Why a turnaround in the economy is not imminent

"Mish" collates a number of emails and comments to reinforce his thesis that we are set for a long and very difficult deflation, for a variety of reasons. One of his respondents is noted Australian economist Steve Keen, one of the dozen or so (out of perhaps 20,000 professional economists worldwide) who foresaw the credit crunch; Keen thinks it would have been better to give money to debtors directly, rather than to the banks, who will simply hoard the cash as so few now wish to borrow the way they used to.

Vitaliy Katsenelson looks at history and finds: "Over the last 200 years, every long-lasting bull market (and we just had a supersized one from 1982 to 2000) was followed by a range-bound market that lasted about 15 years or so (the only exception was the Great Depression)." He expects the market to bounce up and down and "At the end of this wild ride, when the excitement subsides and the dust settles, index investors and buy-and-hold stock collectors will find themselves not far from where they started in 2000," so he recommends that we analyze individual companies and timing our purchases according to when we think their particular stocks are undervalued.

David Rosenberg tabulates lots of ways in which the present circumstances are not like those in 1982 (when the market began to turn upwards in real terms):


By the way, that last statistic about median ages startled me, so I looked elsewhere for information on general US demographics, rather than just the "baby boomers". This graph says that the median age of the US population as a whole rose from 26 years in 1929 to nearly 30 post WWII, then fell to below 28 in the late 1960s, after which there was a steady rise to over 34 years by 1994. This site estimates the median age in 2006/2008 at 36.7 years. Demographic change has had and is going to have an enormous impact on government budgets and the stockmarket.
Bill Gross (of PIMCO, which recently announced its plan to be a net seller of UK bonds) laments the corruption of government that makes him wary of trading in the US at present. He thinks that relative to more fiscally responsible governments like Germany, countries like the USA, UK and Japan will have higher interest rates and this will, of course, hit the value of their bonds and stocks.
Finally, Warren Pollock's politico-economic overview sees threats to two key stabilisers in the world economy - Saudi Arabia and China. Problems there could begin a wider unravelling of current arrangements.
So, as I have done for the last 10 years or more, I am urging caution and the making of emergency plans.
DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

NEST - compulsory pension savings for employees

In the UK, many people face an impoverished retirement. Stakeholder Pensions were introduced in 2001 as a simple and cheap form of retirement saving, but even now, nearly 12 million people have no pension plan, or a very small one. There are reasons for this - including being too poor to invest enough to make a worthwhile difference to one's retirement income.

From 2012, this will change. A compulsory scheme will be introduced in workplaces, for people that haven't already joined a scheme. It's been called by different names and has just been rebranded "NEST" - the National Employment Savings Trust. (The logo (see left) reportedly cost £363,000 to dream up - the equivalent of over 100 years' worth of maximum contributions to a NEST plan.)

There was an earlier, and in my view better, scheme mooted by one-man think tank the Rt Hon Frank Field MP, who set up the Pensions Reform Group in 1999 to address the issue. They came up with the idea of a Universal Protected Pension, which has 5 principles:

1. Together with the Basic State Pension, an extra (funded) pension should eventually lift all pensioners permanently above the poverty line, by providing a total minimum income of 25-30% of average earnings. Those who are able and willing, can pay in more to get more.
2. It should be for everybody.
3. It should operate as a redistributive scheme: everybody pays a proportion of their earnings (so higher earners pay more), but everybody will get the same benefits.
4. The layer on top of the Basic State Pension should be funded - i.e. it would become an enormous investment fund. Without this, the whole scheme would be another expensive unfunded Government undertaking and at risk of being cut or abolished when the national budget gets tight.
5. It should be kept independent of the Government, to keep the politicians' hands off it.

Like other ideas by Mr Field, this one has been well thought-out. And like some of his other ideas, it's been ignored, or badly adapted. Perhaps, in this case, it's because politicians understand the temptation of (4) too well to think that (5) would work.

Let's look at (1 - 3) as well. Without compulsion, many workers not only would not join, but might be foolish to join. This is because of the way the benefit system works. If you reach retirement with an income of less than a certain weekly amount, the State will top it up. So if you know that is going to happen, it's not worth saving up out of your earned income - you'll just get less by way of a free top-up, so it's as though your personal provision was being taxed at 100%.

To answer this objection, the State first discounts each pound of income you provided for yourself, then re-awards you a "Savings Credit" of 60p. But this is still, effectively, a "tax rate" of 40% - Higher Rate Tax for the poor. This explains Steve Bee's comment on NEST:

Now all we need is for the government guys to fix things so that the pension savings of low to moderate earners can’t be devalued by the unfortunate way pension savings currently interact with the means-tested entitlements that are provided for the elderly and we’ll be cooking on gas.

Not surprisingly, financial advisers find themselves in a quandary when advising lower-paid people about funding for retirement!

Under Frank Field's group's proposals, there would be no decision to make, since contributions would be compulsory. But also, however little you contributed, you would still attain the overall target income of 25-30% of average earnings and be above the notional poverty line, so the complicated and self-defeating system of Pension Credit and Savings Credit would be redundant.

Instead, the NEST is universal only for those who aren't already in a scheme, and you only get the results of what you and your employer have put in - no redistribution effect. Presumably the employer will take into account what he/she has to contribute to the pension, when calculating what pay rises to give you, so it's not even "free money" from the employer. In effect, we have a variant on the current unsatisfactory system, plus compulsion.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

Simon Johnson on the coming disaster

Simon Johnson comments on renewed speculative activity by the banks. He fears that the next bubble-and-pop may be in emerging markets, especially China.

For those who wish to understand more, Simon's website, The Baseline Scenario, offers a beginner's guide to the global financial crisis (GFC).

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

Which books should we burn?

Welsh pensioners are buying books as fuel. Discounting differences in book size, and assuming you could gather all copies of the same title, which books would you burn?

On his deathbed, the poet Virgil requested his friends to burn his "Aeneid". Does an author have the right to do this?

GDP: friend or foe?

I attended the British Association for the Advancement of Science Conference in Birmingham in 1977, and even then economists were asking whether GDP was a useful measure. The example I remember was eating more sweets and consequently visiting the dentist more often.

Should we be quite so concerned about goosing GDP with quantitative easing etc, or is it just a trap to make us continue misallocating resources?

Marmite Easter Egg

According to a team of astronomers, the Milky Way is surrounded by a shell of invisible "dark matter" (Htp: Yves Smith).

But the supermassive black hole at the centre of our galaxy is gpoing to take longer to shloop us up than we thought previously.

We have a bit more time to eat that strawberry.

Food for thought for libertarians

Propaganda time

There's a passage in Evelyn Waugh's comic novel Scoop where gentleman nature columnist William Boot, sent on foreign assignment owing to an administrative mix-up, receives instructions from his newspaper's owner:

LORD COPPER PERSONALLY REQUIRES VICTORIES STOP ON RECEIPT OF THIS CABLE VICTORY STOP CONTINUE CABLING VICTORIES UNTIL FURTHER NOTICE STOP

I was reminded of this today when I heard (via Classic FM) the cheery news that Marks & Spencer has enjoyed an increase in like-for-like sales over the last three-month period. As far as I know, "like-for-like" just means sales turnover in monetary terms, and it's perfectly possible to achieve this if you offer deep discounts, which is what they were doing before Christmas ("3 for 2" on clothes and Christmas gifts, for example). It keeps the show on the road, but it's bound to affect profits - though you may be able to disguise that impact if you mix it up with savings from property sales (27 stores) and redundancies (1,200).

Not that we got that contextualisation on the radio, of course. We are becoming skeptical news consumers, like Russians in the days when they said "v Pravde net izvestiy, v Izvestiyakh net pravdy" (In the Truth there is no news, and in the News there is no truth). It's a shame that we can't rely on mainstream news media, because when forced to the blogosphere to find out what's going on, we discover that not everyone who approaches you in a tatty coat tied together with rope is an Old Testament prophet.

But there's also plenty of stuff from more respectable sources, too. Michael Panzner ( who provides a great scan-and-select service for the economics newsfollower) directs us to this column by Morgan Stanley expert Stephen Roach. Brief highlights:

1. Only about half of an estimated $3.4 trillion in asset losses have been officially written off so far, according to the IMF.
2. The slowdown is worldwide, so other nations are unlikely to take up the slack.
3. The American consumer is not able or willing to resume spending as before.
4. 45% of China's economic activity is in "fixed investment" (building roads, factories etc) and there is a risk that they may be creating a lot of "white elephants".

Money is still changing hands here, but Roach says this is "fueled by a temporary boost from the inventory cycle", i.e. vendors are flogging-off surplus stock at bargain prices - which is why I've cited the feelgood M&S article above. After that, I think, comes cool reality - maybe continued lower prices, but also lower wages, lower profits, higher unemployment and an increase in bankruptcies.

Roach estimates a 40% chance of a "double dip" global recession this year. He also fears that economic stimulus will not be withdrawn quickly enough when a recovery comes, so possibly yet another bubble will be created. Another risk, in his view, is that the US will seek to protect domestic industry against Chinese imports; this could threaten the financial arrangements between the two countries, weaken the dollar and raise inflation.

Is it really not possible for radio and TV news to give a rounder picture of reality?

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

Money fund or mattress?

When I first started in financial services, Albany Life (now Canada Life) had a reassuringly-named "Guaranteed Money Fund"; some time ago, this was quietly rebranded "Money Fund" (see page 19 of this brochure).

It's a sign of the times. Money market funds are supposed to be rock-solid - only one ever failed to return 100 cents in the dollar between 1971 and late 2008. But when Lehman Brothers collapsed in September 2008, it caused losses to a large and venerable US money market fund called The Reserve Primary Fund, which owned some Lehman debt. Initially, the loss was not great - Lehman debt represented only 1% of Reserve Primary's total assets - but there was a one-hour window in which investors could get their cash out at 100 cents on the dollar. Naturally, big investment companies, watching their computer screens, were in the best position to know what was going on and act accordingly. So they jumped out of Reserve Primary, in such volume that the Lehman debt was now worth 3% of the remaining (much shrunken) assets.

For the safety-conscious, there is hardly anything more disturbing than discovering that something you trust in completely is not entirely reliable. So a panic started, with investors exiting money funds generally, until the United States government said it would guarantee such funds. At least, it would guarantee those funds that agreed to pay an insurance premium to the government; and only investments made on or before 19th September 2008.

Now the rules on money funds are to be reviewed and understandably, it raises deep suspicions. In this recent post, Tyler Durden looks at a proposal to suspend your right to realize your money market investment, in a time of exceptional turbulence. Of course, that is exactly the time that you would wish to get out, and given the experience of September 2008 it would not be surprising to find that the institutional investors had already moved out before the suspension came into force.

It is important, because according to Durden's article about a third of all mutual funds' (the US equivalent of the UK's unit trusts) assets are in money market funds, and according to this Wikipedia article one-third of all money market funds are held by private investors. So the fear is that Joe Public would be left holding the baby if there should be a run on money market funds.

I think the fear is overdone. The measures discussed by Durden (see the paragraphs re "Recommendation 3") are clearly intended to make mutual fund investment into the money market safer, and less exciting in terms of gains; those funds that try to achieve better returns with higher risk are to be clearly identified and segregated, with tighter regulation plus provisions for emergency backing from central bankers. And removing promises re withdrawal on demand lessens the chances of a panic, by moderating expectations - it's like those commercial property funds that warn the investor that there could be a delay of up to 6 months if he/she wants to cash out.

Besides, even 97 cents in the dollar is a good return, when stocks have, at some points, lost as much as 50% of their value (e.g. between the end of 1999 and the summer of 2003).

A wider issue is the preferential treatment given to one class of investor over another. If The Reserve Primary Fund had cut its realizable value to 99 cents on the dollar immediately and for everybody, it might have prevented the panic, which was at least partly due to not wishing to be the last one left holding the worthless asset.

Nevertheless, there is always the question of what happens if you need money in a hurry. Argentine citizens were caught out in the "corralito" of December 2001, when banks froze accounts for initially a 90-day period (with the right to draw small amounts for day-to-day expenditure). The Argentine peso had previously been pegged to the US dollar, and after de-linking lost almost three-quarters of its exchange value by June the following year.

The real story, then, is the need for (a) emergency cash, in a form you can get at when you do really need it; and (b) for investors, a watchful eye on exchange rates, particularly in the light of economic problems because of out-of-control debt.

On the latter point, it's worth noting that the rot has already set in: the British pound has lost about 25% against the Euro in the last 3 years alone (and about 17% against the dollar, in the same period). A professional investor I read, called Warren Pollock, recently opined that the pound should eventually trade at around US $1.38, which means a further fall of 14%. Both currencies have lost against the Euro; but quite a few members of the European Monetary Union now have severe economic problems and it is not impossible that the dollar may enjoy a (relative) resurgence, not so much because of America's strength as because of others' weaknesses becoming better understood.

Currency speculation is for the high-rollers; but some ready money is a good thing to have, especially if inflation is not burning up its value. Maybe not under the mattress, though; as the Times reported in October 2008, sales of safes in the UK have soared in the crisis - as they did when Japan entered its long recession, years earlier.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

China, Tibet, Arunachal Pradesh: the giant stirs

I don't know how I can have missed it, but Peter Hitchens reminds us today: Britain has given Tibet to China, thanks to Foreign Secretary David Miliband. Hitchens suggests it's something to do with the credit crunch and the price of China's support for the IMF.

China is struggling to provide for its people, and needs (among other things) wood, water and minerals. Tibet is a valuable source of such resources; but after floods caused by deforestation, and ice melts because of industrial activity, China has begun to consider sustainability and is working to undo some of the damage. The Chinese don't need finger-wagging from pseudo-religious green zealots: this is a matter of survival, and the undemocratic nature of their political structure may allow them to make longer-term, and therefore more successful plans.

Nevertheless, one suspects that unlike here in the Mrs-Jellyby-like UK, but like in most other sanely-led countries, China operates on the principle "look after our nation first, and worry about the rest of the world after that". So despite the protests of Free Tibet and others, that, sadly, is that.

But diplomacy to foster better treatment of ethnic Tibetans might have had more success if we hadn't given away such a powerful bargaining point, all in one go. There is a Japanese saying I read in one of James Clavell's novels: "give fish soup, but never the fish". I think we are represented by a boyish amateur.

You may say, if I'm so in favour of our minding our own business, why bother with Tibet? My answer is that we should be trying to encourage our future master to be kinder to his servants.

Besides, giving way on the Tibet question implicitly undermines our position on the 1913/1914 Simla Accord, which also established the border between India and China, which leads us to the next item on the land acquisition list: the province of Arunachal Pradesh, on which I commented in April 2008. The Dalai Lama clearly understands the implications as His Holiness visited the province last November - much to China's annoyance (here, also). Interestingly, it now seems difficult to access the Dalai Lama's own newspage on this story - another Chinese cyber-attack, or a diplomatic self-censorship?

Anyhow, these are more straws in the wind.

Starve the beast

I don't know if there's anything similar in the UK, but if this takes off the system would indeed change. Move Your Money website here.

Context matters

Story here.

Were there once superintelligent humans in southern Africa at the end of the last Ice Age?

http://discovermagazine.com/2009/the-brain-2/28-what-happened-to-hominids-who-were-smarter-than-us/article_view?b_start:int=0&-C=

Why hold cash?

A couple of days ago, I looked at the housing market and mortgages, especially the US government-sponsored enterprises "Fannie Mae" and "Freddie Mac". The hook for the story was the news, slipped out on Christmas Eve, that the government is considering doubling its existing support for these two agencies, to maybe $800 billion. Some thought that the move might presage forgiving a proportion of the mortgage debt, though it seemed more likely to me that it was about making reassuringly generous provisions against loss from defaults.

One aspect I had overlooked was, who exactly might need this reassurance. The biggest holder of mortgage-backed bonds from Fannie Mae and Freddie Mac is and has been for a long time, reportedly, China. Back in 2008 when the credit crisis was under way, a Chinese commentator pointed out that China stood to lose heavily if those bonds decreased in value.

If bonds are perceived as having an increased risk of default, buyers in the market expect a higher income to compensate. Since bond income is fixed, the way that the yield increases is that the traded price of the bond falls. So, a potential capital loss for existing bondholders, including China.

The bigger picture is the need for governments to keep interest rates low, to prevent further collapse in the housing market for political-economic reasons, but also to keep down the cost of servicing the government's own debts. This is especially important because national debt has ballooned, not only because of official intervention in the markets but because there is more unemployment benefit paid out and less tax coming in. Damping the interest rate is forcing the government to take on further debt, which makes it even more vital to keep the rate down... it is a vicious circle.

Calculating total debt is difficult, but it's generally accepted that in the USA, the combination of public and private debt is higher than ever before, even when compared to GDP. Some will also factor-in a notional amount of debt, relating to the government's future obligations in terms of social security and medical care. One of those people is David Walker, formerly the US Comptroller-General, who toured the country from 2007 onwards to warn of coming economic difficulties. This commentator has estimated the debt at $57 trillion.

Debt is either repaid or defaulted. But default would affect all owners of the bonds concerned, including US pension funds and other collective investments, so to some extent this would be cutting off one's nose to spite one's face. And cheating outsiders would be dangerous - a "credit strike" by foreigners (China alone probably owns $1 trillion-plus of Treasury debt, directly and indirectly) would cripple the debt-dependent US with rapidly-rising interest rates. The dangers might not be merely economic, either.

So debt is going to be paid off the hard way, and that means a long and painful period as people spend less and start to pay-off their loans, and pay more in taxes. The picture is much the same in many advanced economies - it's thought the UK is in an even worse situation - and developing economies are still greatly dependent on trade with us Western spendthrifts.

Is there anyone who won't be affected? Perhaps there is a country that balances its budget, does not let its economy be unsettled by flows in and out of international cash (see what happened to Iceland), and doesn't trade much with the rest of the world; but if such a place exists, it's probably a very poor country anyway.

One question that I think will be asked time and again in the coming years, is whether democracies can take action that is tough enough and quick enough to deal with the problem. Politicians seeking re-election will be tempted to apply the brakes too gently. But if they do not act decisively, especially in trimming public expenditure, those who still have money to lend will be the disciplinarians instead - interest rates will rise. Deferring the treatment will only mean nastier medicine later.

Unfortunately, that's what I think will happen, and so I believe we face a period when it will be very important to get out of debt, and quite rewarding to have cash savings. In fact, that has already been so when you look at the last decade; but I think it will continue to be so for some years yet. Yes, there are some who will use short-term trading to make good gains - look at how the market bounced in 2009 - but if we are in a "secular" (long-term) "bear market", there is more probability of loss than gain. "Bear market rallies" can and do break the fortunes of bold investors. For the more cautious, currently itchy to get a better income than the bank offers them, I suggest we are still in a phase where the return OF your cash matters more than the return ON it. The grass on the other side of the fence may be greener, but there are hidden predators concealed in that grass.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

Deflation and economic cycles

Experts are uncertain about the way the economy will go - will we return to normal, do we face inflation (plus recession) as in the 1970s, or is it to be a "deflationary depression"?

Deflation is when there is less money (including borrowed money) in the economy. In such a situation, "cash is king". In this article, James Wood argues that the large government financial stimulus will not work, because an even larger amount of money has been lost on the stockmarket and in the housing market. He's talking about the USA, but much the same could be said of the UK (though here on our crowded island, it may be that the housing market does not suffer from quite such an oversupply as in the United States.)

Thinking along the same lines, Robert Prechter offers some recommendations. Here are a few major "dont's":

• Generally speaking, don’t own stocks.
• Don’t own any but the most pristine bonds.
• Generally speaking, don’t invest in real estate.
• Generally speaking, don’t buy commodities.

Prechter is an advocate of the Elliot Wave theory, which tries to fit a pattern onto long-term stock market movements. According to this analysis, the current market recovery is merely a temporary upturn before a long drop to the lowest point in the cycle, when it all begins again.

There are other theorists who have attempted to find cycles. One such is Nikolai Kondratiev (or Kondratieff), who thought he saw "long waves" in the economy, lasting a couple of generations. His followers think we are heading for the low point in that cycle - the Kondratieff Winter. In this time, deflation means that people try to store their money in whatever they consider safe - for example, government bonds, cash and gold. If the cycle is as regular as some would have it, "winter" will end somewhere around 2016-2018 - which is an interesting coincidence, because adjusted for inflation, the Dow Jones Index took 16 years to decline from its peak in 1966 to its bottom in 1982 (according to K's followers, that was the "summer" season). Here is a seductively attractive graphic summarising the Kondratieff cycle (please click on the image to enlarge it):



There are a couple of problems with all such attempts. Firstly, the human mind is wonderfully adapted to find patterns, and will find them even in randomness, which is why people once thought they could see a system of canals on Mars. Even if there is such a thing as a long-term economic cycle, there is the question of fit: exactly when will the change come? Once you think you see a pattern, there is the temptation to jam reality into the theory, like Cinderella's sisters trying on her slipper even at the cost of losing a toe or heel in the process.
The second problem is that we are dealing here with human behaviour, and unlike other things in Nature, this subject can take into account the theory that attempts to describe it - and change accordingly. For example, if I say I know what you are going to do next, and tell you, you may then alter your plan so as to prove me wrong. If all investors followed the Elliott Wave theory, they would presumably try to anticipate each other's reactions and that would alter the pattern.
However, these groups of theory-followers are, I think, still in a minority, so maybe the patterns will work, roughly. The contrarian instinctively feels that the way to win is not to follow the crowd - I remember the rich Yorkshire farmer in one of James Herriot's books whose principle was "When all the world goes one way, I go t'other".

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

A straw in the wind reveals the changing direction of power

The public are gradually coming to realise that, within our countries, our institutions and businesses are not run fairly and for the general benefit of voters and investors.

Now, as the balance of economic power is shifting towards the East, we may discover that the rule of international law does not constrain the strongest. A straw in the wind is this story, about a small Chinese company that has defied a Goldman Sachs subsidiary, refusing to pay $80 million relating to derivatives contracts. The significant element is the reported preparedness of the Chinese government to support national businesses against foreign banks in the law courts.

Much more worrying, in my view, are the implications of this pugnacious stance if it is applied to copyrights and patents. Since the West cannot compete with the low labour costs of the developing world, it is placing its hope in its long-accumulated expertise and technology. Should mighty foreign nations begin to disregard intellectual property rights, we could find ourselves in a very difficult position. I raised this issue in 1997 - here, here and here. Please also see my review of James Kynge's "China Shakes the World", where Kynge is given the run-around when he tries to enquire into copyright theft in China.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

The US (and UK) mortgage crisis continues

Update: China may now be experiencing a housing bubble

__________________________________________

Economist Mark Thoma comments on news (which was released on Christmas Eve - a "good time to bury bad news"?) that the US Treasury is considering doubling its line of credit to "Fannie Mae" and "Freddie Mac", from $400 billion to $800 billion. What does this mean?

Let's start with the background to these two "government-sponsored enterprises" (GSEs).

"Fannie Mae" is the familiar term for the Federal National Mortgage Association, set up in 1938 at the tail end of the American Great Depression to help make mortgages more easily available to low-income housebuyers, by buying the loans from mortgage lenders. Effectively, this was a way of guaranteeing poorer-quality loans and so it supported and encouraged lenders as well as borrowers.

In 1968, Fannie Mae was split into two companies; one private, doing the same job as before, but without an explicit guarantee against losses from defaults. The other part was a new public organisation, the Government National Mortgage Association, aka "Ginnie Mae"; this did guarantee mortgage-backed investments, but was originally intended to serve defined groups of borrowers, e.g. public employees and veterans (ex-military personnel).

In 1970, "Freddie Mac" (the Federal Home Loan Mortgage Corporation) was created to do much the same as Fannie Mae, so providing competition and helping to increase the supply of mortgages.

Given the quality of the loans that underpinned their products, Fannie Mae and Freddie Mac were particularly vulnerable to problems in the credit market and were so badly damaged in the "Credit Crunch" of 2008 that they were taken into public control, or "conservatorship". This helped maintain confidence in the banking system, but at a cost: the Treasury has, in effect, become the guarantor against losses, which now become the liability of the taxpayer. Some would say that a second cost is "moral hazard", in that reckless lenders have been shielded from the consequences of their actions, and so will not properly learn their lesson.

Returning to Mark Thoma, we find that mortgage defaults may eventually total $400 billion, which in inflation-adjusted terms is similar to the losses sustained in the Savings and Loan crisis of the late 1980s. (The root cause of the problem then was the same - treating houses as another type of speculative investment - and the trigger for the fallout was the Tax Reform Act of 1986, which (among many other changes) removed or reduced tax breaks relating to residential property investment.)

Why, after all this official support, are we expecting heavy losses on the housing market?

The answer, as I understand it, is that the wrong problem has been solved. By bailing-out banks and other lenders, governments on both sides of the Atlantic have attempted to preserve "liquidity" - the availability of money. But this doesn't tackle the real problem, which is "insolvency" - i.e. when debts outweigh assets. Housing is overpriced - valuations swiftly doubled in the four years after 2002 - and when people perceive that the prices are unrealistic in the long term, the prices have to come down. However, home loans don't come down; they are fixed amounts of debt, that is either paid or defaulted. So as house valuations decline, more and more homeowners find themselves owing more than the resale value of their property. Behind them stand many others who fear that they may find themselves in the same situation, or who realize that renting would be even cheaper than paying their mortgage.

For although interest rates have dropped to historically low levels, the capital still has to be repaid, and so the total monthly cost can't be reduced much more. In an economic downturn, the weight of this obligation is unlikely to lighten because of quickly-rising wages, and until house prices rise significantly, they will also look like a poor capital investment to the borrower. For millions, a mortgage is now a useless millstone around the neck.

Back in September 2008, I floated the wild idea of paying off all US mortgages and making all such loans illegal in future; a comment by one reader, "Sobers", suggested the more moderate approach of partial debt forgiveness. Thoma speculates that one reason for the increased Treasury line of credit for Fannie Mae and Freddie Mac may indeed be a preparation for writing-off a proportion of mortgage debt.

This would be a radical step and maybe it's more likely that the US Treasury simply wishes to make enough money available to cover all likely defaults, with enough extra to prevent the spread of panic in the housing market. After all, people who bought their houses 10 years ago or earlier, are less likely to be in "negative equity" now; unless they took out extra property-backed loans for consumer spending (known as "secured loans" in the UK, and "home equity line of credit" - or HELOC - in the US). Paying off part of everyone's debt would give help to those who didn't need it as well as those who did; and might carry its own "moral hazard" by allowing future borrowers to hope that they might one day be bailed-out, too, so encouraging them to spend too much and get into unaffordable debt. Better, on the whole, to underwrite the losses of the worst cases and discipline the defaulting borrowers with the stigma of repossession, which is a warning to other borrowers, though sadly not so much of an object lesson to lenders.

Another strategy, since interest rates are so low, would be to reduce monthly costs of borrowing by extending the term of mortages and so cutting the amount of capital that has to be repaid each month. You can play with variants on interest rates and mortgage terms here - Yahoo offers some American versions here - and as you can see, extending the term offers some relief. However, there's only so long you're likely to want to have a mortgage, unless we descend to the 100-year mortgages of Japan.

There's also not much scope for cutting interest rates further. The banks loaned out far too much money in the good times and cut their reserves to a dangerous minimum. When the governments made more cash available to them, they kept a lot of it as a temporary buffer, so borrowing for housebuyers and businesses has continued to be on difficult terms. And the banks haven't passed on much of the drop in interest rates, because they are trying to rebuild their reserves. The central banks could cut the interest rate to zero and the banks that borrow from them would still be charging us something like 4%. Until the banks are solvent, we are going to remain hard up; unless there is debt forgiveness, and I don't think that will come for quite some time yet.

In short, I expect the current half-optimistic mood to evaporate gradually in the coming year, as people realize that the problems are enduring and begin to adjust their expectations and behaviour accordingly. I anticipate a longer-term reduction in the inflation-adjusted valuations of houses, though there may be temporary rallies from time to time, just as you get them in a "bear market" in stocks and shares.

I said years ago to friends and colleagues that whatever you treat like an investment will behave like one, and not for the first time, the housing market is copying the behaviour of equities, with the added disadvantages of being less easily and more expensively sold, and of being bought with borrowed money.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

When to invest?

This interactive resource from the Wall Street Journal (hat-tip to the Wall Street Pit blog) looks at 10-year returns from investing in the NYSE (companies listed on the New York Stock Exchange) and the S&P (Standard & Poor's) 500, i.e. the top 500 US companies. The last 10 years look like the worst decade since records began.

Now, some may say that it's a great time to get back in. But if you look at the S&P 500 graph at bottom right, you'll see that returns are calculated in both nominal and inflation-adjusted terms. Sometimes you get an apparent gain which is really much less so, or even a loss, once you take inflation into account.

This is exactly what happened in 1970-79. My fear is that all the current monetary pumping will stoke inflation and the market will rise in nominal terms, but these gains will be undermined by a general increase in consumer prices.

If we have a re-run of the 1970s, it could be years before the market yields real returns.I've covered this topic quite a few times on my old blog - in this post for example, I show that in nominal terms, the worst point was in September 1974; but adjusted for inflation, the real bottom came in July 1982:


It's said that history doesn't repeat itself, but it rhymes. If anything, that has worse implications for us, because by any measure, the levels of debt in the US and UK economies are much higher than they have ever been in history.
I can quite believe that the market will zoom up a bit more, but my feeling is that we are in what is known as a "bear market rally" - a temporary upward twist before a slump. Gamblers may make fortunes in the current rise, but the reversals in a bear market can be unpredictable, sudden and savage, just like the creature after which such a market is named.
Personally, I'm in favour of diversifying investments, and building up emergency supplies of cash and the things you need for daily life. I don't expect things to run smoothly in the next few years.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

More on gold

During this crisis, we hear more from the "gold bugs" - people who are convinced that most modern currencies will become worthless, because they are "fiat money", i.e. the government can make unlimited amounts of them since they are not related to anything in fixed supply, such as gold (or land, when the Nazis restructured the mark).

One such is an American called Jim Willie. He reminds us of debt problems, not only in the USA and Britain, but Spain, Greece etc. Even Swiss banks are under pressure, because of loans to small European countires whose currencies have since devalued. Willie thinks the Euro will unravel because of the difficulties of a number of its member economies, and that Germany will reintroduce the mark, perhaps under some reassuringly Euro-like pseudonym.

Germany happens to have the world's second-largest official holding of gold - 3,400 tonnes compared to the USA's 8,100 (assuming we are being told the truth about how much the USA actually has in its vaults, and that is a matter of serious debate). This article reports China's ambition to increase its own holding of gold, from around 1,000 tonnes now to perhaps as much as 10,000 tonnes in 10 years' time.

The gold mania is not universal. Writing in the Daily Telegraph, Ambrose Evans-Pritchard predicts that the price of gold will actually fall next year - among other bad things such as the collapse of America's social security pension fund. He may be right. In a panic, people want ready money, so maybe cash will (for a time) be king. But when an economy is in dire straits, its government will do whatever it can to ease the pain, and many think that the strategy will be to increase the money supply, or even introduce a new form of the currency, as has just happened in North Korea.

The attraction of gold is for pessimists. It doesn't earn any interest, so mainly it is seen as a last-resort store of value when the money system breaks down (and it's nice to wear and show off). It is perfectly possible that you could make a loss on gold, but it will never be worth nothing at all, unlike the old US Continentals, or Confederate money after the North won the Civil War. In this context, it's worth noting that Reuters news agency reported back in September that Hong Kong moved its gold reserves out of London and into the gold depository at its Chek Lap Kok international airport. A sign of something, but what?

Gold is not the only tangible store of value, of course. Agricultural land, houses, food, medicines etc all have intrinsic value, i.e. they are worth something because of what they can do for you themselves, not just because they can be exchanged for something else.

Inflation remains a serious long-term threat. Comparing the past and present value of cash is difficult, because the economy has increased in size and changed in nature; but depending on the measure you use and looking at what has happened since 1971 (when I started at college), the British pound has lost 90% - 96% of its buying power. It's still (until April next year) possible to retire at age 50 in this country, so if history repeats itself, you could see a similar devaluation during a long retirement.

In short, it's not about the value of gold, but the unreliability of money.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

House prices: the second wave down?

Edward Harrison looks at statistics for US housing and quotes Frank Veneroso*, who guesses that, on average, houses with mortgages have almost no equity left in them:

"... the flow of funds accounts tell us that the total value of residential real estate is $16.53 trillion. The share owned by households with a mortgage is probably $10 trillion to $11 trillion. Total mortgage household debt now stands at $10.3 trillion. In effect, for all households with a mortgage taken in the aggregate, their loan-to-value ratio is now close to 100% and perhaps close to half of them have a zero to negative equity."

For some US housebuyers (especially if they haven't taken out a second mortgage or secured loan on the property), the law relating to their loans says that they can return the house to the mortgage lender and if there is any debt left over after selling the house, that's the lender's hard luck - there's no pursuing the buyer. So if a homeowner is in negative equity and interest rates rise, the easy thing to do is strip the house, rent a van to move the stuff, and mail the house keys to the mortgage company (this is jocularly known as "jingle mail").

In some cases, the paperwork on the mortgage (written in haste in boom times) is so sloppy that mortgage lenders may not even be able to legally foreclose and seize the house.

Others, suspecting that the market will go down further, may wish to sell to get out what equity they can while there still is any. And actual or imminent unemployment may force still others to leave - the official US unemployment rate is around 10%, but some say that if looked at properly the true rate is more like 17%. (Update: John Williams says 22%)

I have also seen graphs (like this one) to show the large number of low-initial-fixed-rate mortgages that are going to return to variable rate in the next year or two, just as (it seems) interest rates may be on the increase.

So there are a number of reasons why banks, the housing market and the economy generally may still face very testing times.

*Veneroso also believes that for years, central banks have held far less gold than they would like us to believe. If this is correct and the currency comes under pressure, there may be a steep rise in the price of gold as the Federal Reserve and others buy back hastily, to reassure us that the currency does indeed have some kind of backing. But please remember (a) this is speculation and (b) gold has already appreciated very considerably in the last couple of years.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

'Tis a gift to be simple

Via Lifehacker, I find a sane blog to counter my (and possibly your) OCD: Small Notebook. One of the principles it stresses is knowing when to stop.

I'm adding it to my sidebar as a still, small voice of calm. Maybe you should do the same.

How should we invest if we're back to "boom and bust?"

Edward Harrison analyses the current financial situation, and thinks that governments will continue to try to stimulate their economies by increasing public debt. This will increase (or support) asset prices, but you can't rack up all your expenses on your credit card forever: another crisis will come and then it's time to pay the bill. The money base will shrink and asset prices will decline again.

The gamblers will try to buy into the false boom and sell before the bust, but this is a risky strategy. I haven't the nerve for it, though some would say you should be prepared to speculate with 10% of your investment money.

For the ordinary investor, it's a difficult time: holding cash will seem like a losing strategy, and he/she may be tempted back into the market at exactly the wrong moment - the moment when everybody thinks that "you can't lose". We saw this in the technology boom of the 90s, and the house price boom a few years ago.

What is clear is that the system is unstable. In these wild times, fortunes will be won by some, lost by others; but the prudent saver looking for secure and steady rewards will have to diversify and consider all sorts of safety measures. Let's look at common investment options, in what used to be thought of as ascending risk order.

If governments try to counter the downturn by producing too much new cash and credit, the result may be inflation and that will punish bank and building society accounts. The insurance company I started with in the late 80s used to have a handout on the effects of inflation: it showed the real purchasing power of money placed in a bank account for 10 years from the mid-70s to the mid-80s - even letting the interest accumulate in the account, your cash had lost 50% of its buying power in a decade. And the events of October 2008 have alerted savers to the fact that money in the bank is not a risk-free option - thank goodness for the limited (up to £50,000) protection of the Financial Services Compensation Scheme.

Government bonds (or gilts) are a problem, too - their yield (their annual income as a percentage of their current traded price) is very low, but when interest rates rise the capital value of gilts will fall correspondingly. There is also mounting concern about national credit ratings and the growing risk of default. For those who still have faith in the UK government's promises, National Savings and Investments claims to offer "100% security for your money" (actually, there is no such thing, but you know what they mean). For example, it is still possible to buy National Savings Index-Linked Certificates, to guard against inflation.

I suspect that with-profits funds will continue to face huge challenges in the coming years. They were set up to deliver modest but (most importantly) reassuringly steady growth; but the volatility of modern markets has stood up in their boat and is rocking it violently. Look out for further occasions when with-profits managers have to impose "Market Value Adjusters" (MVAs) - temporary discounts on the face value of your holding if you're trying to cash-out at a turbulent period. They're trying to preserve balance in an unbalanced time, and I fear they may not succeed.

Higher interest rates (maybe higher taxes, too) and increasing unemployment will tend to affect house prices. In a recession / depression, much commercial property will stand empty and so that market will decline, too.

When the money base shrinks and interest rates increase, businesses will suffer and many stocks and shares (aka "equities") will be hit. Already, professional investors have increased their holding of "defensive" stocks - shares in companies providing things we always need, such as energy and reasonably-priced food and clothing. You can reduce investment risk further by holding shares in more than one company and in more than one type of business; you can also diversify by including foreign equities.

Which brings us to another topic: currency depreciation. The British pound has lost some of its buying power abroad, in part a response by foreign investors to our problems with debt and a weakening economy. The pound has lost ground against the US dollar (not because the US economy is strong, but because the US dollar is still - for now - the world's trading currency) and the Euro over the last couple of years, so even if prices here in the UK seem stable, you might have gained by investment in other countries, or even just holding some money in foreign currency. Of course, the key questions are, which investments, which currencies, when to get in and out?

For the adventurous, there are commodities (everything from pork bellies to agricultural land, oil and gold), emerging markets (developing economies - remember the saying, "an emerging market is one from which it may be difficult to emerge") and specialist funds/shares, such as in technology and medical research.

Further up (or off) the scale are the outright financial gambles - futures and options, derivatives etc. These things - supposedly originally designed to cover and so reduce risk - are now the instruments that threaten our security. I think the main cause of the problem is that there seems to be no notion of "insurable interest", as with life insurance. Prior to the UK's Life assurance Act of 1774, it was possible to take out insurance on a complete stranger, whereas now you can insure only against the loss you might suffer if someone dies. If modern options trading was regulated in the same way, the market would be far smaller and much more secure. Perhaps that will come, one day.

This not the place for any recommendations, but if you are lucky enough to have any investments or savings, perhaps it's a good time to review them, maybe in consultation with your financial adviser. If you don't know which horse to back, then at least you can try to bet on a wider selection, or even all of them; for unlike racecourse betting, there is (most unfortunately) no option to stay out altogether; not unless you have nothing.

UPDATE

Z. O. Greenberg looks at ideas for diversifying investments out of the dollar. This would apply similarly to those who are chary of the British pound. But beware - some say the US dollar may strengthen soon.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

Time for a radical rethink

Warren Pollock considers ideas of Buckminster Fuller in relation to the economy and the real world. This is a most interesting video article and quite short (under 10 minutes). One point he makes is how vulnerable city-dwellers are, to dislocation of supplies. Click here to view the article.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

Not time to get out of the market?

USA-based Chris Puplava at Financial Sense looks at indicators and thinks that although the market could suffer a downturn, that doesn't seem to be imminent.

This kind of analysis is for the active, more risk-taking investor: market timing is notoriously unpredictable.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

The inflation-deflation debate

Sheffield-based analyst Nadeem Walayat demonstrates that, apart from a blip a few months ago, the long-term inflationary trend in prices continues. Whether you look at CPI or RPI (the latter includes mortgage costs), household bills are rising.

He also examines the trend in UK public debt, which again seems to be rising unstoppably. The Chancellor has predicted growth for the UK economy, but that growth is more than paid for by borrowing, so overall we will be worse off. Controversially, Walayat suggests that the motive is political: deliberate damage to the economy in order to leave the next (presumably Conservative) government "scorched earth". We must hope that British governments do not really operate so irresponsibly.

Walayat concludes with a look at some commodities that investors may choose as hedges against inflation: energy (natural gas), gold and silver. He offers some technical comments on fund charges and whether the way the fund invests is likely to track the real progress of the commodity's price. He feels that gold and silver funds correlate better with actual prices in these markets, though he warns that theft and fraud are always possible.

But the readers' comments are worth looking at, too. "Raleigh" points to an estimated $6 trillion reduction in the value of US housing, which more than offsets the recent $1 trillion increase in US government borrowing as a result of the banking crisis. His view, if I understand it correctly, is that such net deflation will put a downward pressure on prices and wages.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

The inflation-deflation debate

Sheffield-based analyst Nadeem Walayat demonstrates that, apart from a blip a few months ago, the long-term inflationary trend in prices continues. Whether you look at CPI or RPI (the latter includes mortgage costs), household bills are rising.

He also examines the trend in UK public debt, which again seems to be rising unstoppably. The Chancellor has predicted growth for the UK economy, but that growth is more than paid for by borrowing, so overall we will be worse off. Controversially, Walayat suggests that the motive is political: deliberate damage to the economy in order to leave the next (presumably Conservative) government "scorched earth". We must hope that British governments do not really operate so irresponsibly.

Walayat concludes with a look at some commodities that investors may choose as hedges against inflation: energy (natural gas), gold and silver. He offers some technical comments on fund charges and whether the way the fund invests is likely to track the real progress of the commodity's price. He feels that gold and silver funds correlate better with actual prices in these markets, though he warns that theft and fraud are always possible.

But the readers' comments are worth looking at, too. "Raleigh" points to an estimated $6 trillion reduction in the value of US housing, which more than offsets the recent $1 trillion increase in US government borrowing as a result of the banking crisis. His view, if I understand it correctly, is that such net deflation will put a downward pressure on prices and wages.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

Janszen: Gold is not overpriced

"Gold ads bug us from the TV and radio. To the new gold experts this means gold sentiment is now too bullish. We’re due for a crash.

Have they noticed that the gold ads are about selling not buying gold?"

In a long but well-worth-reading article, Eric Janszen of iTulip maintains that despite eight years of rising prices, gold is not undervalued, because the economic system is unstable. He points out that, for the first time in many years, central banks have started to buy gold.

Unlike many commentators, he doesn't support the notion that the dollar will collapse, because other major economies (e.g. China and Japan) have become dependent on the USA to buy their exports. Global inter-linking means that the coming bust will not take the same form as previous ones.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

Inflation and then a bust, by 2012, says Andy Xie

Andy Xie, a respected former Morgan Stanley economic analyst says that low interest rates (cheap money) will lead to increasing asset prices until the game simply cannot continue, whereupon there will be a massive, world-wide breakdown, which he expects in 2012.

But Xie's ex-employer thinks the credit crisis may hit Britain as early as next year (hat-tip to "Jesse").

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

Could Britain go bust?

Britain's debtor weaknesses

Update: PIMCO has announced that it will be a net seller of UK bonds this year. The European portfolio manager is Andrew Balls, brother of UK government minister Ed Balls, so one wonders what the siblings may have to tell each other.
This week's Spectator includes an article by Irwin Stelzer, a noted economic commentator, entitled "Who would lend to a bankrupt Britain?"

Stelzer's comments follow recent developments in the market for "credit default swaps" (CDS) - insurance contracts that pay out if a business or government defaults on its debt. The premium (price) of the insurance reflects the degree of concern, and in the case of the UK, that concern has deepened.

CMA DataVision supplies information on the CDS market. Its third-quarter report on sovereign (national) debt assesses each country for the chances of a default within the next five years (CPD, or "Cumulative Probability of Default"), the cost of default insurance and what that means about creditworthiness. In this report (see page 14), the UK is rated as having a 4% CPD, with an implied credit rating at "aa+".

The top "aaa" credit rating is enjoyed by the USA, Australia and a small handful of European countries including ourselves, but things have moved on and it looks as though we are heading for a downgrading. The CMA report linked above covered the market for CDS contracts between July and September. On 7 December, the average CDS risk premium for the UK reportedly increased to 0.74% p.a. (85% higher than in the third quarter), which compares very unfavourably with the USA's premium at 0.32% p.a. This insurance repricing suggests that the UK's risk of default within 5 years may have risen to around 5.5%.

Are we going broke? Not yet, but our economy is not as strong as it used to be, and this is reflected in the price of gilts (government bonds, or Treasury securities). Gilts offer a fixed income for a fixed period, but can be bought and sold many times before their maturity date. Factors influencing their price include interest rates available elsewhere and the chance of default.

If gilts become cheaper, their fixed income is higher in comparison. The relationship of income to the traded price is called the "yield" - effectively, an interest rate. Immediately after British Chancellor Alistair Darling delivered his Pre-Budget Report to Parliament on 9 December, 10-year gilt prices fell and their yield rose from 3.81% to 3.85%.

The bond markets are, so to speak, the judges on Strictly Come Borrowing, and they are not impressed by the proposals they have seen. This, not bankruptcy, is the implication of CDS premiums, gilt yields and national credit ratings: we can expect to pay more for access to extra funds.

Since we are already so indebted, personally and nationally, an increase in interest rates will add to our burdens, at the same time that (in a recession) profits and tax revenues are decreasing; so Britain could have to borrow even more just to keep going. Spiralling debt and the growing reluctance of lenders could eventually force us to call in the International Monetary Fund as a lender of last resort, which we last did in 1976. That was bitter medicine, but still better than what would happen if we defaulted altogether and credit markets shunned us completely (or imposed loan-shark rates and terms).

However, we are very far from the worst case globally. The same third-quarter report by CMA DataVision named three countries that had a five-year default risk of over 50%: the Ukraine, Venezuela and Argentina. The annual CDS risk premiums for the first two were 12% and 11.25% respectively; both have since increased to over 13% per annum. Closer to home, Ireland's risk premium is 1.55%, Greece's 2%, , Lithuania's 3.2% and Iceland's 4.4%.

Although the USA is still regarded as a safe borrower, individual States are not: California's annual CDS premium is about 2.5%, reflecting an estimated 20% risk of default within 5 years.

British banks themselves now have a significant CDS premium, ranging from about 0.9% p.a. for Barclays to 1.4% p.a. for the Royal Bank of Scotland - the latter implies about a 10% risk of defaulting within 5 years.

So, no panic yet, but grounds for considerable concern.

Derivatives: a bigger worry?

A second worry is the state of credit default swaps themselves, and other "derivatives". The total amounts insured in this hard-to-understand market are vast, much bigger than any country's GDP. The USA's GDP is something like $14 trillion, but the CDS market is worth about $36 trillion - down from $62 trillion in 2008.

The derivatives market as a whole is much larger - an estimated $1,400 trillion in April 2009, many times the entire world's annual GDP. It's a mammoth global insurance/betting game, and if a major player comes unstuck it could destabilise finance, just as the collapse of Lehman Brothers and others threatened to do not long ago.

We think of insurance as reducing risk, but actually it's about transferring risk. Promises can turn out to be very expensive: the world's oldest mutual insurer, Equitable Life, suffered a major crisis because of a guarantee it made regarding minimum annuity rates for some of its pension investors; Barings, the oldest merchant bank in London, was destroyed by derivatives traded by its employee Nick Leeson.

The derivatives market is huge, interconnected and inadequately regulated. It is the fourth threat identified by Michael Panzner in his prescient book, "Financial Armageddon," which I reviewed in May 2007. Let us hope that this one can be neutralized in time.

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DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

The end of the dollar? But where else can we go?

The market is inherently unpredictable: if you think an accident is bound to happen, that still doesn't tell you when it will happen. However, this article by Paco Ahlgren takes the long view and maintains that the dollar must one day become worthless.

In the short term, who knows? In times of panic, many investors could run back to holding the dollar and temporarily boost its value.

Other countries are also weakening their currencies. Even the Euro suffers from flaws in the economies of some of its member countries, so although it may seem strong now against the pound and dollar, it too may be overvalued.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

Education or Indoctrination?

Sackerson directed me to the following article: http://www.overcomingbias.com/2009/12/school-is-propaganda.html

In response, I argue that we have public schools because (based on the data):

a) they are cheaper than private schools;

b) they out-perform private schools, on average;

c) it is better to educate than imprison;

d) education is the only modern means for social mobility.

Bringing down the Temple of Dagon

I listend to Radio 4's Any Questions? last Saturday and a question about bankers' bonuses reared its lovely head. And then the pundits fell down, one after another.

I can't answer the conundrum about the sound of one hand clapping, but I sure heard the sound of punches being pulled. Perhaps some of the speakers have banker friends; perhaps some are hoping not to alienate the Masters of the Universe in the weary stagger up to a General Election. But here's what I'd like to have said, and it proceeds from a simple question:

Did the bankers know the likely consequences of their actions?

If they didn't, they are incompetent and instead of dithering about the threat of the RBS' board to resign, the government should sack them and all like them. Doctors who are that bad at their jobs would be sued and/or worse.

If they did, they should be jailed. In my view, Max Keiser is not exaggerating when he calls them terrorists. They have wrought destruction on our economies and though the human cost may be hard to assess accurately, it is and will continue to be terrible.

So, why isn't it happening? A number of reasons occur to me:

1. It is convenient for politicians to have a few people earn (sorry, be given, legally steal) vast sums of money. The lucky recipients of this largesse can be taxed at 40% (or even 50% as under today's draft Budget proposals) and still have more than they can possibly eat, drink, wear or stick up their noses. "Tax doesn't have to be taxing", as that wretched radio advert chirrups.

2. Clapped-out politicians may one day be looking for a well-overpaid sinecure, like T--- B----. Best not to be too hard on your potential future employer.

3. Embarrassingly, the roots of the credit crunch are not (not merely) in socialist profligacy, but date back to the early 1980s. It was a so-called Conservative government, supposedly a convert to monetarism, that opened the floodgates of credit and tsunamied the economic "boom". Not a genuine boom, and now a very real bust. Criticising the present hapless bunch too sharply would beg a loud, sustained argument of "tu quoque" ("thou also didst so").

4. Just as an addict is partly responsible for the sins of the dealer, the consumer is implicated in the phoney house price rises and the spending spree. But I say that the Devil has the lowest place in Hell, because his knowledge was greater.

5. Nevertheless, if push came to shove, the bankers could point out that effectively, they were acting as the agents of a government determined to win re-election.

Very well, then. Let us have our punishment - we shall, anyway, and the next generation after us. But they must have theirs - the bankers, the politicians and the Fourth Estate that got too close and too cosy for too long.

Go for it.

Debt: UK economy worse off than USA's

This article from Credit Writedowns looks at the development of debt over a long time, in both the US and UK economies.

Two things stand out (see charts 1a and 1b):

1. US debt (as a proportion of national income) is a worse problem now than in the Great Depression of the 1930s.
2. The UK's debt burden is signficantly worse than America's.

Consumer indebtedness exploded in the early 1980s - see the the first chart on this site. Up to then, it had pretty much kept pace with the growth of the economy generally. This is a major part of how our economic problems have developed - a deliberate loosening of credit to restimulate the stagnant economy of c. 1982. The banks grew fat on the loan-financed consumer boom, and on the inflation of property prices.

Now, our governments are looking for a way out. Mass unemployment and bankruptcies will turn the voters against them, so they have tried to keep the banking system going with loans that future generations must pay off. Insiders will tell you that they don't really know what they are doing, but they are in a panic to do something.

Technically, we are experiencing deflation - the total amount of money plus credit in the economy is shrinking, as lenders and spenders have become more cautious. But just as with Dubai recently, foreign investors are losing confidence in our ability to repay debt, and the dollar and pound have become worth less on the currency exchanges.

In the UK, as in the US, we spend a lot on things that come from outside our economy, and some of them are hard to cut out - energy, for example. So while house and car prices may be coming down, other costs are still rising, in pound terms. And as economic problems continue, it is possible that the pound may have further to fall.

So a combination of a slowed-down economy with price inflation - "stagflation" - is a potential threat to the UK.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

Beware the stock market boom

Another commentator I follow is an American called Warren Pollock. Here he says you should think twice about investing at this time. Companies raise cash from you by offering shares; now they have money, and you have hope.

In 1999, I attended a monthly meeting for brokers where a representative from one of the investment houses gave his views on the boom in technology shares. According to him, what we we were seeing was nothing to what would come after - the "super-boom". This was what we were to think, so we could advise our clients to buy into his company's technology fund.

Fund management companies earn a percentage of the money invested with them, so according to them it is always a good time to invest - the bigger their fund, the bigger their earnings.

If you are an investor who bought your shares through a stockbroker and you got in at the right time (low price), you need to get out at the right time (high price), so you need another buyer who thinks the price will go even higher. If you bought via a collective investment (e.g. the unit trusts that underpin most ISAs), then you can simply sell your units back to the fund - which means the fund has to find the cash to give you. And if the fund doesn't find new investors, it will shrink. So, maybe, that's the time to send their rep round to the brokers.

So you can see that at least two groups of people have a vested interest in encouraging optimism in you, even when they may not feel it themselves.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

Can we trust government information?

This snappy clip from the Mint.com blog (tip of the hat to Nathan's Economic Edge) examines official U.S. unemployment criteria and argues that the real jobless rate is not 10% but 17%.

As governments on both sides of the Atlantic continue to flounder, perhaps we can expect more misleading information and carefully-biased definitions. The inflation rate looks like another good candidate for this kind of treatment.



DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

Britain faces stagflation, says Walayat

Sheffield-based market analyst Nadeem Walayat argues that Britain's debt burden will continue to increase, accompanied by inflation as the government prints more money and the pound weakens against other currencies. Interest rates will have to rise to attract further lending to the UK, and the result will be economic stagnation.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

China takes the long view

From Pension Pulse:

Keith thinks that all this talk of excess capacity in China is missing the bigger picture. He told me that China is planning and preparing for the future so they have every reason to over-invest now and build up their infrastructure aand stockpile the resources. It makes sense when you think about it; they saw all the mistakes the Western world made and decided its best to be better prepared for the future.

There are still problems in China, most notably the disparities between the rural and urban population, but they're making leaps and bounds in almost every area, including clean energy where China is securing first mover advantage in the market for renewable energy.

Could Japan inadvertently start a run on America's credit?

Florida-based professional investor Karl Denninger comments on a rumour that Japan is considering selling U.S. government bonds ("Treasuries"). He reflects that such a move could begin a run on U.S. Treasuries, and the largest holder by far is China, who some think may have up to $1 trillion of U.S. debt.

A selloff would put pressure on the U.S. to raise interest rates, and this could have a domino effect in other countries. Higher interest rates make businesses' finance tougher, as well as hitting their customers' disposable income and therefore reducing demand for goods and services. So a crisis of faith in America's ability to repay its debts, and to maintain the exchange value of the dollar, could plunge the world economy back into recession. The investment outlook in this scenario would not be positive.

Denninger is a long-standing Cassandra on the U.S. economy, but he has a fairly sizeable following in the American personal investment community and despite his tendency to express himself in stark terms, his views and information should not be lightly dismissed.

A further reason to take him seriously is what has been happening between China and its U.S. debtors. It's been said some time ago, that China has been selling the debt of U.S. States and corporations in favour of U.S. Treasuries, because the latter are fully backed by the American Government. In retrospect, this seems to have been a very prudent move, since a number of U.S. States are now having significant difficulty in balancing their budgets, owing to a shrinking tax income and rising bills for unemployment benefit. It's understood that China has also been selling longer-term Treasuries to buy shorter-dated ones, because the latter offer an earlier exit should America's credit rating and currency weaken. So the notion that China might suddenly need or want to sell off Treasuries, is not entirely implausible.

On the other hand, America is China's best customer and if the dollar fell sharply or consumer spending reduced even more severely than it has already done, this would hit Chinese exports and increase unemployment in China, which is already a significant problem. It is in both parties' interests to manage the situation. The wider picture, many believe, is a long economic decline in the West as the East develops markets closer to its home, but at this stage everyone will prefer an ebbing tide to a tsunami in reverse.

Perhaps we should instead expect a slowing in the rate at which U.S. debt to China is increasing; and maybe an increasing reluctance on the part of the Chinese to purchase new Treasuries when the old ones mature.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

News: North Korea steals from savers

See Denninger.

India: reasons to be cheerful?

A briefing from SimplyBiz (the IFA support company) gives reasons why India may be an economy worth watching in years to come.

The demographics are in favour (half are under 25), the system is entrepreneurial and there is a large class of well-educated people.

The country has not yet adequately developed the infrastructure to support a booming industrial economy, but the government intends to spend $500 billion in the next five years to remedy this - and half a trillion dollars buys a lot more in India.

DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.

Is inflation on the way?

According to one commentator I follow, Japan has been pumping extra money into its system, seemingly with a view to making its currency weaker, which would make its exports cheaper and so stimulate extra demand.

If that was the plan, the first part of it seems to have worked, except in weakening the Yen vs the US dollar. The dollar went lower on world currency exchanges and Mr Pollock's reading is that the markets have started to wonder whether America will seek to do the same as Japan.

Pollock compares this situation to the beggar-thy-neighbour system between the two World Wars, when countries imposed tariffs on each other's exports to protect their own industries. Devaluing currencies was not so easy when they were backed by gold; now, nations can more easily expand their money supply to create inflation.

If other countries follow suit*, then the relationship of money to real things will alter and people will look to get rid of cash and buy things that will hold their value. Perhaps this is one of the factors behind the rise in the price of gold, but there's lots of other ways we could invest our money. Few are guaranteed to counter inflation, except products like National Savings Index-Linked Certificates; and even there we have the question of how the Government calculates the rate of inflation.

It is unsettling for the ordinary saver. Just when it seemed that "cash is king" and the prudent, frugal person was going to be rewarded by seeing prices drop (look at houses, cars, cruises, TVs and computers etc), the value of his/her money may be hit by inflation once again.

UPDATE (1st December):

* North Korea has just done something far worse. It has replaced the old currency with a new one, but only allowing a certain amount of the old to be changed into the new - effectively, a robbery of the larger saver.

UPDATE (4th December):

Koreans burning old money in protest, Korean government easing restrictions on converting currency (BBC) - (hat-tip to Credit Writedowns)
DISCLAIMER: Nothing here should be taken as personal advice, financial or otherwise. No liability is accepted for third-party content, whether incorporated in or linked to this blog.