Tuesday, July 21, 2009

America is for now still blowing bubbles

By Richard Bernstein
Published: July 20 2009 19:30 (Financial Times)

Although many market and economic observers quarrel over whether the Obama administration’s involvement in the private sector upholds the American principals of contract law, private investment and capitalism, this discussion misses the most important point for investors. The question is not whether there is a battle between socialism and capitalism, but whether the US economy is on a path to mimic Japan’s.

Financial history shows that bubbles create capacity, which is no longer needed once they deflate. An inevitable and intense period of consolidation follows. For example, the internet bubble gave rise to hundreds of publicly traded dot-com companies, many of which either merged with other technology companies or went out of business once the bubble deflated. Similarly, the gold rush of the 1800s led to construction of outposts that subsequently became ghost towns after that bubble subsided.

The global economy has experienced during this decade the biggest credit bubble in our lifetimes, and virtually every industry in every country benefited. In fact, all the growth stories of the past decade (such as China, emerging market infrastructure, residential housing, hedge funds, private equity and commodities) are capital intensive investments that benefited from easy access to cheap capital. The global credit bubble seems to have created a global economic bubble.

History would suggest, therefore, that there should now be massive overcapacity in the global economy. That is indeed the case. Global capacity utilisation was recently at generational lows.

Ignoring this history, the goal of Washington’s policies has been to stymie the inevitable consolidation, keeping companies operating – and employing voters – rather than managing the consolidation to maximise the economic benefit. History says that Washington’s is an unwise and ultimately fruitless strategy. Certainly, there may be short-term gains in an economy by keeping a bubble’s unnecessary capacity alive (this may explain the recent improvement in economic statistics), but the continued misallocation of capital significantly hinders longer-term growth.

Washington’s tact has not been unusual. Politicians everywhere are naturally fearful of post-bubble consolidation because it always means higher unemployment and voter distress. As a result, policies in post-bubble environments tend to sustain an economy’s unneeded capacity, with the hope that economic growth will rebound so the economy can eventually grow into and soak up those excesses.

Japan’s post-bubble strategy during the 1990s supported excess capacity and stymied the post-bubble consolidation forces. Companies were deemed “too big to fail”, and excess capacity (particularly in the financial sector) was kept alive. Basic economics states that significant overcapacity leads to lower product prices, and Japan’s policies accordingly resulted in an extended period of deflation. Japan did have some inflation during its “lost decade”, courtesy of China’s boom, which soaked up Japan’s excesses. However, deflation returned to Japan and overcapacity grew once the Chinese economy cooled.

US policymakers made a clear choice to follow a Japanese-like route when they declared that a select group of financial institutions were too big to fail, and devised the troubled asset relief programme (Tarp), term asset-backed securities loan facility, and public-private investment programme. The bankruptcies of General Motors and Chrysler may seem to run counter to this contention, because the government took swift action to reduce unnecessary productive capacity, but it will be interesting to see how the government deals with the resulting consolidation within the industries that supply carmakers.

Recent private sector support for CIT Group – which saved the lender from failure – may be a good deal for investors who bought CIT’s debt at a discount, but it is clear that lending capacity will not be reduced as much as it would under a full CIT bankruptcy. If CIT had failed, some rightly feared that lending to smaller companies might have been constrained. However, the government could have encouraged other Tarp-funded institutions to lend to small businesses rather than continuing to allow bailed-out institutions to make outsized trading profits. If public policies insist on maintaining excess financial sector capacity, then at least utilise that excess capacity productively for the economy.

Many observers claim that comparisons between the US and Japanese economies are inaccurate because the US economy is more “dynamic” and less “rigid”. There are, of course, differences between the two economies, but it seems increasingly clear that both the US public sector and, with CIT, now the private sector too are working against post-bubble consolidation, slowing the economy’s dynamism and increasing rigidity.

A California roll is an American version of a maki, a type of sushi. It is based on Japanese tradition, but has a decided American flavour. Similarly, the actions of the US’s public and private sectors seem to mimic Japan’s. Although the markets’ short-term reactions might correctly be positive, investors should be wary that the US will be an American version of Japan’s moribund economy.

The writer is CEO of Richard Bernstein Capital Management and a former chief investment strategist at Merrill Lynch

Monday, July 13, 2009

“The Invisible Hand, Trumped by Darwin?” - My Critique

This is my response to an article written by Robert H. Frank, an economist at Cornell University, titled “The Invisible Hand, Trumped by Darwin?”

Given the times we are living, I am not surprise that such nonsense by Mr. Frank is camouflaged as scholarly. First, Adam Smith never attached “greed” to his “invisible hand” statement. This was done by free-market haters to further their flawed economics. They, like Mr. Frank, conveniently disregard Smith’s Theory of Moral Sentiments written in 1759, which buttresses any legitimacy of equating “invisible hand” with “greed.

Second, the basic premise of Darwin’s theory provides the foundation to socialism/communism/totalitarianism. This is why Karl Marx said it was the “most important and suits my purpose in that it provides a basis in natural science for the historical class struggle.”

Third, although never explicitly stated by economic Darwinist but certainly inferred, implementing their theory means a few (e.g. a committee or an elite group) coordinate the most efficient allocation of capital in a society. In other words, a few control the many. Any which way one looks at it, Mr. Frank’s philosophy is anti-free market to the core.

Monday, July 6, 2009

Why hopes of a fast recovery have been much exaggerated

By Eric Uhlfelder
Published: June 28 2009 (Financial Times)

When he was made chief economist at the International Monetary Fund in March 2007, Simon Johnson was deeply concerned about the state of finance across the world’s major developed markets.

But under secretaries of Treasuries, deputy ministers and deputy central bank governors of G7 nations reassured the IMF that in spite of some rumblings all was well.

While he was amazed by how unprepared these leaders were for dealing with the worst economic meltdown seen since the depression, Mr Johnson acknowledges that everyone, including himself, “bought too much into the idea that the financial industry, particularly big banks, had a complete grip on what we thought was risk and how it was being managed”.

But a year after the initial market hit in August 2007, Mr Johnson felt much of the developed world was still in denial about what needed to be done to address the crisis. So he left the IMF and became an academic at Massachusetts Institute of Technology. He is now professor of entrepreneurship, global economics and management at the MIT Sloan School of Management.

“I was trying to speak out while I was at the IMF,” he recalls, “but certain constraints come with position, and I found it was time to speak more bluntly than I could as an official.”

And blunt he was in a recent article in The Atlantic entitled, The Quiet Coup, in which he noted a disturbing similarity between emerging market failures and the US. “Elite business interests – financiers in the case of the US – have played a central role in creating the crisis,” wrote Mr Johnson, “making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse.”

What he finds even more unnerving is that these special interests “are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive. The government seems helpless, or unwilling, to act against them.”

This is not to say Mr Johnson thinks administration policy is way off mark. He likes the mixed-bag approach. “It makes sense that if you’re not sure what will work, you try a bit of everything: fiscal stimulus, housing support, and recapitalising the banks.”

While he thinks Barack Obama has been a little overweight on the fiscal stimulus, he says the president “bent over backwards not to really annoy the banks or to do anything harmful to their interests”. And to Mr Johnson, this could be Mr Obama’s Achilles heel. He thinks the so-called bank stress tests underestimated the worst-case scenarios by as much as a factor of two.

So, then, is the market rally for real?

Mr Johnson thinks it is mostly a response to the end of the panic phase of the crisis and calm returning to financial markets.

But he does not think those two features alone can carry stocks very far. “We’ll need to see a turnaround in the real economy before investors believe the current rally is sustainable.”

He fears that hopes of an immediate recovery have been greatly exaggerated, and thinks there is still a lot of nastiness that has to work its way through the system.

Asked about a model portfolio, Mr Johnson thinks in terms of US securities as he believes America has the greatest capacity to regenerate through the creation of new technologies and innovation.

Seeing a lack of creative policy response across the eurozone, he is sceptical about western European prospects. He anticipates anaemic growth for some time to come due to the European Central Bank’s refusal to sufficiently lower interest rates and embrace quantitative easing [where Treasuries purchase securities to pump capital into markets].

He is much more keen about certain emerging markets that have already weathered their own crises over the past 10 to 15 years. “I like Brazil, Mexico, India, and South Korea,” says Mr Johnson, “countries that have made systemic changes, which have helped them to hold up much better than most people anticipated.” With an eye on good management, he would have between 20 to 30 per cent of a model portfolio in such places.

However, he would be underweight equities in general. “I can’t imagine a return to the kind of equity growth we had seen over the past two decades, but I can imagine a 10-15 year period where stocks go nowhere.”

He admits his own retirement account is too equity heavy and should include more bonds. He also feels this crisis has taught many investors they have been holding too much stock, and that lots more volatility comes with such exposure. He thinks the recent market collapse proves the need for investment horizons of at least 20 years when investing in stock.

Since he believes quantitative tightening will be no easy feat to ensure impending inflation is contained, Mr Johnson agrees with many financial advisers that commodities will likely prove an effective hedge to future rising prices. But he cautions investors about the likely reinflating of commodity bubbles.

For the same reason, he also likes inflation-linked government bonds.

Overall, he thinks we are still in very uncertain times and believes the average investor would be well served by sticking with safe investments, such as US government debt. But he cautions “that even ostensibly safe sovereigns may not be for the faint of heart”.

Friday, July 3, 2009

Causes of Recessions

There is a perception that the current economic crisis stemmed from appropriate regulatory oversight, compounded by the creation of opaque financial instruments. None of these issues by themselves adequately explain the dire circumstance we are presently experiencing. In fact, considering the first part of the alleged reason leaves a lot to be desired. The fault lies in Central Bank policy.

The creation of money out of thin air by Central Bankers all over the world gave financial institutions perverse incentives to undertake unprofitable business. The financial instruments created during the bubble period could not have happened if money were not so easily available. Indeed, any financial firm (just like any other business) that desires to expand needs capital, which comes from saving not by resorting to the printing press. Printing money is not capital. Ask yourself this question, why is that a large number of businesses, which its owners are risking their capital in this endeavor and receive profits by adequately forecasting future demand, suddenly and in unison fail in their function? In other words, why business owners experience a “cluster of errors”? The answer lies in that Central Bank policy (i.e. printing money) fools them.

The severity of an economic crisis is directly related to the level of interference preceding it. The U.S. Central Bank, for example, lowered interest rates to historically low levels in 2003-2004 (1%). The easy money fed through the financial system and to the housing market. When the Central Bank reversed the easy money policy in 2006, the bust phase was inevitable. The economy began to crack in mid-2007 and busted in 2008. “Austrian” Theory says that we are not out of the woods yet; but rather a bigger bust is ahead, given the unprecedented level of market interference that has occurred thus far.