Color My Yuan Gold

Those who read my blog certainly know my views on China's role in world economics. I have written on why China can't be the savior of the world and why the Chinese middle class purchasing power has been stifled by a central command policy of keeping the exchange rate range bound. I have also written about the rise of gold and the search for a new alternative reserve currency. With all my not- so- positive views on China there still is a way to profit from a Chinese attempt at giving the yuan a more prominent role in international trade; hoping that one day it will replace, or at least rival, the dollar in international settlements. While I don't believe the yuan is able, as a single currency, to replace the role of the dollar; attempts at doing so by the Chinese government will give rise to both the yuan and gold.

Everyone agrees that a main requirement for an internationalized yuan is free convertibility. That means markets will determine the value of the yuan and that is almost sure to translate into a higher yuan against the dollar. With a still developing economy the question is what will provide the support for such a young currency, on the international platform, to be the trade currency of choice. Of course many other reforms, political as well as economic, have to be implemented first, but the answer was given to us couple years ago when Chinese officials said they will be adding to their gold reserve. That of course makes perfect sense. China still has more poor people than any other country. The Chinese economy is still too immature to provide self support of an international yuan. That support will have to come in the form of physical gold. There is evidence of Chinese accumulation of the metal over the years. The power of the Chinese middle class has been kept in check by a foreign exchange policy that pegs the yuan to the dollar within a tightly managed range. If the Chinese want the yuan to be an international currency, and I believe they do, than they have to let the yuan float. This of course will hurt Chinese exports but will unleash the purchasing power of the middle class. The effect of such policy is not the goal of this article. Here my only objective is to point out that if I am right and China does finally let the yuan float than there is profit to be made. Keep in mind that will not happen overnight or over few months. It is more likely to unfold over a period of few years. But the payoff will be handsome.

There should be room in every investor's wallet for a little Chinese change. Soon you may be able to pay for that "Peking duck" lunch with "Beijing currency". It is easier than ever before to open a yuan account through the Bank of China, New York branch.

From Shang[High] to [Low] Chi Minh City

Globalization is the internationalization of capitalism. It basically applies the old economic concept of division of labor introduced by Adam Smith in his book "Wealth of Nations" (first edition 1776), to modern day movement of capital and the manufacturing of goods around the world.

Once again capitalism, and the inherent economic inequalities that are an integral part of it, proves its superiority to any other system we have seen over time. The differences in economic classes, like I have argued before, are necessary for societies to thrive. Built within capitalism is a safety valve that provides relieve when pressure builds inside the system.

Not long ago multinational corporations were rushing to either establish physical manufacturing presence in China or to outsource their production to the Chinese (and others) to take advantage of cheap labor. That is exactly what capitalism calls for: the pursuit of the most economical way, within an established set of rules, to produce a product or a service. With globalization this pursuit went from a country to a region to an economic bloc and finally worldwide.

The shift of manufacturing to China (China here is used as an example. Throughout the years other countries were the "Chinas" of manufacturing) brought with it an influx of badly needed capital. The result was prosperity, at least to a segment of the population, and the cementationof the idea of free market principles (at least to a certain degree). But the prosperity of China came at the expense, in part, of other neighboring economies. And this is part of the economic circle of life I tried to explain in my post, Money! The Misunderstood Concept And The Financial Pie (January 15, 2011), and the economic ladder with its ever changing upper steps.

The pressure I am talking about here is the inflation in China and the rise of wages. We are beginning to see a reverse of the influx China has seen over the last 15 years or so. Multinationals are now looking for other venues to produce their goods and services. The safety valve that will relieve the inflationary pressures for the multinationals is made available by the same system that gave rise to China at the expense of its neighboring economies, and that relieve will come from some of those neighboring countries.

Vietnam is that safety valve and will undoubtedly take some of that Chinese shine in coming years. Vietnam has a highly skilled but cheap labor. Government policies have been moving more toward free markets and away from centralization. This is the beauty of the economic circle of life made possible by free markets. It detects failures and allows for alternate solutions. Because we all are vying for a bigger share of the same pie and because all resources are limited it is only logical to expect a solution from within.

While for a period of time globalization may be, or seems to be, unfair to a particular country; its long lasting effects are positive, constructive, educational and motivational. Globalization allows for division of labor. It frees up capital in consuming nations to import more or consume more locally produced goods and services while providing exporting countries (those with lower standard of living) with a better life and an opportunity to climb the economic ladder. Countries, like China, have acquired a new set of skills that will remain with them in good and bad times. Ups and downs are part of the system, hence the economic circle of life within the limitations of the pie.

Remember while the objective of a manufacturing company is to move from Shang[High] to [Low] Chi Min City, an investor's goal is to buy [Low] and sell [High]. If you think about it, in this case, the reverse is the same and both producer and consumer benefit.

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The Train Has Left The Station And It Is Full Of Gold

In a sense it really no longer matters what the politicians in Washington decide to do with our debt problem. That issue has become a secondary determinant, along with the European debt problem and the Chinese inflation/hard landing story, of the price movement in gold over the long term. All these issues remain important factors in short term fluctuation in the price of gold. An agreement on the U.S. debt and debt ceiling issue will definitely cause gold to go down. The European deal to create a super fund to rescue failing EU members was responsible for a drop in gold prices last week. But given the few details about this agreement and what appears to be a lack of private participation in debt forgiveness is really not very encouraging with respect to finding "the" solution for the European debt issues.

But all these problems mentioned above have no baring, longer- term, on gold prices. In other words assuming all three issues are resolved gold prices will remain on the rise for the next few years. The IMF's latest figures show that the percentage of central banks reserves around the world that is held in dollars has been on the decline reaching 60.7% by the first quarter of this year compared to 71% in 2001*. Central banks bought more gold in 2010 than in previous years. The single most important determinant of gold prices in the long term now is the process of finding an alternate reserve currency, and while this process may have been set in motion a while ago it certainly has gotten a huge boost from the kind of behavior that we have seen coming out of Washington that sends tremors through the international economic system and shakes the confidence in our ability to provide a politically stable environment. The reason is simple: uncertainty. Uncertainty as to what will replace the dollar. This will be a long process as the world goes through a "figuring it out" period likely to last years. While the replacement may not be gold (even though it is likely to be) there is nothing that boosts the price of gold like a world full of economic problems in search of a reserve currency. The train has indeed left the station and it is only a matter of when it will reach its destination. The smart ones will be ready to help unload the content (or should I say the profit?). All aboard??!!

* From an article by Matthew Lynn, MarketWatch on 7/7/11

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Do The World A Favor And Let Greece Default

It's a movie we have seen before and are likely to see again unless certain things happen. A year or so ago some praised the first Creek bailout and declared an end to the European financial crisis. But there was one thing I could not comprehend back then about this end-all solution. How do you solve someone's inability to pay off his existing debt by piling on more loans without a significant increase in that individual's earnings? While austerity measures can be effective in certain situations this was not, and is not, the case here. Politicians do not solve problems, they just paper over them. They are fully aware of the causes and the solutions but intelligent enough to offer illusionary fixes that guarantee their re-election.

Capitalism is the best and most efficient economic system mankind has ever seen but only if allowed to function based on the principles of free market with minimal government interference. That means risk is rewarded and failure is punished. Not risk distorted and failure not allowed by government interference. Yet this is exactly what has been happening in the U.S, Europe, Asia and elsewhere, and people wonder why the world still can't shake off the consequences of the 2008 financial crisis.

By not letting Greece default the first time around (a nicer way to say it is to let them restructure their debt) the problem was magnified. This is how. Back then the ECB lowered its standards for the quality of collateral it would accept against lending European banks money to keep them afloat, including Greek banks. But since Greek banks could not raise money in the bond market they issued bonds with the Greek Central Bank guarantee and turned these over to the ECB for cash. On top of that billions from the IMF allowed Greece to pay off the interest due and retire its maturing debt. But two things were missing from this solution. First, the hope was that the world economies would recover and together with the austerity measures implemented (or not) then would allow Greece to generate enough revenue to service its debt and find its way back to prosperity. This hope did not pan out and we ended with Greece still in the same situation it was in a year ago but with much more debt added to its books. The second, and more important missing part, is that the bailout did not involve a restructuring of the debt that would have caused private bondholders, including other European banks, to lose portion of their investments therefore putting Greece in a much better situation able to service the now much smaller debt load. This is the distortion part by not allowing failure. So the result is that a year later we have a world economy that at best is not getting worse and a country with more debt and less means.

I am very careful here to advocate a market lead restructuring and not a government forced one. You see one of the main principles of capitalism is that a set of understood laws be allowed to govern private business transactions free of government interference. Otherwise, lenders in the future will be very hesitant to help finance the world economies.

For the Greek bailout to be effective the European governments and the ECB should make it very clear that they would step in to help only after the private bondholders, including European banks, have negotiated a restructuring of the debt. I understand that many of these bondholders are European banks, even the ECB itself. But this would send a very powerful message to the private sector that government is not going to step all over laws that allow for a clear way to determine and price risk. The pain will be severe if this action is taken, banks would have to be recapitalized, standard of living will have to come down for many years but at the end there is going to be a bright prospect for all. The alternative is the same severe pain extended many years out and another visit of the Greek debt a year or two from now. Yes this action may cause a recession in the short run but as long as the restructuring shaves enough off the overall debt, together with the austerity measures, Greece will be just fine albeit with a lower standard of living. After all who says I am entitled to live the high life with my neighbor's wealth? This solution is a bold one that many governments may not be willing to endorse. However, it is the best and most fair for it punishes those who took the risk and lost, both the lenders and the borrowers in this case, while preserving and re-enforcing the foundation of capitalism. So please do us all a favor, make us suffer, take away our luxuries and let's get on with the healing process. Is there a better feeling than the feeling of not having debt? isn't a mind free of worries indeed a luxurious one?.

On a different note I have been watching China very carefully over the past couple of years. My thoughts, for the most part, have not been positive. But two fairly recent events have reconfirmed my belief about China and have given rise to an alternative investment vehicle to the factory of the world. First, news abound in the last few weeks about unrest in several Chinese cities and provinces (to include a car bomb) whereby the state had to deploy thousands of security/military personnel to ensure these demonstrations don't spread or become acute. Simply put the have not (the vast majority of the Chinese) are protesting inflation and the lack of jobs. Second, closely related to this rise in inflation is the skyrocketing wage increase for Chinese labor. Combine that with an appreciating Yuan (perhaps even as a desire to make it an international currency) which will make Chinese imports cheaper but Chinese exports more expensive and you can see why multinationals will be looking for alternatives. One country that comes to mind is Vietnam (more on that in a later post).

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Gold, Oil and Short Treasuries: The Trinity of Investment Plus One

Indeed this is a time unlike any we have seen since WWI, perhaps even earlier. A time so full of economic and political tribulations of worldly proportions that has left the best and brightest of Wall Street and World Street scratching their heads trying to make sense of it all. It is never an easy task to rationalize market movements because investing is not an exact science. Rather it is a behavioral science, sometimes with the logic of exact science. In this behavioral science the numerical value of "1+1" doesn't always have to be "2". A change in the value of any of the components of the equation "1+1+1=3" may or may not maintain its equality, yet it would still make perfect sense. The reason for that is the unpredictability with any certainty of the actions and reactions (+ and -) of the different components of the investment equation and of market forces that are sometimes hard to identify. Investment books and literature, as well as CNBC, tell us that the existence of certain elements guarantees a specific outcome such as when the dollar falls the price of oil goes up, or an increase in supply leads to lower prices, etc... in other words 1+1+1 must equal 3.

Here are the reasons why the "trinity of investment plus one" make perfect sense even though they may seem, at times, contradictory. One has to sidestep the CNBC conventional wisdom for a second and engage in out of the box thinking in these unusual times.

GOLD

Gold prices continue their climb on a path charted by the world central banks in an effort to stimulate economies that pulse only because of governments borrowed money . Despite QE2 and the purchases of the Federal Reserve of government bonds interest rates continue to rise in the U.S. The tragedy in Japan increases the likelihood of a QE3 by the Fed further debasing the dollar and cementing the role of gold as a reserve currency. Inflation is popping out everywhere, in China, in India, in Brazil and in the U.S. Inflation was the spark that launched the rolling revolutions in the Middle East and will catapult gold to its destined status (see previous posts on gold).

OIL

The unthinkable has happened. People in the Arab world have finally said enough is enough. And while democracy does wonder for a free economy this is not the case here. For starter we don't know yet if the Middle East is going to adopt democracy (there are hopeful signs but nothing more). Tonight we hear that the cries for freedom have taken four lives in Syria ( a very serious development). The rolling revolutions in the Middle East are not what will cause the price of crude to go even higher from its currently decried levels. The actions of Iran to counter Saudi presence in Bahrain will be the main determinant of higher oil prices. By creating uncertainty and a perception of a potential oil supply disruption through attempts to destabilize regimes in the region Iran can enjoy a much needed higher oil revenues while scoring a political point or two.

I am at a loss to understand the prediction that the unfortunate events in Japan will be a drag on oil prices. While this may be true in the very short time, absent the events in the Middle east, I see the Japan situation very bullish for oil. Not only is the rebuilding going to require a lot of energy but also the drop of the dollar and the strengthening of the yen (not necessarily against each others) will encourage more oil buying. Once the nuclear reactors problems are under control Japan will embark on a rebuilding campaign that will be very bullish for oil. The intervention of the G7 to halt the appreciation of the Yen is meant to ensure a robust recovery for Japan.

Short Treasuries

Everyone seems to be concerned about the repatriation of Japanese money to pay for the costly rebuilding. But what worries me is the possibility of non-Japanese money leaving U.S. treasuries in search of a better investment opportunity in Japanese equities. No matter how you look at it Japan is going to further add to its debt, which stands at 200% of GDP, to finance its rebuilding. In this case additional debt is a good thing because of the immediate return on investment that will be measurable and productive. If this shift of non-Japanese money from treasuries takes place it will indeed be a negative for U.S. bonds. Couple this with inflation and larger and larger debt as a percent of GDP (in many countries) and you can see the effect on bonds prices.

Plus One

Sometimes the components of the investment equation must be looked at individually and in isolation in order to understand the risk reward ratio. While together they may not maintain the integrity of the equation, individually they make perfect sense. Food is the "plus one" in this equation. Despite all the worries facing the world economies, despite debt and inflation, despite wars and revolutions, or perhaps because of all of that, and despite the lack of wage increases people of the world will consume more food and nations of the world will rush to buy more agriculture products to make sure their populations are fed. Does China want a food revolution? Yet because of the world limited resources (see the post about Financial Pies ) higher food prices are inevitable irrespective of a broader inflation.

so in this perspective 1+1+1 equals 4. Go figure, who says there is no new invention in math?

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The Visible Ghost Of Inflation

Can you see a ghost? I can if we are talking about inflation, and I am. For about two years now, and following the unprecedented money printing the Fed has been doing, some have been adamant that inflation is not a problem nor would it be because the Fed has a "plan" to drain out all, or most, of the liquidity it pumped into the economy. Even today with gold at around $1,350 some still refuse to acknowledge that inflation is even a possibility. Really!!! tell that to the rioters in India and Bangladesh. Tell that to the Tunisian people who toppled a well entrenched dictator because food prices are rising fast. Convince the Egyptians, whose government may fall before these lines are finished, that price increases are a figment of their imagination. Inflation is spreading throughout the world mainly as a result of all the money the central banks have been printing but partly because some up and coming societies like Chindia and others are now consuming more because of their new found prosperity. Those who believe inflation does not exist cherry pick their data. While they acknowledge some basic commodities prices are higher they counter that real estate values have plummeted. They got that right! except that for the most part plummeting home values do not result in increase in disposable income . People don't have to buy something they can't afford but they do need to buy wheat, rice, butter etc...so this attempt at arguing there is no inflation doesn't really hold water. Additionally, because of globalization what used to be a home grown phenomena, inflation, is now like any other commodity that can be imported from far away places. As the factory of the world China exports its inflation just as easily as, and through, its exports of manufactured goods. Like other economic concepts inflation can take many forms including outright increases in the price of basic raw materials and the appreciation of a currency. That is why countries have been rushing to fight off inflation by increasing interest rates or imposing measures to devalue, or at least limit the appreciation of, their currencies by making them less attractive to foreign investors hoping to discourage foreign capital inflows.

The ghost is here. It may not be fully visible yet because most companies have not been able to pass on the increase to the final consumer. Make no mistake business to business inflation is here and widely acknowledged. If there is no relief at some point (soon) businesses will have to make the decision of whether to take a hit to the bottom line or attempt to pass on the extra cost. Do you want to bet which way they will go?

It is nearly impossible to reverse the flow of water once it starts down the drain. But again maybe this is the plan. Bernanke said a little inflation is not a bad thing. The problem is how do you engineer and control a little inflation with such a huge amount of liquidity. The answer is you can't. You just hope that the length of the drain that water has to travel is short. And short treasuries is what you do to keep your head above water.

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Money! The Misunderstood Concept And The Financial Pie

I once had a friend say to me "I don't know why our government does not print enough money for everyone to have everything they want so we can all be rich". My reply was if printing, or having, money was the answer than Latin Americans would be the richest people on earth. To the contrary, printing money without economic productivity to justify such an action is a slow but sure way to the poor house. It creates a false sense of prosperity. Money is nothing but an agreed upon medium of exchange. Money by itself does not make a person rich. The purchasing power of that money is what determines the wealth of an individual. Many factors go into determining the purchasing power of a specific currency. Chief among these factors are free market forces and government economic policies. However there is another less talked about , or should I say less understood, but equally important factor that determines the purchasing power of a currency. That is the limiting factor. This translates into productivity within the confine of what I like to call the financial, and other, pies. That is what makes an individual or a nation rich. Rich only in comparison to other not so productive society(ies).

Our ability to produce (economic activities) is limited by many factors including human resources, natural resources, political stability, free market principles or the lack thereof and yes financial resources as well. Economic activities require, among other things, financing and the financial pie is by my definition finite, no matter how big it is or how big it grows. There is always a limit on our ability to grow that pie. Limits are imposed ultimately by the value of money. Money is just another commodity that has a price that is determined by, among other factors, what the perceived value is and what others are willing to pay for it. That could be in the form of outright purchase or exchange for other currencies, services or simply the interest rate attached to that currency's debt. All financial pies are limited (by definition) but all are not equal. In other words Americas' financial pie is limited but much bigger than all other countries' pies including China's.


Today, America is faced with the phenomena of other economies vying for a greater share of the financial pie which ultimately determines the size of all other pies these economies can afford (production pie, consumption pie, etc...). Even though the size of the pie does grow over time to reflect changes in demographics and economic activities and changes in human economic behavior ( desire for more goods and services whether as luxury or as necessity as we see today in Bangladesh and Tunisia), its borders are always defined. As I always say if everyone is economically equal society could not function. Economic inequality is a necessary beast in our society as we know it today. Of course that does not mean that individuals or nations can't progress. They can, they should and they do. But it does mean that the progress ladder will always have lower steps that have to be climbed to reach the ever changing upper steps. If one tries to jump to the top they run the risk of falling hard. The point I am trying to make here is that because of the pie shaped limitations the betterment of any economy(ies) always comes, in the long run, at the expense of another economy(ies). China at the moment seems to be capturing a bigger share of some of the pies, certainly the financial pie. However, this comes at the expense of denying its people the right and opportunity of a better life by keeping the value of the yuan artificially low and at a substantial risk to the economy going forward. But China can't be ignoring market forces for good and it certainly can't keep artificially growing its economy much longer. So eventually China's share of the pie will stop growing and start declining giving others an opportunity.

Because money in itself has no value other than being a medium of exchange printing more of it causes the value determining factors of that currency to assign it lower valuation.

As for me I have always liked apple pies because they are as American as pies can be.

The Chinese Fear Bear

The Soviet bear, back in the days, was a nasty beast with potential dire consequences had it decided to bite. Of course the fear was emanating from the Soviets military power. But what ultimately brought down the iron curtain was not a military style confrontation. Simply put it was the superior economic system of the West backed by democratic principles and the ability of capitalism to thrive.


Now, the talk is of a Chinese bear and what China's recently acquired status as the second largest economy could mean to America's economic dominance. A command economy will never pose a threat to a free economy because over the long run market forces are much more powerful than a State's plan or a one man's ideology. These exact market forces brought change to the former communist block countries and forced China to adopt some of the economic principles she so despised for such a long time. China's continued rise as an economic as well as military power strong enough to challenge the dominance of the U.S. faces daunting challenges. Other than the ability to mobilize large numbers of troops China's military is still a long way from reaching the technological level of its western rivals or Russia. Additionally the Chinese military has more pressing issues to deal with near home preventing it from really exerting any meaningful power on the world stage. China shares a huge border with India. Both lay claims to territories occupied by the other. As both are developing and using more resources they will be facing each others off to capture more of the world resources needed to meet the needs of their poor populations.



As I have mentioned several times in previous pieces the Chinese economy has been nothing more than an export machine dependant on the well being of western economies and their consumption needs. Therefore, there is no meaningful Chinese middle class able to keep that Chinese economic engine humming. As long as this is the case the potential of a strong and sustainable independent economy capable of challenging the U.S. remains small. China's per capita income is about $3,600 compared to $39,000 in the U.S. and about $25,000 in the EU. Therefore the prediction that China will soon overtake the U.S. economically has to be predicated on the impossible assumption of double digit growth for many years to come while the U.S. stays in a lackluster state. The export model will work for a developing economy for a short while but unless that economy can turn a producing population, at least in part, into a consuming one the model will eventually fail. China got in the limelight lately simply because of its export economy and its abundant cheap labor which by definition is the essence of a poor, albeit, upcoming population. Everyone talks about China's up and coming segment of the population or the newly made millionaires and billionaires; but no one ever mentions the vast poor segment that struggles each day to make a living. This is exactly why China can not grow at double digits forever. As China is forced to fight inflation to protect especially the poor the economy will slow pinching its most vulunerable and vast population segment, the poor, she will also be compelled to use some of its massive foreign exchange reserve domestically to stave off civil unrest leaving her with less to project power internationally.

Until China develops a consuming middle class, adopts more of the free market principles, abandons command of economic activities, moves towards a more democratic political system and has a military that is able to project its power on the world stage without having to keep an eye on its neighbors (including Russia and North Korea) there is no reason to fear a Chinese bear. A Chinese bear market, on the other hand, is a different story. As China takes steps to fight inflation, which could have a devastating impact on its poor population, the Chinese stock market will correct (inflation not the only cause. See previous posts). Actually we may see a steep correction in 2011, but over the next few years opportunities are abound in China. So fear no Soviet style bear or a Chinese economic takeover. As Larry Kadlow says: free capitalism is the best path to prosperity.








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Coming soon:

Its the "Deleveraging" Stupid


A Rare Opportunity Indeed

The Invisible Wars and The Rise of Gold

Look around and you see wars everywhere. In Iraq, in Afghanistan, in Africa and elsewhere destruction and the loss of life have become such a routine daily event that most people ignore them and go on about their daily lives. Yet with all their savage methods and the physical destruction traditional wars cause their effects usually last until the politicians/generals come to their senses and put an end to them. It is that simple. A decision is made and wars stop. You know when the physical destruction ends and when the rebuilding starts.

There are other kinds of less visible but more destructive wars whose effects are difficult to quantify and whose end almost always impossible to call until years later. The impacts of such wars are long lasting albeit less obvious because their destructive power gradually and slowly eat at their prey. These kind of wars are called trade wars. They take different shapes and venues. The most common are tariff wars and currency wars. Their intended, but never stated, goal is to improve the lot of one economy at the expense of another. The latest such wars was last week direct intervention by the Japanese government in the foreign exchange market in direct support of the Yen. Such direct intervention is rare among democratic economies and usually undertaken only as a last resort. Although currency intervention can be either to the upside or the downside the Japanese action was to weaken the Yen which has recently hit a 15-year high against the Dollar. The obvious goal of such an intervention is to strengthen Japanese exports. However, this should not be looked at in a vacuum.

Trade wars have been going on for several years between all the major economic blocks or countries as part of the seismic economic shifts shaking the global economy. Trade wars in the form of tariffs between the U.S., China and the EU are nothing new but are very worrisome at this time in particular because of the deteriorating, or at least stagnant, economic activities worldwide. The consequences of such action at this time are much more grave because there is no counter balance economy to pull the other way. Because trade wars usually feed on themselves and become a vicious circle the fear is that such wars could have the unintended consequence of dragging the world economy further down.

The Japanese may have other geopolitical reasons for their action such as putting pressure on the Chinese to actually do the opposite and let the Yuan appreciate. The Chinese may turn out to be their own worst enemy. By keeping the value of the yuan artificially low for so long in order to encourage exports they have kept a lid on the purchasing power of their middle class when world economies were expanding. In order to avoid a wider currency war the Chinese may now be forced by the Japanese action, as well as pressure from Washington and Europe, to let their currency appreciate. However, this may still not afford the Chinese middle class to show off its purchasing power because the desire may not be there at a time when other economies are shrinking. But such interventions, while in the short term, may seem beneficial to the initiating party actually may have long lasting adverse impact on the intended target. That is because such actions usually trigger a similar response from others that results in a distortion of true market activities leading to uncertainties taking years after the cessation of such actions to work themselves out of the system. Any undue interference by any government in any market leads to the same distortion, although to a varying degree. Additionally such actions come at a cost of a declining purchasing power of the domestic consumer and may end up feeding a deflationary cycle.

In the midst of all this there emerges a winner in gold. While China, Japan, Europe and the U.S., in their own way and for their unique reasons, seem to be clamoring over each other in destroying the value of their currencies in the name of stimulating depressed economies, one thing stand out as a fact: the value of all these currencies is falling in terms of gold. In other words, the value of the true measure of wealth is on the rise. While traditionally a rise in gold is associated with inflationary pressure, I believe we are now witnessing the formation of a rare phenomena during which the convergence of several factors as a result of decisions taken by politicians, rightly or wrongly, in the name of stimulating world economy, are giving gold an opportunity to shine the like of which we have not seen in a long time. Presently gold is acting as a reserve currency and its value is on the rise because of all the currency devaluation going on. So currently gold is a play on deflation and fear. After this cycle ends, and it will, the rise in gold will continue but this time in its traditional role as hedge against inflation. Gold is in a win win position over the next several years. In the meantime it will go through its ups and downs just like any other asset class. While there may be better buying opportunities for gold in the coming weeks and months, make no mistake about it there is nothing invisible about the glitter of this shiny metal.

Inflation or not it really doesn't matter. The bigger force here, at the moment, is fear of the unknown. Fear of the huge amount of debt accumulated by western governments to fight what is a natural and necessary deleveraging process that will give us a better chance at a better life. Fear that the "paper tiger" economy is really not vibrant enough to lift all others because it is dependent on all other economies. Fear that the establishment has to move away from the falling major fiat currencies.

The time to fear inflation will eventually arrive. In the meantime enjoy the glitter courtesy of fear of the invisible wars.

The Good The Bad and The Debt

What happens to an economy if the debt concept did not exist? the simple answer is that it would not be much of an economy, denying citizens the opportunity of a better life and stifling the entrepreneurial spirit. Over the long run a debt-less economy is a dead economy. This is not an open invitation to pile debt on one's balance sheet or on that of a country. The only time taking on debt makes economic sense is when that debt is expected to potentially generate a net return. The emphasis is on the word "net". The concept is not exclusively specific to the purpose of the debt. In other words, depending on the entity, the potential return has to take into account the overall cost to an entity or society. Additionally, for that debt to serve its intended purpose it must have a clean source of funding.


So what does this mean to our current debt situation in the U.S? well, we can throw away the idea of "making economic sense" when it comes to government as well as individual debt. On the government level we are told the only way to get out of debt, or reduce our deficit, it to take on more debt to stimulate the economy and therefore generate enough revenues to reduce the deficit. We know this has not worked over the last two years even as trillions are poured into the system. The solution lies, to a big extent, in cutting spending and lowering our expectations. So all that stimulus we had did not generate net return. In fact the cost is tremendous to our ability to fund our deficit by borrowing. This in turn has a big impact on the status of the Dollar as a reserve currency. On the individual level there actually is hope as we are seeing Americans spend less and deleverage.


We also fail the test of clean source of funding for several reasons. One is that interest rates are kept artificially low by government interference in the market making it very difficult to gauge the true price of risk and therefore distorting markets and future cost of servicing this debt or rolling it over. Second, a very dangerous and disturbing trend is emerging in the name of supporting a weakening economy. That trend is the printing of money by the government to buy and guarantee government debt. In other words it is like, assuming I have the power to print money, me borrowing from myself, at an interest rate that I set, and guaranteeing my own debt; and in order to keep my borrowing cost down I keep printing more money to buy my own debt and pretend that the market is fair and free. How could that be when I am the issuer and the only buyer of an asset? (here I am specifically referring to mortgage backed securities).


Interest rates are determined by many factors the most important of which is the unhindered ability of risk takers to judge the level of risk assumed and price it accordingly. Currently this process is nonexistent. Another factor is the confidence a creditor has in the borrower. This is even more important nowadays as our creditors see government policies undermining the Dollar by keeping the yield curve artificially flat. Higher interest rates may or may not be good for an economy and the same argument is true for lower interest rates. Higher interest rates may be a good indicator of a recovering economy as businesses compete for limited funding sources. While lower interest rates may indicate the opposite, it can also be a play on fear. I believe the willingness of today's investors to flock to the safety of U.S. Treasuries is misguided and fear based.

All these distortions and uncertainties are causing investors to flock to the perceived safety of U.S. Treasuries. I say perceived because our ever increasing deficit may actually turn the U.S. government guarantee worthless. Yet the dollar keep loosing value (against gold) even with the flight to the perceived safety of Treasuries indicating this flight is fear based. While this shift in investment preference may last a while it is inevitably a wrong bet as rates may spike higher and fast when creditors realize they may be holding worthless assets and start questioning the value of the government guarantee. The Fed must, and does, have the ability to manage short term interest rates, but messing with the long end of the curve is an extremely dangerous step that may have serious consequences in the future.

We are not entitled to a high life funded by the savings of the Chinese and others, nor should our social security (retirement) be at the mercy of the Chinese social insecurity, for this model works only in the short run. But we should be entitled to an opportunity to better our lives based on productivity and lower and reasonable expectations (lower standard of living). Debt is good and necessary when accompanied by sound money management practices. Debt should be a bridge and not a highway to nowhere.

The good: investors are gobbling our debt (for now) at a time we most need funding.

The bad: investors are gobbling our debt out of fear (perceived safety) and not based on the expectation of a strong economy.

The debt: the sense of entitlement and the belief that the world will continue to be our cheap banker is a sad reality.

Unless we bring our house finances in order we are in for a rude awakening and that is the ugly part of it (I have always wanted to be like Clint Eastwood :) )

Stimulus 101

The word "stimulus" is defined in the dictionary as: something that incites to action or exertion or quicken action.... In economics, or the business world in general, the word stimulus is used to describe the act of government pumping money into the system to incite to action an otherwise sleepy economy where lenders are hesitant to lend and businesses and consumers are unwilling to borrow and or spend. The reasons an economy goes into contrition mode are many but chief among them is lack of credit/liquidity or the demand thereof. So the recent action by our government to pump nearly three trillion dollars into the economy no doubt was intended to alleviate the credit crunch and therefore cause a multiplier effect that is supposed to kick start the economy. This sounds great in theory but did not work and will not work for this current crisis.


First let me refute the opinion that the stimulus has actually worked. Those of that opinion basically site two examples of how or why the stimulus has been effective. Example one is that because of the stimulus we have saved roughly 650,000 jobs. This number is derived as the difference between the monthly job loss in January '09 of 779,000 and last month job loss of about 125,000. Example two is that without the stimulus we would be in much worse situation (or at least we could be). There is no doubt that the rate of job losses has fallen from its high and the administration has not wasted a moment to credit the stimulus package for that drop. Yet they can't tells us where or how these jobs were saved. I, on the other hand, will at least offer a theory as to why the decline in job losses has nothing to do with the stimulus. The theory is based on something known as the inventory buildup cycle. There is a natural process that takes place when economies are in recession. In that process are built in safety measures that may, later on, be breached but in an orderly manner (if there is such a thing in fast worsening economies). I am talking about the initial reaction of businesses at the beginning of this crisis, or any crisis, and that is the draw down of inventory to dangerously low levels. Once those levels are reached businesses face a critical decision even in the face of a still deteriorating economy. Unless they resume their activities (for which they were created) they risk going out of business, literally. So the natural act is to stop the firing and start building up their inventories for when the sun shines again. Hence the drop in job losses. However, unless those inventories make their way to the final consumer job losses could accelerate again. The stimulus money could not have had a positive impact on job losses because for the most part that money never made it to the segment of the economy that actually effect the kick start. As a matter of fact a large chunk of that money remains at the Fed and the Treasury where it was created in the first place stimulating nothing but political grandstanding.


The part that made its way to businesses or consumers was mostly a disaster. Billions were spent on propping up the housing market hoping to limit and reverse the foreclosure trend. At least that is what we were told. Funny thing is that the exact opposite has happened. Home prices are still declining and foreclosures are projected to be higher that the 4 million of 2009 . According to Forbes magazine as of July 1, 2010 one third of all homes for sale have seen their asking price lowered by an average of 10% (Phoenix being the worst at 13%). Some investment!!


As for the money that has so far kept the banking system afloat, I do have to say that at least some of it has actually been a great investment for the Treasury as evidenced by the return the government has received from the sale of various options that it had in some of the banks. But it did nothing to stimulate the economy because the banks are not lending. Here is the problem though: the government didn't actually have to print that money to get the interbank market pulsing again. All it had to do is come out and give its explicit guarantee as a backstop for the interbank market. Other stimulus programs such as cash for clunkers and the bailout of GM and Chrysler didn't fare any better.


There is another portion of this stimulus that simply shifted the losses from the private sector to the Fed's balance sheet. So instead of private shareholders taking the hit for the assumed risk now you and I have to pay for that, again doing nothing to stimulate the economy.


The suggestion that we could be in worse shape but for the stimulus may be right, although , again just like in saving jobs there is no evidence to support that. In fact, I argue that this is our way out of this mess. In other words our problem few years ago was too much liquidity and easily available credit to worthy and unworthy consumers alike. Of course I am not suggesting that all credit be cut off, but we also don't want to pump so much money into the system that the end result would be an inevitable return to the easy money of a decade or so ago. And that is exactly what will happen when that stash of cash makes its way to the economy.

Until we work through all the excesses we have and as long as the consumer is overwhelmed with debt (total households debt is 90% of GDP) the economy will not recover no matter how much money is pumped into the system. The simple fact is that government does not buy everyday essentials. The consumer is too busy deleveraging and businesses are weary of uncertainty and therefore are unwilling to plan ahead and spend when they see a retrenching consumer.



Another reason the stimulus (or additional stimulus) will not work is that the deleveraging phenomena is not confined to the U.S. As I have mentioned in previous blogs the two other main economic zones are either suffering through their deleveraging or are so dependent on the other two for their growth.


I know the effort is well intentioned but it simply cannot work in the face of all the headwinds domestically as well as internationally. So why throw good money after bad. You simply can't stimulate an over leveraged consumer by throwing more borrowed money at him. The consumer knows it will take him years before he feels the need and want to consume more. The same goes for businesses, and that is why this recession is not your garden variety one and traditional tools are ineffective.


The amount of debt the government is piling on is going to be a factor in delaying the recovery and making America's product less competitive in world market. This is not your father's America anymore and therefore what may (emphasis on "may") have worked back then will not work today. Back then America was an island with a huge domestic market whose products were pretty much unchallenged. Today the world does not need America's products, actually Americans don't need America's products. Back then America was exporting capital. Today America not only has to compete for money to fund its deficit it actually has to plead for it. In other words America finds itself in most need of liquidity to finance its overextended way of life at a most unfortunate time that the rest of the world is demanding, and in some cases actually supplying, more and more of that limited pie of financial resources.


All is not lost quite yet. But the sooner we acknowledge our deficiencies the sooner we can be ahead of the world in capturing a larger portion of that pie. But this cannot happen until we bring down our standard of living. This can either be planned and carefully thought out resulting in minimum shock or it can be forced on us with dire consequences, but it sure cannot included the paralysing effect of more debt.


What we have is not stimulus. Rather it is a transfer payment. In short, shifting money around creating the illusion of a stimulus.

If I sound a pessimist it is because I am a realist. We should be politically strong enough to tell the nation what needs to be done and not offer politically acceptable solutions that only kick the day of reckoning down the road.


You can email the author at gnasr59@yahoo.com

A Tug of War

Today we had two earnings reports that paint different picture of the state of the economy and its future direction. Earnings results from Yum and Intel pulls the economy in opposing directions. Yum, an end consumer oriented company, posted second quarter results that were below expectations. But the more telling numbers are those of its forecast for the rest of the year. Those projections tell a story of a retrenching consumer that will be a drag on the recovery (see my post about the consumer psyche published on 5/8/10). Intel on the other hand reported great results and increased its year- end forecast. But Intel's success may be short lived because Intel's results are more a sign of IT spending by corporations. In other words it is the result of an inventory build up cycle which may have ended with the second quarter (see my post about inventory recovery published on 5/18/10). For the recovery to be sustained we have to see the Intel products make their way to the end consumer. I just can't see this happening yet because , among other reasons, of the lack of credit available to the consumer and the unwillingness of that consumer to pile on more debt at this time. So the tug of war goes on for now with a bias in favor of Yum's directions. The full impact of this war may be felt in few weeks following the end of earnings season.



You can email me at gnasr59@yahoo.com

Where Are We Headed?

Under the directions of the government banks in China are recapitalizing at a fast rate. At times, when private interest was lacking these banks have turned to sovereign funds to ensure the success of their IPOs. This follows an unprecedented lending by Chinese banks over the last two years, again under the encouragement of the government. I can only think of three reasons this urgent and large capitalization is taking place. The first would be an equally large expansion that would require increased lending activities. I am not sure this is what the Chinese government had in mind when it ordered this massive recapitalization, not when it took steps to cool down the economy and its own lower GDP projected growth rate. The second, and more likely reason, is that the Chinese government expects an increase in the banks' nonperforming loans portfolio and therefore the need to have enough capital on hand to meet the necessary reserve requirements. The third, which is closely related to the second reason, is to hurry up and recapitalize before the capital markets shut them out.

Today (7/7/10) the Financial Times reported that European banks are using their gold holdings to raise cash in swap agreements with the Bank for International Settlements. This can't be a good sign, not at a time when Europe is still experiencing a severe debt problem. This move is very negative for the European economy because it indicates deteriorating values of European debts, especially those on the banks books. On the other hand, depending on the magnitude of these swap agreements, this may be bullish for gold prices.

We are certainly facing huge uncertainties with respect to the global economy but the above mentioned examples add an element of urgency and increase the odds that we are headed toward something truly big that will leave a deep impact on our lives. I don't know when or what but I am not very optimistic about the state of the economy.

What's Yours Is Ours

If I told you I have a gambling addiction and asked you to lend me money to pay off some debt would you? The answer is most likely no, because any reasonable person would not believe the money would go to settle debt. Rather, I am more likely to gamble it away. Why? because I am addicted. The solution to my addiction and debt is not to give me more money. Rather, it is by making me realize and understand that "my world" of gambling is not an entitlement just because I got used to it. The same can be said about the state of our economy. Just because we got used to easy and cheap money doesn't mean we are entitled to it. Worse yet, is taking other people's money to satisfy our addiction. Yet this is exactly what our government is doing with private as well as public money in the name of curing our addiction. I say private money because that is exactly what happened with the bondholders of Chrysler and GM. They were forced to accept a fraction of what they are entitled to legally under our existing business laws. The public part is the endless printing and spending of money by the federal government as well as the Fed. Both fall under the Robin Hood syndrome, taking from the rich to help the poor. This is a very dangerous precedent that will hamper the ability of the economy to recover. The Robin Hood syndrome also extends to the banking industry, the energy industry and the health care industry but seems to exclude the politically sensitive unions, Fannie Mae and Freddie Mac. I guess Robin Hood took only from a select group of rich people.

The idea of government spending, on the scale we have seen lately and in an economic state we are experiencing now, acting as a stimulus is flawed for the main reason that the American consumers' psyche (as well as that of businesses) is shaken to its foundation. This is not to be taken lightly. Spending is not on the mind of many Americans, but deleveraging is. Hence the government can print all the money it wants without any real results. The government does not buy everyday essentials like the consumer does. The only stimulus will come from the consumer once he/she has deleveraged and is confident enough in our fiscal and taxing policies. In addition, I think we can all agree that government does not create jobs. Thus that money the government is spending is money that is not available to the job creating private sector, thus delaying recovery. Second, for that money to be stimulative it has to bring something new to the table but this can't be because the money is borrowed money that increases our already huge deficit and hinders our ability to borrow more or even service our existing debt. In other words taking money from my left pocket and putting it in my right pocket does not add to my net worth, and therefore does nothing to make me want to spend and by extension create a job or two. It is a waste of expanded energy (wasteful spending) that creates a short term illusion of economic activities (my right pocket has more money now). The first quarter GDP was reduced from 3.2% to 3% and finally to 2.7%. The GDP for the second half of the year is projected to be even lower. The jobless rate is still at 9.5% and likely to stay there for several years. So where is all that stimulus that is supposed to take place? where were these promised jobs created? in China? which poor people were helped by raiding the coffers of the rich? The starving in Africa? the answer may be in the "now you see it now you don't" pick up in the housing market thanks to all the incentives that pulled in from future demand (no net increase) at a huge expense that will burden us for years to come.

What we are witnessing in terms of public policy is nothing short of madness targeted at a segment of our economy. I say that because by now it is well known that creating economic equality among the population does not work. Hence the ex Soviet Union and the new Russia, China and a host of newly created nations that have embraced the concept of capitalism even in the midst of this crisis. Big government, even if just perceived, sends anti-growth vibes through the economy as well as unsettling uncertainties of a centrally planned economy. Big government does not have to be involved in the day to day business decisions. It is enough to set a tone and make an example of an industry or two and the message is received.

The premise of taking what belongs to the successful ones and spread it more equally among the rest of the population in the hope of instilling a sense of government responsibility or creating a sense of equality does nothing to stimulate creativity and risk taking which are necessary to create jobs. It actually has the opposite effect. It sends the message that either there is no need to, or we are incapable of being creative or productive; the government will do it for us. History, as well as common sense, shows otherwise.

China is widely held as a model of modern day capitalism. To a certain extent I agree. However, I caution that China is still to a large extent a centrally planned economy as evidenced by its control of the banks and other state owned entities that are responsible for the larger share of GDP. China had to embrace certain principles of capitalism because it knew it will not be able to take care of its population, and risked falling behind the rest of the world. The difference between China and the current U.S. administration way of thinking is that the two come from opposing backgrounds and are heading in opposing directions. That is why China is very mindful of the ineffectiveness of the Robin Hood syndrome while the U.S. seems to think that restoring economic power and prosperity is not only to take from the rich and provide for the poor but to also borrow from the Chinese to fix our many social ills. I am not promoting a Chinese style economy either (see previous blog). I still think that China's economy is not what it seems to be. But at least China seems to be forward looking in terms of its business practices (not enough) and in terms of its acknowledgment of the power of lower taxes ( no capital gains tax in China) while the U.S. seems to want to revive an old worthless system (by the way the U.S. has one of he highest corporate tax rate in the world in addition to the soon to be 40% capital gains and dividend tax rate).

There are signs that policymakers are beginning to realize their misguided efforts. Today's job report and the slowing economic activities as well as the urging of some of our European friends to cut back on spending and stimulus may help speed that realization. Let's hope it doesn't take a European style debt crisis to awaken us because by then it may be too late and the consequences will be severe indeed.

Robin Hood may have been an entertaining legend and character but never the savior. On the other hand we are facing reality and our responses have to be equally realistic and future looking. That is not to say there are easy and painless solutions, to the contrary, the solutions are difficult and quiet painful (not literally), but absolutely necessary and should not include a Robin Hood style solution.



Coming soon: What An Investor To Do?

Boom or Bust

There has been a lot of talk lately about whether the U.S. and other economies are in recovery mode. Proofs on both side of the pendulum usually point to the same set of data. So it boils down to how you interpret this data and what benchmark you are using.

In this piece I will argue that the worlds' economies are headed for more trouble in the months ahead. I will also lay out my road map to navigating the treacherous waters created in the name of "big government to the rescue." Keep in mind where we are coming from and what we are trying to achieve; namely coming from the high flying days of cheap and unlimited credit resulting in unprecedented consumer spending and going toward the goal of restoring jobs lost in the last three years, and then some.

Last week's job report was nothing to write home about. Actually it was a very weak one given the almost three trillion dollars thrown at the economy. A year and a half into the supposed recovery and all that money spent should be yielding hundreds of thousands of jobs monthly not just mere thousands . Sometimes one has to look around his surroundings and apply simple logic in order to get a view of the big picture. Here is what my surroundings are telling me: two friends of mine who are small business owners employing 3-5 people each have downsized recently. One gave up her lease on a 7-suite office and downsized to a two room facility with another small business. The other moved his office to his home and stored his equipment with another business paying a fee every time he uses his machines. Both said the move was done to save on overhead as both their clients have cut back on their spending. What is telling about these two stories is timing. Neither one downsized at the height of the crisis or shortly after. Both have done so within the last two months. If indeed the economy is improving and the consumer is back as some would suggest or would chose to view the erratic positive numbers (positive only compared to the very low benchmark) as trend making events than how come these businesses chose to layoff workers in the face of a recovering economy? The U.S. economy is weighed down by too much debt, a weak and worsening housing market, a banking system shackled by its own toxic assets and a bleak profit generating environment as well as deflationary pressures. All the spending programs that were supposed to kick start this economy have failed. All the securities purchases that have expanded the Fed's balance sheet like never before have failed to achieve their stated goals. One of the reasons for this failure is our refusal to accept a lower standard of living. Think about this for a second. All the money borrowed and spent by the government was to return us to a living standard made possible only by excess borrowing and easy availability of money. After all the goal is to restore all the jobs lost in the last few years. Jobs that , again, were only possible by a spend today never worry mentality. The U.S. economy is facing heavy headwinds going forward.

A year ago when I suggested that the Chinese have funneled most of their stimulus money to state owned enterprises with instructions to stockpile commodities and buy shares of Chinese companies I was met with skepticism and ridicule. Recent reports have suggested that Chinese dumping of commodities is behind the recent price decline. If true, this adds credibility to my thinking that commodities prices surge was not due to increased manufacturing activities in China , and by extension increased consumer consumption in the west, rather it was a miscalculated risk on the Chinese part. A risk that now may prove to not have been worthwhile. In his article dated 6/1/10 Jim Jubak points out that the three largest investors in the recent Agriculture Bank of China IPO are China's Ministry of Finance, China's sovereign wealth fund and China's national pension fund. I believe the Chinese banking system and financial policies are not as wise and sound as they are held to be. The Chinese are new at this and the prominence they have gained is courtesy of their foreign exchange reserves which may prove to be a burden (mostly held in U.S. dollars and Euros) (see previous post "China not the savior some thought").

The European crisis is still unfolding and far from over. All that was done so far is to place a band aid over the wound. All the causing symptoms have still not been dealt with and the patient is bleeding internally, out of sight. Who knows what is hidden on European banks' balance sheets. The spread on some Northern European debt is widening, not a good sign, and the Euro is still under pressure that will be lifted only after a credible rescue plan that includes government spending cuts is enacted. The sense of entitlement has to be replaced by a desire to live within one's means, and competitiveness and productivity have to be restored to the economic models of Greece, Spain, Italy etc. That means cut in government spending, lower standard of living and a lot of time and pain.

The difference between 2007-2008 and now is that now all three major economic zones are facing the same declining growth, banking and sovereign debt crisis (excluding China regarding sovereign debt), weak consumers and currencies that can't hold their value. The U.S. dollar, contrary to some beliefs, has not been gaining lately. It actually has been losing value when measured against the true store of wealth-gold. The dollar has only been gaining against other currencies indicating that the dollar is the best of the bad bunch out there. Don't be fooled by May's China export numbers because they come against a background of falling currencies and may include contracts signed few months ago before the rise of the European crisis. So China won't be able to come to the "fake" rescue like 2008.

There is something of a paradox to the noble idea of wanting to restore lost jobs. These jobs were not created by the government. They were created by the same capitalist phenomena that the Administration wants to protect us from. Taxes and regulations don't create jobs; they sap the ability and desire of businesses to do so. Economic freedom and creativity are the bedrock of an expanding, job creating, economy.

Until I see a well thought out plan that includes spending cuts as well as a plan to reduce the deficit, cut taxes and stop bailouts this is my road map to navigating the economic landscape facing us in the months to come:

1- Cash is king. There will be much better investment opportunities ahead.

2- Gold will preserve your purchasing power and then some.

3- For the little daring, but afraid gold may not pan out, shorting treasuries is the way to protect against a certain inflation.

4- I can always short the market.

The sun will shine one day but not before a painful process takes its course. That is why cash remains king.

The American Banking System: America's Hope

General Motors,IBM,Google,Microsoft,Apple,Caterpillar and countless other great American companies that at some point (some currently) were the symbol of America's power, envy and prestige.

A Subway franchise, a local hardware store, a gas station with a convenience store, a neighborhood Laundromat, a medical practice, a medium size business etc... together they provide most of the private jobs in America.

This combination of status and economic power is the result of ingenuity, hard work and ability to innovate in a free society with a stable political system and minimal government interference where capital is most efficiently allocated by those willing to take a risk.

There was a time when America did not have to worry much about competition from abroad. Of course that is not to say that foreign companies did not exist. But American technology and know how were sought after the world over. Today a Japanese company can produce the same quality product for less, a Korean manufacturer can out innovate an American company, even Airbus can cast shadow over a great American icon such as Boeing. It seems that America may have lost its technological and manufacturing edge in a world of globalization. This could not be more evident than in the surge of Chinese exports (and others). There is still one area in which the United States,even after all that has happened over the last three years, still holds a big advantage. That is America is still the financial Mecca of the world. However this advantage may not be with us much longer if the current policies of attacking, regulating and blaming the banking industry continues. Let's get one thing straight here. I am not suggesting that American banks are financially sound nor am I defending some of the practices of wall street but I am defending and arguing for the need for wall street to innovate. This can only happen in an open and free environment where business decisions are left to the private sector and regulatory uncertainties are kept to a minimum. Otherwise we risk losing a very defining edge of the American way.

No question some on wall street have committed social injustices if you will. Some may have even committed punishable crimes; but it takes two to tango as they say. Banks could not have lend all that money to buy houses if they didn't have willing clients, and Americans would not have borrowed as much if money was not readily and cheaply available. Greed goes both ways. But here is why I place more blame on the consumer in this case. First, it does not take a genius to figure out that if you make $50,000 a year you probably can't afford an $800,000 house (common sense people please!!!). Second, a doctor, a businessman and perhaps even a banker cannot claim he/she were mislead by an aggressive banker. The point being, if you look at the statistics and the market segments affected you will see that highly educated people are in the same boat as those claiming (some justifiably so) ignorance and having been mislead. The comfort of a safe and stable business environment comes from the dependence on and the knowledge that an agreed upon set of laws apply to a certain situation. In other words people will not invest in an uncertain political or judicial environment. Hence New York is the financial capital of the world, not Shanghai or even Tokyo; not even London (even though we saw some pretty aggressive moves by the administration especially with the auto industry). So let's use the laws on the books now to prosecute those who have broken the law. If the argument is that the laws are outdated than let us update them but let us not make the mistake of applying collective punishment for that achieves nothing but short term political gains at the expense of future viability of the banking system.

For those who know me know that I have argued, contrary to popular belief that our banking system is now healed, that there are more pains for this industry ahead. The most obvious to me are all those toxic assets that suddenly everybody stopped talking about when the regulators did away with the mark-to-market rule. They may have done away with the rule but not the toxic assets which are still sitting on banks' balance sheets. By not having to set aside reserves (or as much reserves) against these toxic assets banks have been showing what I call fake profit. A quick glance at the major banks reports show that most of the money they have made over the past year or so came from trading activities and not from traditional commercial banking transactions (the exception beingtwo or three investment banks). This is unsustainable. The slowdown in world's economic activities will put further pressure on banks' profit. In addition all the talk about increased fees and taxes on banks and banking/investment related activities does not lend itself to a nurturing and predictable environment needed for capital investment. Capital should and will go to where it is less restricted and most needed. Does anyone believe that a bank will lend money out when it is told by the government who to lend to, how much to lend and how much to charge? It is unrealistic to expect anyone with excess capital to turn over the decision of risk management to the government.

It will be a long time before American banks are back in shape for it will take years to work off (charge off) all these toxic assets in a slow economic environment yielding minimum profits at best. Otherwise their only quick and painless solution would be a sudden V-shape recovery of the housing market, something I believe even the most optimistic forecasters don't see happening for many many years to come.

I believe a vibrant and innovative banking system free from government shackles is what will ultimately lift us from this economic malaise for it is the best way to allocate capital where it is most needed based on free market principles. In this day and age a technological edge is not necessarily the sole determinant of a society's dominance. In fact I would argue that a free banking system is a better indicator of a country's future. No matter how great ideas are most would remain just that if not for the ability of a financial system to take on risk of its choosing and allocate private capital where it thinks would be most productive. Apple and Google,to take just two most recent examples, would not be where they are today without the help of our free banking system and specifically investment banking.

With all its past present and future problems or inequities our banking system remains the best engine to power future growth in the US as well as globally. If you are a believer in the China story or the emerging market story or whether you subscribe to Africa as the last investment frontier or space travel as our future then you also have to believe in a strong, free and capitalist banking system capable of innovating without worrying of having rules changed haphazardly and unexpectedly. Yes life is not fair but as to why it is not fair no one on this earth can convincingly say. A banking system of the kind I support may and will have some injustices but it is still a far better system for society as a whole than a centrally planned politically charged allocation system the kind of which we have witnessed disintegrate with the fall of the Soviet Union. Society cannot exist where everybody is a doctor or a banker or a Judge or a cashier etc...society is only sustained by the variety of functions necessary to complete the economic circle of life.

As sick as the banking system is (or perceived to be) it still is the heart that supplies blood (credit) to the body. A feeble heart is not capable of delivering the necessary amount of blood to keep the body going. The patient gets sicker and eventually dies. The creativity of IBM, the innovation of GM (in the past of course), the vision of Apple and Google and the ability of a Subway franchise to create jobs would not have been possible without the ability of our free banking system to take those ideas to the next level of actual execution. So please let's keep those arteries open and unobstructed by any hick ups or regulatory buildup. The way to do this is not by proping up some banks or exempting some from the upcoming regulations (think Fannie Mae), rather you achive this by letting the free market weed out the weak (let them fail). Than and only than would the heart regain its strength and ability to sustain a growing body.

Don't bank on our banks as an investment in the short run but do bank on them to pull us out of this mess eventually and keep America's edge going forward.

Looking For A Black Swan

There is real fear the US economy may see a double dip soon. A quick glance at the housing market following the expiration of the government credit and the heap of banking regulations coming soon seem to confirm the inability of the economy to generate necessary credit to sustain the recent growth. Why would banks want to lend to a consumer who is unable to repay when the government is dictating to them how much loans they can make and how much fees (and who knows what else) they can charge. Better yet, why would they lend when they can have their cash parked with the Treasury earning a guaranteed return. The US economy is facing deflationary pressure just like the EU is. The growth we have seen over the last year or so comes from cost cutting and not from increased revenues for companies have no pricing power. It seems department stores, and others, have daily sales going on. Combine this with heavy cost cutting and you have the unsustainable growth we all celebrated. Unlike China our stimulus money is still kept,for the most part, within the banking system (that is between the Fed and the Treasury) and therefore has not had the multiplier effect that usually accompanies such stimulus spending (ironic, because that is the exact reason for a stimulus). The challenges facing the US economy in the coming months are many and serious. Unemployment is stubbornly high and likely to remain so for few years. Difficult times await the Dollar as well as Treasuries. Our deficit is simply too large and will prove costly to finance going forward when either interest rates inch higher or when buyers shy away from Treasuries. The most serious problem facing the economy is the future of our banking system and its ability to innovate and be competitive (more on that in a future blog).

Europe and China are facing their own economic problems. In the case of China too much growth that has created a bubble or two. Nonetheless the end result is the same, but perhaps to a varying degree. In the age of globalization it is difficult to see how the world's main economies can grow when they are dependent on each other at a time they all seem to be heading in the same wrong direction. So how do we get back on track to growth? there is only one sure and quick solution; and that is a pretty heavy shock to the system. By that I mean stop all government interventions and let the chips fall where they may. This is a harsh but necessary treatment. The risks are high but less so than following a path of slow economic self-destruction. It is all about duration. It makes more sense to suffer the same consequences over a shorter period of time; then we can get on with the recovery. The crisis we have experienced is not your garden variety one and therefore normal government intervention is not effective.

Geopolitical events may yet give another boost to slowing world recovery. The west, lead by the US, is moving forward with plans to impose sanctions against Iran despite its agreement with Turkey and Brazil regarding its enriched uranium. North Korea is threatening war against South Korea; and a potential war between Israel and Hizballah threatens to go regional.

In his book Nassim Taleb defined a black swan as a rare event with an extreme impact and retrospective predictability. Are we about to witness a black swan so close to the recent one (the financial crisis of 2007-2009)? If so in what form or medium? Is the collapse of the US dollar the next black swan? Could an Israel attack on Iran transform oil into a black swan event? or would the heavy burden of the US deficit turn Treasuries into swans? Perhaps the ultimate black swan will turn out to be golden because of the lack of confidence in the world's major currencies. No matter what the answer is there is a way to profit from it, assuming one is right of course. In that case I want my reward to be a black swan one indeed.

Inventory Recovery

This evening I had the privilege to listen to Bob Doll, BlackRock Vice Chairman and Chief Equity Strategist, speak in Phoenix about events driving today's global markets. The presentation was very enlightening and interesting. Mr. Doll sounded a definite long-term bull, especially on US equities. He pointed to the very healthy earning season and improving job market yet still acknowledging the head winds facing the US and global economies. Mr. Doll seems to be a believer in the inventory buildup cycle and the comeback of the US consumer. He attributed the tame inflation to the lack of the multiplier effect of the huge stimulus plan. Far be it from me to disagree with an established and highly regarded money manager and Vice Chairman of a company with well over $1.3 trillion under management. However, it seems to me that a lack of a multiplier effect is inconsistent with a spending consumer and growing economic activities. Hence, I would argue that unless the inventory buildup cycle, which I believe is mostly business-to-business, reaches the end consumer, the US economy runs a real risk of double dip.

China Not The Savior Some Thought

The economic rise of China over the past twenty years has been nothing less than spectacular, or at least it would seem so on the face of it. Many economists, analysts and political observers alike have been predicting the end of American economic and political dominance in the world in favor of a Chinese rise to power based on China's economic growth. Many others are pining hope on the so called mighty Chinese economy to rescue the world from its financial and economic doldrums. Is there truth to the thinking that a thriving capitalist economy in a communist political system will come to the rescue of the free world? Not so fast. Remember that China is still a communist country ruled by a one party system that when threatened, or perceived to be threatened, will not hesitate to pull the plug to ensure its existence. Example of this are plentiful, the latest being the squabble with Google. It is ironic to think that the very reason Chinese officials embraced economic reforms- that is survivability- may be the same reason that one day will cause the political elites in China to reverse course or at least take away many of the economic freedoms that lead to such phenomenal growth over the last two decades. There are already powerful voices in China calling for the abandonment of the new found system. The term "paper tiger economy" (no pun intended) may be an appropriate description of the Chinese economy for the following reasons:

While it may be true that the Chinese economy has been firing on all cylinders according to Chinese government figures it is also a fact that China is home to the largest poor population among the countries of the world. The gap between the very few rich and the very many poor is only growing wider and is bound to create social unrest in a country where economists predict the economy needs to grow at 8-10% year just to absorb the 20 million or so new job seekers. It is fairly easy to grow at double digits over a period when credit creation and availability was abundant and cheap; and when the start point was almost zero. That is the same period that the American consumer, by far the biggest spender, had access to unprecedented credit (not anymore, at least for now.) It is not realistic to pin hopes of rescue on a consumer that makes a fraction of what the American consumer makes. It is unrealistic to look up to a "Chinese middle class" (that does not exist) to put growth back into the world economy when the average car price is three times the average annual salary (think credit bubble given the number of cars sold in China over the last 3-5 years) and when the real estate price ratio is even worse. China's enormous currency reserves, which would otherwise give it prominence and power on the global stage, would have to, at least partially, be diverted internally to help create a middle class and to help stem the social tensions and problems created by the widening gap between the haves and the have not in the coming years. Some of this reserve may be converted into gold (see previous post "Does Gold Glitter?"). Even if you believe the Chinese government figures the reality is those figures point to an export lead economy and not an internal consumption driven growth.

The western economies, by far the most consumption oriented,(see previous post "Is There A V-Shaped recovery Of The Consumer Psyche?") are in an economic slowdown and face real deflationary pressure. The EU is the largest trading partner of China. How realistic is it to expect meaningful growth in an export dependent economy at a time when its largest trading partners are forecasting feeble growth at best. While it may be easier for America to go it alone (to decouple somewhat-which I don't think is possible) it is not the case for China because its economy is export driven and because it lacks a meaningful middle class. This is the age of globalization and the world economies are intertwined like it or not. Otherwise how can one explain the phenomena of China acting as America's banker by using American financial innovations (raising and efficiently allocating capital) to sell Chinese goods to American consumers in exchange for their dollars which in turn China uses to extend credit to the same consumer so he/she can go on buying Chinese goods or otherwise finance the American deficit.


While the steps the Chinese government has taken recently to help slowdown the runaway growth may or may not work they point to the problem the Chinese economy is facing in the coming years. Faced with a slowing world economy China pumped huge sums of money to keep its economic engine humming. But because it lacked a consuming middle class China had to direct most of the stimulus money to state owned companies that went on a commodities buying binge and built unneeded factories or entire cities that remain empty to this day. Herein lies the future headache of overcapacity at a time when the rest of the world is being thrifty. The other problem the Chinese will be facing soon is in their banking system. All that crazy lending over the last few years, mostly to state owned companies, is creating a situation not unlike the one we faced in the US, perhaps not in complexity but certainly in terms of simple loans gone bad. China has a bitter experience with such loans, dating back to 1999, which are still on the books of the so called AMCs (Asset Management Companies), otherwise known as "Bad Banks" in the west. A burst of a credit bubble or a real estate bubble will certainly trigger the need to recapitalise Chinese banks unless of course the old communist regime reverts back to its old ways.

Perhaps the most telling of the state of the Chinese economy is the fall in the premium between the A shares of Chinese companies traded on the Shanghai stock exchange and the H shares of the same companies traded in Hong Kong. That premium reached a high of 40% in favor of the A shares over the last three years. This is telling because the A shares are not available to foreigners (for the most part), meaning it is a true reflection of how the average Chinese feels about the economy.


Whether we believe the Chinese government figures or not a simple application of the test of logic should be enough to realize that China will not be the shoulder upon which the rest of the world's burden will come to rest. Rather, the Chinese economy is a paper tiger one waiting to crumble in the short term. Longer term, and after the excesses have been dealt with and as the US and the EU start to emerge out of their slumber, China will have its appropriate role to play on the world economic stage but not one that will upstage the US.

Does Gold Glitter?

In 1946 the Bretton Woods System established a fixed exchange rate of $35 per once of Gold. That is when the dollar and the U.S. economy were the envy of the world. In 1971 President Nixon ended the fixed rate peg and the dollar (and other currencies) was allowed to float supported only by the strong U.S. economy, low debt and the full creditworthiness of the U.S. government. Smelling blood and lead by Russia in 2009 we saw the BRIC bloc declare their support for an alternate world reserve currency to the U.S. dollar. What will the form of this alternate currency be and what will support it? Neither of the BRIC currencies is strong enough to carry this burden and privilege. Nor can the BRIC bloc be unified enough to form the backbone of support for they are (geographically), politically, economically and culturally far apart. I don't think for a moment the BRIC thought they can actually replace the dollar as a reserve currency with another currency, not even an SDR. They also did not create a road map for the replacement. However, recent events may be turning their desire into reality no thanks to them.

The U.S. dollar is weighed down by too much debt and an uncertain regulatory terrain of the financial system to retain the title of "reserve currency". Don't be fooled by the recent tactical retreat to the safety of the dollar following the horrible but expected events in the EU. Simply put the dollar is the lesser of the evils out there at the moment.

With the announcement of the massive bailout the Euro just started down the path of the dollar. Tapping into future earnings to pay for past spending is a sure way to tame growth for years to come. This massive bailout is more of an attempt to preserve Europe's ability to face an aggressive Russia at its doorstep more then anything else; for economic unity, no matter how feeble, brings political determination.

At times of great uncertainties countries must and will do what they see is in the best of their interest. China's massive dollar reserves can be a blessing or a burden. China is facing its own economic problems stemming from fast growth. Recently the Chinese government has taken a series of steps to curb the runaway growth of its economy and what many consider a huge bubble in its housing market. Faced with a declining dollar and weak prospects of its largest trading partner, the EU, China may well decide to rid itself of some reserves- who wants to hang on to a declining asset- and preserve its wealth in gold. For over five thousand years people have been turning to gold to preserve their wealth at times of distress.

For the last couple years we saw some central banks around the world increase their gold holdings (India among them) while others declared their intention of doing so (China). Given the unprecedented amount of debt issued over the last decade and the additional debt burden assumed (think potential inflation) lately in a failing attempt to rescue the system and faced with a real slowdown both in Europe and in America (think uncertainty) signs of a perfect storm are beginning to form giving rise to all things golden and a De facto undeclared new world reserve currency.

At a time when no one currency is strong enough to be dominant the country (or countries) holding more gold has more say in the shape and composition of a future reserve currency. The competition is on.

I say gold does glitter.

Death of Capitalism Times (X) 2

Enough with the congratulatory comments and kudos for the latest EU bailout. How can this be a good thing when you take a trillion dollars of future earnings to pay for past spending. Where is the growth going to come from with the deflationary pressure this move will cause. There is only one solution, which had it been used in the US we would probably be out of this mess by now, and that is to let the market correct the problem. Yes let Greece fail (restructure its debt), yes let the big European (and American) banks fail. Stop interfering with the natural process of dealing with failed entities. This is not the end of the crisis. It is now beyond a geographically contained area. This is a loosing attempt at saving the integrity of the Euro and delay the day of reckoning. Let market forces shake off the rotten fruits.

The US can not decouple from Europe. Not when the EU, the largest trading partner of China, is going into a prolonged period of uncertainty and economic malaise at a time that China, our banker, is facing very possibly the same fate. The same wheel goes round and round.

Is There A V-Shape Recovery Of The Consumer Psyche

For the last year or so Larry Kudlow, whose ideas and views I agree with almost always, has been promoting and rightly so the idea of a V-shaped recovery of our economy. There is no question that such a V-shape recovery has been underway as supported by numerous economic data. But the questions remain "is this recovery sustainable?" And "what is fueling it?". The answer to the first question in my opinion is NO because any sustained recovery is contingent upon the ability and willingness of the [end]consumer to spend. After all, all goods and services are produced for the end user - the consumer. In this blog I will attempt to explain why the consumer will remain weak for many years. I'll leave the answer to the second question to a later blog.

The shock that the U.S. economy, indeed the world economy, suffered over the last three years or so is far more damaging that many would accept beyond the quantitatively captured harm. It was not a normal and a necessary healthy recession that every free economy needs every now and than to rid of excesses. This recession shook the very foundation upon which a free capitalist system is based- and that is the concept of credit availability to fuel demand, and by extension the manageability of debt, both on the individual and government levels.

It is not the intention of this piece to argue the causes and responsibilities of this enormous shock, but to explore the consequences it left behind. To understand this one has to understand that consumer behavior is like many other human behaviors based on confidence. Once this confidence is broken one has to go through a series of steps, processes and time to gain it back. The deeper the crack the longer the build up process. This notion applies to the entire chain of economic activities. Meaning that each entity in the system (a government, a manufacturer, a doctor, a bank, a lending officer, a purchasing manager, a teacher, a cab driver etc,....) at some point is a consumer in his/her business entity capacity and has to make decisions just like the end consumer does. It is hard to see how a bank or a bank officer can lend money to a confidence shaken business or decision maker just as it is hard to see how the end consumer, who for years used an artificially inflated asset price (his/her house)to fuel an unprecedented level of demand for all goods and services produced, can embark on a shopping spree the kind of which we experienced over the last decade or so. Yet that is exactly what wee need to sustain the V-shape recovery. Remember not only has that end consumer seen the value of his/her largest asset and piggy bank plummet in value but he/she has also watched his/her retirement fund plummet as well. So now the piggybank is gone and any future earnings has to go to replenish the retirement fund and for many who were hoping to retire soon now have to extend their working years. Not to mention the pile of individual (and public)debt accumulated during the boom years. I ask you does this bring confidence back to a broken psyche? Therefore, there is neither the ability (credit availability) nor the willingness (consumer behavior)for this recovery to sustain itself at the pace it has for the last year. Given the global economic conditions and the amount of sovereign debts the world has to deal with the U.S. economy will grow at a very tepid pace in the years ahead.

It is also worth mentioning that business entities are made of individuals whose personal experiences heavily influence their decisions- bad memories tend to linger for a while.

Some may say that the same economic figures that point to a V-shape recovery also point to an engaging consumer. That may be true to a certain extent. Still one has to ask what is fueling this limited consumer participation. Many are the answers embedded in the same economic figures. Others have offered countering answers that, if true, spell a pretty disturbing picture (such as people who are upside down on their mortgages intentionally skipping payments-thanks, in part, to all the government bailouts- and spending that money elsewhere). However, these figures reflect a bounce from a very steep drop and the unemployment rate is still near 10%. My answer to those who say that the other 90% are still employed is twofold. First, remember that many have to work harder and longer and save more in order to replenish some of what was lost in this crisis. Many had counted on their home price appreciation as the retirement fund. Second, we need that other 10% working to fuel the extra end demand needed to sustain a V-shape recovery.

This is not a gloom and doom view. It is merely a realty check. The sooner and the more embracing we are of the facts the faster the recovery is and the more reasonable expectations are. This is not a consumer lead recovery. This is a liquidity driven short term bounce.

In short there is no V-shape recovery of the consumer psyche. It is time to tighten the belt one more notch and acknowledge that a lower standard of living await us all.



Coming soon:

Does Gold Glitter?

China Not The Savior Some Thought

Sovereign Debt: Can More Debt At Higher Cost Bring Debt Relief?