years? It is clear they can't stand around and boast we are GM, get out of the way, can they? This company has not only made obligations they couldn't keep, but it appears they are run so purely inefficiently that it is a wonder they ever made a dime. I remember when they were the first company in the world to net a billion in profit. That has been a long time ago.

Here is what concerns me. They burned through $6 or $7 billion in cash last quarter. They supposedly have $20 billion right now. If I had that company, I think I could figure out how to get to January before I burned up $8 billion, but that is beside the point. The economy isn't going to get any better next year than it is now, as it has just recently gotten bad. This means that come January 2010, they are going to need another $25 billion if they don't do something. We are faced with 2 problems if they do get the money. One is that the current management of GM is incompetent. The second is that I doubt there is a group of managers that could be brought in to manage an auto company the next year that would be any better. And, heaven forbid you let the government bring in their people, as their people move on to companies like Fannie Mae and Freddie Mac and Wall Street firms where the pickings are easy, not to truly competitive situations. So, you put in $25 billion and hope a group of idiots can figure out how to be geniuses over the next year?

Does anyone have a clue how much money $25 billion is? It will pay 1 million people $25,000. GM is going to need another $25 billion next year if simple math means anything. Remember this group has been a deer in the headlights for a long time. In any case, the typical American probably pays no more than $5,000 a year in income taxes, so GM swallows the income taxes of 5 million working class Americans every year it is on life support.

This wasn't a sudden event. Back in 2003, GM borrowed a large chunk of money and its stock rallied. Anyone with a brain who noticed what GM paid on that money had to realize their credit rating at the time was a joke, as investment grade companies don't pay 9% on money. It also goes to show you how stupid the American investor has been. I will leave that for another writing, but GM is just one example of how poorly Americans have done investing their money. But, this example might also shed light onto what the same group of people might do in backing GM again.

Had you asked me a week ago if we should bail out GM, I would have said, do we have any choice. In fact, I thought guys like Dennis Kneale on CNBC were flat stupid saying it needed to go bust. I still believe we are looking at a disaster should they go under, but do we have any choice? Remember, this company knew it needed to pull its act together in 2003. Its labor force knew it needed to pull it together in 2003. They had 4 banner years of auto sales to allow them to get it together and now we have a company that is burning $20 billion a year in cash? This is like giving an alcoholic another case of whiskey and $5000 so he can get over a rough spell.

I can't begin to know all the details of GM's operations, but I believe I can spot a losing proposition when I see one. Ford is going to need a bailout to, especially if they bail out GM and it might only be because GM was bailed out that Ford will need help. Ford is in better shape than GM and it has fixed most of its quality problems to the point that the last I read, they were making cars on par with Toyota. Chrysler is also on life support and it appears to me that GM attempted an end run to merge with Chrysler so it would have more ammunition to get bailed out. Why does GM need Chrysler? Don't they already have the horizon covered with Buick, Pontiac, Chevrolet, Cadillac and GMC trucks, not to mention Saab and whatever else they own? Not only did that seem to be a political ploy, but I wouldnt be surprised if it wasn't to get Cerebus, their partner in GMAC some free money?

It is clear that Ovomit is coming to the rescue after the evil Bush has failed to respond. Bail out banks, but not union jobs? There is a difference between attempting to prevent trillions in systematic losses and saving a few hundred thousand union jobs. I am sure that Obama is going to attempt to reunionize the US and force the Japanese automakers to pay union wages as well, thereby polluting the entire US labor force. This will only be the death knell for the entire American auto industry as the jobs move to Korea.

So, for me, the question revolves around whether $25 billion will do the job? I don't believe it will and I believe the US consumer will begin to get very inferior automobiles out of GM should this occur. There will be no incentive to make GM work as long as Uncle Sam is standing there with all the money they could ever need. It is clear that American management has to change and the relationship between shareholders and management has to move more toward taking care of the investment made in the companies. I can't blame labor in this matter, as management negotiated these contracts. I blame Wall Street and the shareholders for not taking care of American business. It is clear that Ford is in better shape than GM, if for no other reason than a major shareholder, the Ford family is still involved with the company. Fail to bail out GM and Ford might not need a bailout.

How do you fix a paradox?

This is a paradox built out of a paradox. I think it might be the end result of charging interest. My mother most likely correctly puts it at the feet of wiping out usuary laws back around 1980. That was maybe the start.

The problem with the financial system is multifaceted, but the primary problem is that assets are liabilities and liabilities are assets and the assets that are liabilities cannot pay the liabilities that are assets. If this confuses you, then you have to learn something before you can even start to talk about this or understand that the banking system is based on fraud or at least misconception of the participants, quite often even the ones intentionally engaged in fraud or better yet a game with no mathematical solution. Who can pay switches from one side to the other, but when a particular group,the banks can't pay, we are at end game.

I would quit discussing the dollar as for what it is worth. The Dollar is the collateral for the world financial system and you can't use the dollar and Argentina in the same breath unless you talk about Argentina not being able to pay off its dollars. The dollar could really care less about the Euro, Pound, Franc, yen, yuan or peso. The values are reversed, those currencies against dollars, weighed by bankers, not by the man on the street or by the governments around the world. Let the flow of dollars get interrupted and the rest of the world becomes insolvent. We saw that happen almost overnight last month.

There isn't a solution because there isn't a solution to a math problem that presents no solution. A potential solution would be for the governments of the world to seize all the gold, lets say at $1000 an ounce and coin money, lets say at $5000 an ounce. If you took this to mean 1/2 the gold in the world, it would amount to about $12 trillion and a profit of $9.6 trillion. In any case, this would maybe produce enough spare money to pick up the debts and rebalance the banks around the world for another 25 to 50 years if we were careful. It would be a way of creating debt free money maybe to the extent necessary to bail out the insolvency. The debt would have to shrink by means of an interest rate so low that money supply would shrink along with debt. This would mean we would have to give up the growth formula for a few years in order to get out of the abyss.

Here is the problem. When banks create money, they do it through lending, usually against assets. The assets might be the credit of a business or the home of a consumer or the future earnings of either. This includes the central banks, who originally created currency off of gold and commercial paper. The problem with this method is they lend the principal and never the interest, so the amount of money created is never enough to pay the loan. There is probably a way to do banking, keep the money supply relatively extinguished and compensate the banker reasonably, but man hasn't agreed yet on how to do that yet.

Here is the problem in a nutshell. The rich get richer and the poor go along with this system. That isnt' so bad because it is very likely that both would be much poorer without it and the depression would probably be better than prosperity without this system. This is only speculation and it is clear that the trauma associated with depression is probably worse than anyone could stand and no one would choose it intentionally. But going forward, all rich don't get richer and all poor don't get poorer. In fact, Wall Street and the hedge funds are loaded with men and women for moderate and even lower middle class backgrounds that are now filthy rich. The only difference is there are well to dos that are there in some cases only because they had someone set it on the tee for them. I don't intend this to be a philosophical argument, but to say the successes and failure come from all directions, which is one reason our system, even with its collapses and depressions works better than the alternative.

In any case, most of this revolves around the seasonal need for cash and the need for one person to have access to his cash and for another to have access as well. It would be real difficult to keep a system liquid where you might have to find 100 people with $1000 to borrow $100,000 and keep them all happy as well, so banking makes it possible for those 100 people to put in their $1000 and for even 5 or 6 people to have access to the entire sum, as long as the $100,000 doesn't leave the bank and go into a wall safe or under the bed. In that case, the central bank is there to create liquidity, as the banker should also have matching funds or somewhat close to the original deposit. This works very well as long as the sum of public liabilities in the system are kept relatively close to the bank liabilities. Thus, the first thing to know about this is the liabilities and assets and to realize that one is the other and the other is the one. This means that the banks credits are the publics debits and the banks debits are the publics credits. For those that need an accounting lesson, as all money really is, even if it is gold is who has it and who owes it or who has it that owes it and who owes it that has it and so forth. In any case a banks ledger is made up of loans and other assets on the debit side and deposit liabilities and shareholders equity including paid in capital and retained earnings on the other side. Basically all deposits are owed back to the bank.

I put that in bold because in a nutshell, this is the problem that has to be solved. It is the root of all growth from the start in an interest bearing, return earning system and it becomes the problem at the end. There is more, because we have seen non-banks get involved and securitize money to the moon, but they really have no power to create money without using the banking system for something. I theorized long ago that it would be the non-banking part of the equation that became illiquid and the system would lack close to the bone money to liquidate it. Thus the assets of these non-banking organizations would fail and their liabilities would have to be liquidated. We are seeing this in the SIV's and the commercial paper money market accounts around the world, along with the securitization of credit cards and the mortgage messes of FNM and FRE. It could have just as well happened inside the banking system, but this corporate financial structure outside of banking was the trigger now and I believe it probably was in the 1930's as well. Wall street firms and companies like GE and AIG dominated finance more so than most of the commercial banks.

As long as the banks operate in a sense where the flow of loans go to those that can gain access to cash to pay them back and the cash banks owe to depositors is owed to those that generally use it to transact trade and have the intent of paying it back to those that took out the loans the system works fairly well. I have believed for a long time and this is coming true that once the assets of the financial system become loans that bear little link to those that own the liabilities of the banking system, the game is up. As long as the pile of money owed by banks is quite likely to flow in a direction where it can be used to service the assets of the banking system, the system works okay. Bank profits are moderate and their need to get their deposits back is not so great that they have to pay the checking accounts interest. Those that can't pay the banks back, what are usually a marginal few, can file bankruptcy and the system remains in relative balance.

I am going to venture that if you throw your house out of the equation, that most people on this board have more near cash assets than they owe for the rest of their debt. I would venture that those of you that day trade likely have 6 or 7 digits of cash in accounts in excess of what you owe to credit cards, on auto loans and other secured and unsecured debt. Most of you didn't get that money by running up your credit card balances and in some cases taking the equity out of your homes, though I would venture that a great deal of middle class cash balances did come out of the equity of their last home and indirectly borrowed out of the loan balance of their next home. In any case, if you cashed in your chips and put it on the table, the banking system wouldn't have near all your cash outside of your mortgage and your personal property and even your stocks. I am merely talking about what your net position is with the banks.

Now you could go out and pay cash for 10 cars if you had that much and that would extinguish your net position with the bank to the extent of what 10 cars are worth and maybe help extinguish GM's or their autoworkers or the dealers net negative position with the bank. This is known as a reduction in the money supply. There are problems with it, because the money supply is needed to service debts and create demand. At least it is believe to be so.

But, in any case where we are is the people that owe the financial institutions are not the people that the financial institutions owe. We aren't talking now about what used to be commerical banking, where a business borrowed $2 million for liquidity purposes and their account balances floated between lets say $1 million and $4 million, depending on the inventory cycle and the bank could call the note if they wanted. No we are talking now about credit cards that created cash to do commerce that are now owed by someone with 25 cents in his account or a home mortgage financed through some leveraged fund and the money market, that is on a house of declining value where the equity is insufficient to pay the loans off and the tenant (you don't call people that owe their entire equity to the loan company homeowners)can't pay the difference. There are trillions of financial assets that can't be collected to pay the financial liabilities. Technically the system is always marginally in this shape, but it is managable. Not when the financial system becomes insolvent, where the collectable assets of the banking system fall well short of their liabilities.

Here is why the solution is next to impossible. If you are a person with lets say $1 million in near cash assets (if your stock holdings are $500K and you are a speculator who goes from cash to stock, back to cash, you are playing in the street, but you could count the $500K as cash because there is likely someone on the other end doing the same thing, but both of you can only account for $500K together and not the $1 million combined you would think you have, so maybe you count half of it and the other guy counts half of it, but money cannot come out without another putting it in and extinguishing their cash balance) and you don't owe anyone, are you going to give up your $1 million to fix the problem? We could dissolve the banks, require the depositors to take only 80% of their money and take the other 20% in stock and for the time being it would be fixed. But, the money supply would drop 20% immdediately. Hopefully the non-cash assets of the bank would then make up the shareholders equity and you might have a chance. In some fashion, the depositors have to be the ones that recapitalize the banks because they are the only ones with the bank liabilities that can't otherwise be extinguished.

Now, who wants to go first? There is talk that the government put money into the banks. I don't believe this. I think they put good assets into the banks in order to have something to liquidate to satisfy deposit liabilities. If they loan money, they create more deposit liabilities. Money is a liability in the sense that if it had been put in the banks, it would be owed back to the Fed. This game was created in the fashion the injection was somewhat equivalent to normal capital and not owed back in a classical sense, meaning it wasn't a bank liability. Only the preferred dividend is a bank liability and it can be suspended if needed. A Federal Reserve note ia a liability of the people to the Fed, one more backwards instance of banking. The Fed owes us nothing for a FRN, but we owe the Fed the debt they acquire in return for the cash plus the interest,meaning more than they put out. As long as the Fed's assets are good collateral, the dollar can't go to nothing.

In any case, who goes first? If we reduced the money supply to the point that this entire game could be serviced, then we get into international debt problems. But, in a no inflation situation, the interest on a trillion dollars is reduced to $20 billion or $30 billion if you want to use the real rate of interest game. A $20 billion trade surplus fixes that problem, so that might not be impossible. In any case, for a long time the world would be looking at a reduced level of economic activity and people would be forced to build better mouse traps, rather than just put it on their credit cards. I don't know that this solves anything or not,but it moves toward the solution of an imbalance between financial assets and liabilities.

The problem is that the assets and liabilities in the financial system don't match and the problems cannot be fixed in typical fashion by the normal actions of the system over the short term. The New Deal solutions were merely band-aids, the FDIC to prevent runs on the banks, the removal of gold, the devaluation against gold, the social spending (this solution, as they are going to rudely find out has already been used up, as putting more uncollectable debts out there isn't going to fix anything). We need a world bankruptcy re-organization, where the acting bankers are forced to give up their seats, illiquid institutions are liquidated and new capital derived out of existing bank liabilities used to recapitalize, not government debt. The US could technically pay their debt to the Chinese by minting a big $2 trillion coin because the government can mint dollars and we owe dollars, not yuan. That is what separates the US from China, but we would probably see WW III against them and our other creditors if we pulled that trick. Plus, the dollar is the collaeral for the Yuan, the yen, the Franc, the Euro, the Pound, and all assortments of pesos and dollars around the world so it can't be abandoned.

The problem with even trying to deal with deleveraging is that it means paying down the debts, which would leave the unpayable debts and the unencumbered liabilities of the banking system, meaning the insolvency grows and the money supply shrinks and we deflate. All you are doing is wiping out the bank assets than can be paid and leaving the ones that can't be paid. All that is left in deposits are those owed to those that don't owe anything. Deleveraging cannot be done, which is why I laugh every time I hear about it, like the problem will be solved. It is like the often stated notion of money coming out of bonds into stocks. How?

Sunday, November 9, 2008

What Causes Deflation

There is a blog called hypertiger wisdom that talks about the bottom being sucked dry by the top, which isn't entirely true, but it hints on what the real problem is once we reach the point of deflation. I have known for years that what causes a deflation is a lack of credit going forward. There is more. I believe the Keynesians thought that it was one group of people having too much money and the other side having not enough. This goes deeper than this simple equation, as there seems to be a troubling idea that giving money to people to spend hasn't solved this in the past. Some think public works or war should be employed to create this new demand, but in the form of public works, it is clear that this hasn't solved anything in Japan.

This is my theory and I believe it is a good one. Time goes on and more and more money becomes concentrated in fewer hands and the debts of those that don't have money get larger and larger. As a result, the capacity to profit from doing businuess suddenly becomes difficult as there are fewer and fewer customers among the lower side of the income scale. Since the upper income people are usually either employed or own the businesses, they are left with being their own customers. I know I am going to have to work on this idea because the entire game is complicated and the fact is that recovery could never take place if this theory is true. But, then again, this might explain the societal collapses we have seen over history, that commerce eventually gets to where it can no longer function and the leaders run out of solutions.

There is something to be said for business as a whole that employs a group of employees and makes money. This implies that business has to make more than it pays its employees. But the problem is the employees and the other business owners are the customers of the businesses as a group and their expenditures have to be greater than their pay for something to be left over. This would be true whether we are talking about a single country or the world, as something would have to give.

What we are really saying here is that the upper class can't pay the lower class and make a living off itself. We have reached the point of maximum profit potential and now moving to a lower level of profits and probably to no profits at all. There cannot be profits greater than the sum of payments for ever. We can only have them for a time.

An example might be drawn out of the California housing bubble, where the cost of owning a home so far exceeded the rent the home would provide that the bubble collapsed in on itself. Also, there wasn't another sucker with enough money to buy out the last sucker, thus no one to sell to for a profit. Since this was all financed, it went on as long as the financing was being provided to someone. Once the cost of providing financing exceeds the income from providing financing, the financing leaves. At some point, those that owe money reach a point they either cannot pay it back or cannot keep up the payments and common sense prevails.

I am going to do a post on how the Dow is going to finish this mess, most likely under 1000. This is something that few believe possible, but I believe it is going to happen. The reason I believe it is going to happen is the government is out of real tricks. The debasing of the money and allowing banks what was almost infinite credit has already been done and the banks are now at a point where they cannot collect their assets to service their liabilities. The under class and in a lot of cases, even richer people are going to be forced to either pay or declare bankruptcy. If they pay, they won't be spending. If they declare bankruptcy, the bank incurs a reduction in capital which reduces its capacity to lend more money. In either case, the amount of money available for creating demand and profits for business has declined. This is even more severe when the businesses themselves are in the position of the prior mentioned consumer.

We have reached a point where legitimate demand cannot support prior profits and the value of business declines. Unlike hte typical middle class person, most well to do people know that they need to match income with outgo and thus they don't let money slip through their hands. Their enterprises depend on them having money to operate. If they spent all the money, there wouldn't be any capital spending and if they spent all the money on capital spending, there wouldn't be the demand for the finished product, as demand is already insufficient.

The current government efforts are being concentrated on the ends of this problem, the capitalization of banks and the demand from the lower end of the income scale. This is clearly a right now solution, but it doesn't fix the math problem that has been present since the beginning. At best it provides government debt in return for consumer debt. If the consumer spends the money, the banks probably need more bailout funds and if they pay the debts, the level of business activity declines.

The American public isn't ready for what will be necessary for government to put out in order to reverse this problem. The real problem is collateral has either been used up as is the case with home equity or the value of assets have imploded to the point that they no longer merit more money being loaned against them. Or course, there is only one place to get the money to pull off such a series of transactions and that is business and its owners. Thus we are looking at a solution to prevent collaspe that will eventually lead to a collapse.

We are quite probably going to the bottom on this one and this will require the total reconstruction of the economy as we know it. I cannot see government morons running the business of the world, as they would lose sight of what was needed and lead the human race down roads that would lead to starvation and war. Profit motive and having the door open to the masses for success is probably key to the survival of mankind. Otherwise, genocide is going to be used as a solution as it always has in totalitarian economies. So, capitalists and mild socialists are going to need to get together on this one or we are all in a mess.

I am going to suspect that the government is going to end up with the banks. They will also end up with the bad loans and the liabilities of the banks. I don't believe they can keep rolling the banks and expect them to stay in business this time. We have reached the point where debts probably can't be paid without government help and what eventually happens here is the government eventually becomes the debt. I am not sure they will allow this to occur.

The point here is that enough people in society have to hock their future in order ot have a present in business. This is probably a perpetual flaw in capitalism. Hypertiger calls it an I want to be a rich guy tax, but I suspect it is just as much I want it now tax and neither side of the equation wants to give. The point about the US is the American consumer and worker have taken both sides of the equation to the extreme. The other point is that the US had been the demand for the world or the financier of the world for the past 60 or so years, which means the rest of the world goes with us.

If the government would come up with a ways to start this game over and exacty when to do so, we could probably go on and on with it. It is clear that the value of all assets are probably in shrink mode, but it is also clear that the bank liabilities are going to have to be liquidated at some point. The other effort, to keep the bubble inflated isn't going to work and is going to destroy the US for once and for all.

Thursday, November 6, 2008

Obama Market gains? I think not

I was just watching a soundbite interview between a guy named Seigal and another guy. I don't know who either of them are, other than to say that Seigal was an older guy and the other guy was younger. It appeared Seigal was less prejudiced against political comparisons. Seigal hit a lot of the disparity between returns under Democrats and Republicans in the markets being more on timing than actual performance of the administrations. I don't know where the market was January 20, 1969, but I bet the prior 8 years didn't come close to the 8 years that preceeded it. Nixon-Ford was a disaster, but it was only minimally Nixon-Ford, except the Watergate mess. That was more a case of the dollar being bankrupted by the 1960's Viet Nam war and War on Poverty than anything else. Nixon should have stopped this crap, but he let it go on instead. Carter was a disaster and Reagan had a huge bull. Bush I was sideways and Clinton created a bubble with his henchmen Rubin and Greenspan. Bush inherited the biggest bubble in US history, at least a double of the 1929 market, so it was impossible to make a return. FDR got the market near its all time bottom and inflated, so he had the market set on a tee for him. Clearly Clinton had the best return, but he left a massive bubble that actually bore no relationship to the economy and was in fact the economy, the bubble economy that is finishing its collapse now.
So we had 2 Republicans walk into cyclical bear markets, Nixon and Bush II, Bush I walked into the Japan bust and the S&L refunding on the negative and Reagan and Eisnehour walking into new markets on the Republican side and Clinton and FDR walking into recoveries of some sort already under way. The comparisons are idiotic.
Now they think Obama has it set on the tee. I think he has an impossible task provided the market is above 7500 when he goes in. The 50% point is going to define the top of this market once it settles. The US bubble has broken and there isn't one to replace it. Keep chanting this, the US bubble has broken and there isn't one to replace it. The dividends, cash flows, PE's, consumption and capital spending was all financed by credit from the bottom and to the top. The bottom got subprime crap financing and the top borrowed money to leverage these subprime loans and expand their returns. The results on financial assets was great on the up and devastating on the way down, with the financing and the capital related to this financing wiped out. We are now seeing it liquidated and there isn't going to be any left to do the game over again. In the meantime, those in the middle ran their debts up or put their windfalls in the stock market depending on who they were, or they put it in their homes. The outliers were pumping the insides and now they are all suckikng each other dry.
I have often thought about how stock markets go down to levels that seem impossible to start. It is clear to me that once a credit bubble gets going, the bubble becomes the source of earnings and growth, which it stands to reason that cash disappears and so do earnings and growth. Thus a zero growth scenario needs a 5% dividend instead of maybe a 3% dividend in a normal market, or as we have seen, a 1.75% or lower dividend in a bubble market. Freely flowing cash disappears.
I still don't understand the Japanese market because I haven't seen the inside numbers of corporations. i would venture that Japan probably was valued in line with the Nasdaq at the peak and cash flow out of a real estate bubble stopped. Domestic demand dropped, profits dropped and fundementals adjusted from bubble levels to below trend. This has resulted in a steady decline, especially since export margins in Japan have been cut by cheap China labor. Capital assets have had to be scrapped and the result has been nearly 20 years below the half way point.
The Dow in the Depression market never made it past the halfway point. Halfway back then was actually a pretty healthy market, as the market had difficulty getting past the 100 point level for a long time. A rally to near 200 was a pretty good rebound, but the market really never put 100 in the rearview until around 1950. Relative, the current market had trouble with 1000 for a long time and that is the extreme view, that we would actually move that low. Since the entire move out of 1000 was created by a non-gold backed credit boom, it is entirely possible the unwinding of this bubble could take the market that low. We have already seen 7000 on 40000 in rough numbers in Japan, which would transpire to 2100 on 12,000 and 2450 on 14,000. Most people wouldn't believe below 3000 even though we have already seen it in a competitive major market in recent years.
My point is where does the market start and at what point in the cycle are we in? I believe the fact the Nasdaq failed to recover much past the 1/2 way point shows we are well into a bear market that has yet to break down totally. Remember the Nasdaq went down to interday 1000, an 80% decline. Dow 2800 isn't out of the question in light of this one item.
As I type, Seidman uses the term deleveraging as if the money is magically going to appear to effect that. what deleveraging is, for any of you that are confused is a $1 billion pile of assets that have $900 million borrowed against them are sold for cash and the loan is paid off. This is the optimistic delevraging, but the point is that $900 million in cash is destroyed unless the new borrower also leverages with a $900 million loan, which in effect is no deleveraging at all. The pessimistic side is the asset will only bring $800 million, the bank loses $100 mllion or the seller has to sell even more assets to make up the $100 million shortfall. If the first happens, then the bank loses the capacity to create $1 billion in credit and has to pull in more cash. Thus we are now talking about $1.8 billion being needed to fill the hole.
The credit bubble was just the reverse, the using of credit to replace what should have been done with capital. Thus we are actually transitioning from a credit economy to a capital economy and being the amount of capital in the system is an inverse multiple of the leverage, the supply of money becomes lacking and the flow of cash through the system slows as well.
No one can fix this, as the government can't create capital. I would venture they could leverage their public lands, but I would also venture they have already done this. Eventually the government is going to have its credit rating threatened and this game will end.
Debt has benefitted a lot of corporations in the US and in the world. It is the enemy of corporations and business as we go forward in this kind of economy. Over the past year there has been a lot of loans drawn to be sure the drawers had credit that is now going to weigh on these businesses. But, they are currently in better shape than those that failed to draw their credit lines before they lost them. Servicing these loans is going to not be easy.
This is a long unwind. If the Fed and government are successful in their recent ventures, then the banks will start lending and rescue the bubble. But, they will still have the bubble and it will need tons of new credit to keep intact. Thus it will continue to deflate at a slower pace or it will expand only to burst again in a few years. This is an epic bear market and it is just starting

Wednesday, November 5, 2008

Recession, what recession

How many deck chairs are on the deck of this sinking ship? It seems the Wall Street bulls are spending a lot of time rearranging these chairs while the boat they are on is sinking. Almost daily I see articles and interviews where they speak of how long recession are, when the stock market comes back in relation to the end of a recession, how much money bulls make during Democratic administrations and all kinds of other stuff that doesn't address the current situation. I heard one today say stock hadn't been this cheap in 30 years. I don't know what he was doing 30 years ago, but I doubt he was buying stocks.

3 months ago, the talk was avoiding a recession. Who would even speak of such an idea other than an economic idiot or someone who had something to sell? Clearly these people went through much of the same socialist economics instruction I did and failed to educate themselves as to the real causes of massive economic downturns. In any case, the idea one can spot the end of the recession or even guage when the stock market makes money from the current price level based on the past is absurd. This isn't a past type economy unless y0u want to go back to the 1930's or over to Japan in 1990 for a comparison.

Back in the 1980's, there was much insolvency in financials, mainly out of bad loans in the oil patch and the devastating effect on interest rates and fraud in the S&L industry. When these institutions were closed and recapitalized, save a couple of large banks that went down during the mid 1980's, it had been known for a few years that this problem was going to need to be addressed. When action was finally taken around 1990, most of the damage had been known since 1987. The entire landscape of that bailout was different. They didn't rush a bailout through Congress just prior to recess for the elections, but instead had a long term debate and discussion on what they were doing. There wasn't an emergency, just loose ends in debt to address. Not this time.

This time we had a situation blast upon the scene. For those that have been watching this mess in process for several years, this emergency wasn't unexpected. I think for myself, I was surprised at the force at which it hit, as what we just witnessed was a stock market crash that wasn't a panic, but a financial collapse. Just 2 years ago, bank profits were records, the financial industry made up 40% of the profits in the US and most thought the industry was bullet proof. The whole idea of a $700 billion bailout being needed in September 2008 on January 1, 2007 was next to impossible to envision. There wasn't any planning allowed as there was in 1990, just a sudden demand for money or the entire world was going to belly up.

Now we are being told that stocks are cheap at 14 PE's, if you believe looking back is better than looking forward, with dividends at 3% on the SPX and a busted financial system with no plans to restore the past. The analyst that said they hadn't been cheaper at any time in 30 years must forget that the SPX paid over 6% at one point in the early 1980's and clearly doesn't know how financial values are determined. They are cheap because this is the cheapest most of these 30 somethings and early 40 somethings have seen them, forgetting on which side of the peak we are on. I would be at a minimum, 60 years old to have worked through the 1966-1982 bear market at this stage. You can bet stock at the start of 1970 or whenever that recession was hadn't been cheaper since the early 1950's, but they got cheaper for over 10 years.

The last bear market lasted 3 years if you count the bottom in 2003 as the real bottom. This one is a year old and the problems surrounding this one are much more dire than anything we saw in 2000-2003. I believe at that point, we were coming out of a raging bull and needed some time to adjust, but we also had a raging housing market that benefitted from dirt cheap mortgage rates not seen for 40 years and a financial mania crazed public. Mortgage money floated us out of that otherwise market crash. In fact, I believe mortgage credit around the world floated the entire world economy and that the 1990's stock bubble was also created out of mortgage money.

This started out as something that was going to be contained to the subprime market, mainly in California, Arizona, Nevada and Florida. The bulls had this problem over before it started, in August 2006. They have yet to acknowledge the truth here, that we built an excess of 6 to 8 million single family homes between 1995 and 2007. This is a potential 10 year supply under boom conditions and the special financing to have these homes owner occupied isn't there now. Real estate prices have a long way to fall and they will start falling in areas of the country that have not been affected yet.

The other thing was the disconnect idea, that fast growing areas in Asia and Europe would skip this recession. Either we are being led by economic idiots or liars, but we aren't be led by ethical and educated people in this matter. Maybe one or the other, but not both. These are the people pushing the stocks on Wall Street and selling the investment banking products around the world and their business depends on moving these products. Never forget Wall Street isn't in the business of buying stocks, but in the business of selling stocks. They are like Walmart. You don't bring your stuff to sell to Walmart unless you want to sell wholesale. When the market turns bad, Wall Street is like a pawn shop. This is why we are seeing such big down days.

In any case, the disconnect game is now being played out to be the biggest lie ever told. What is totally misunderstood in bear and bull circles is that American home equity got the whole world game going, that Japan would have deflated off the face of the earth without it, as would have Europe and the 1990's would have been a very dismal economy for the US as well. Instead of dismal, we got the biggest stock bubble in US history and world prosperity and a group of politicians that conspired to create the biggest financial mess in history, mainly unelected ones. Their names, Rubin and Greenspan.

This won't be about Rubin and Greenspan, only about what this is about. What this is about is the end of what Rubin and Greenspan created, though Paulson continues the Rubin creed of bailing out bubbles. What they created was a system that allowed for the derivative system to get established through out the financial arena. Home equity securitization provided the fuel and cheap interest rates along with Greenspans refusal to remove the punch bowl then having to leave it there or face collapse, which allowed for the carry trade to take place. The cheap money policy in Japan also didn't hurt.

In any case, the Wall Street alchemy which has now failed was the economy. It wasn't only the US economy, but it was the process in which money flowed around the world, as it financed a huge spending boom in the US to be spread around the world. American spending became world capital spending and all kinds of bubbles were created. In fact, most other countries around the world started their own securitization bubbles. This will be blamed on the US only because it was the elephant in the room. It won't matter there were plenty of holes kicked in the walls by the Donkeys present at the time. It was the elephant everyone saw.

Maybe one can see where I am going with this and I will be as brief as I can. Bulls are planning a recovery, but I don't know what they are planning a recovery on? This is a worldwide systematic collapse of the financial and spending structure of the world. This is a fall apart and put it back together event, not an economic slowdown. There are difficulties here that haven't ever successfully been addressed in history and what was addressed in the 1930's cannot be addressed this time, because there is no gold standard to abandon to inflate out of a collapse. There is also a much worse public financial standing than there was in the 1930's and the impact of something old won't be the same as something new.

One reason the recession has had such a hard time getting started is the amount of cash created by the bubble hadn't finished its trip around the world. It has now and the sudden end of the impact of that last dose of credit has been met with astounding force. The Chinese have been bailing out their banks as they have been going along, but they won't have a solution for this collapse. The talk of 5% to 10% growth in Asian countries is a joke, as the capacity being built will never be used. Also, the idea we have recovery around the corner in the US when in fact we haven't even felt the credit contraction yet is absurd.

I recall the slowdowns of the 1968 to 1990 period. In every case, the Fed forced a recession. Not this time, as it walked rates up 1/4% at a time. This time, the housing market collapsed under its own weight. The auto industry collapsed under its own weight. We used to have layoffs then slowdowns in auto sales and housing. Not this time. The Fed cut before the recession started, not because the recession was coming or had gotten deep, but because the system was collapsing. Remember, Greenspan kept talking about how well capitalized the financial system was, yet it starts collapsing before the recession hits.

There are several things that are of great importance that have to be overlooked if one is to justify buying stock. For one, we haven't seen the financial damage to the entire economy yet. Second, I don't believe we have seen the last of the big bank failures or bailouts and I believe at least one of the 2 major NY banks and maybe one of WFC or BAC will go under or need a rescue. Also, it appears to me that all the Wall Street brokerages left are there in name only. I am astounded that GS is going to pay out billions in bonuses in their financial shape. This is like taking a luxury vacation on your credit card, knowing you just lost your job and maybe won't get one for a long time. There isnt' a plan to get through this downturn by those in business, only downsize, but keep spending.

The biggest thing they are missing is the bubble wasn't housing, autos or stocks. It was the entire world economy. The earnings in the stock market are part of the bubble and earnings, dividends and cash flow won't look like 2007 for a long time and on a relative basis, not in the lifetime of anyone over 40 years old ever again. Thus, the 14 PE is likely a 40 PE, maybe even 50 sans the bubble and the dividend rate is at best 1.5% to 2% and more likely 1%. This means that to get to a 5% dividend level, which is needed in a no growth economy, we may need to decline 80%. I could be on the conservative side here as well.

Not only can no one tell me how we are going to get the debt level of the economy back to one that encourages long term growth, but there isnt' a way to get back to where we were other than to go back to subprime financing and recreate home equity. That is the biggest problem, the no recovery in a nutshell, declining home equity. Home equity was the bubble of all bubbles and mortgage lending was the key that unlocked it. Both are either gone or on the rocks. There won't be a recovery for a long time that will warrant stocks at current prices.