Tuesday, July 31, 2007

Jim Puplava's interview with Richard Bookstaber

Richard Bookstaber's interview on Financial Sense (21 July - audio file) was interesting. He discussed the derivatives market (which is the subject of his book, "A demon of our own design"), in which he has been intimately involved. It's a long interview and I'll just pick out one or two points.

Derivatives are financial bets. Portfolio managers use them as a kind of insurance, which then means that they can safely (they think!) increase their exposure to equities.

But derivatives are complex, and can have unexpected effects. For example, in October 1987 there was a sizeable drop in the stockmarket, and as the prices went down, automated trading programs noted the crossing of pre-set thresholds and this triggered more selling, which took the market below other programmed thresholds, and so on.

Also, to work properly, the derivatives market needs to be "liquid and efficient". Well, when the major turmoil was happening as just described, people held off buying back in - the scale had scared them. So they weren't doing what the system expected them to do, and this change in behaviour meant that there was less support at certain price levels than the system assumed.

Another way in which the system became inefficient at greatest need, was that certain classes of asset behaved in an untypical fashion. For example, normally bonds move together, and in the opposite direction to equities; but in 1987, when it looked like major disaster, poorer-quality bonds fell as though they were equities (because of fear of their defaulting), whereas Treasury bonds (backed by the government) rose.

I have heard that in times of stress, people make unusual mistakes, such as confusing left and right, and it seems that the derivatives market has similar potential in extreme situations. You can't tell how people will react under great pressure.

Then there's "black swan" events that haven't been factored-in, but can still happen, such as Russia's decision to default on its loans, which very nearly did for Long Term Credit Management and much more besides.

On top of that, there's the question of leverage, i.e. borrowing that greatly increases the risk and returns of an investment. The current debacle re mortgages packaged as interest-yielding investments stems from the fact that not only are the packages leveraged by a factor of 10 or 20 to 1, but the hedge funds that bought them might themselves be leveraged by a factor of 5, so magnifying the basic risk of sub-prime lending by a multiple of 50 or 100. So when things go wrong, they really go wrong. As we now see.

There is also the question of inadequate information about derivatives. The method of accounting was originally developed to track rolling stock for railways, not for super-fast, computer-based trading. The data available may not be what you need to assess the situation properly, and will almost certainly be out of date in the moment-to-moment market changes. Bookstaber thinks we need to use modern technologies to get the right data out of the system fast enough to make sensible decisions.

And in assessing risk, people's memories are too short. Fund managers may be too young to remember really bad times like 1989-91, so run the risk of complacency.

Speaking of age, there's a demographic risk, too: the baby-boomers are coming to the point where they'll want money out for retirement, and maybe the market hasn't fully realised this change in the financial climate. It could be a "slow burn" crisis like the one that hit Japan, lasting maybe 15 or 20 years.

Now, many of these periods of turbulence probably don't impact on the individual investor, says Bookstaber; the private investor should buy and hold, not panic.

However, a systemic risk that could have really serious consequences is the possibility of a major failure in the mortgage and credit markets, which could then roll on to the banking sector.
Yet again, we're back to the banks, credit and the money supply. How ever did we come to think of bankers as responsible people!

Anyhow, listen to the audio file and see if I've represented it fairly. And buy the book if you think it's relevant to your line of work or investment.

Dow survey update

One more day and we'll stop - thanks for your responses. We've seen a little bit of a rally in the last 36 hours and so far (12.35 New York time) the Dow is down 2.55% from its 25 July close. Pessimism is also down a bit - less than two-thirds expect the Dow to be below 13,000 at year end.

Any more votes?

Dow value afterthought

...and if we remember the heady close of December 1999, before tech stocks burst, the Dow was then at 11,497.12. We've had 7 years and 7 months elapse since, with an average growth of just under 2% compound per year. Adjusted for inflation (or available bank deposit interest rates), we've actually fallen behind; or, from a different point of view, we're not so wildly overvalued.

Actually, what I suspect has happened is that the balloon has a tear in it, and has been kept from falling to earth by massive amounts of extra monetary hot air; but "in real terms" we're still stuck somewhere in 1999. In short, we haven't yet faced up to the problems of our economy.

To use a different analogy, we're still drinking, in order to put off the hangover. But maybe there's lots more "booze" left (i.e. the Fed's printing press, aped by the Bank of England and others) and our "livers" (the real economy of production and jobs) will hold out a while longer.

It's not a strategy I'd recommend. I wonder what you think.

What should the Dow Jones be worth?

The Dow closed yesterday at 13,358.31; ten years before, it stood at 8,254.89. That's a compound annual growth rate of 4.93% (less, when you adjust for inflation).

Or if you take it from the big, big scare of Monday 19 October 1987 (close: 1,738.74, down 508 points from the previous Friday!), it's an average 10.88% compound per year. Does that seem too hot a pace? Unsustainable? But remember that we're starting that run from a real panic. If we took it from the happy close of the Friday before, the average becomes 9.53%.

Still too hot? If nearly 20 years isn't enough to establish a sensible long-term trend, let's look at an even longer period: 30 years from 30 July 1977. Then till now, the Dow's capital growth averages out at 9.45% compound per year. The market's folly can outlast your wisdom.

"Two views make a market", and that's it. Mr Market is making his wares available to you - will you buy at today's prices? (I wouldn't - but obviously others will, or the market would be lower.)

You can play with the figures yourself, on this fine page from Yahoo! Finance.

And please click on the poll opposite, to give your prediction for the year's end.

Have I got my sums wrong - or right?

Bill Bonner, in The Daily Reckoning Australia yesterday, quotes Paul van Eeden as saying that gold has kept pace almost perfectly with inflation since the 1920s.

My post of 29 July did some figures with US gold stocks, the price of gold and the money supply, and came to an arresting conclusion. A kilo of gold costs x dollars, yet at that price, all US gold could be bought for 1/66th of all US dollars. There'd be a huge pile of spare paper money left over, completely unrelated to gold.

From one point of view, the current gold price is not surprising, if gold is merely one tiny part of the overall economy governed by the dollar system. Yet the ratio in the previous paragraph - 1:66, which is the same as 1.5 cents to 1 dollar - is almost exactly what The Mogambo Guru (Richard Daughty) said is the difference in purchasing power between one modern dollar and one 1913 dollar. According to him, the modern dollar is worth two 1913 cents.

Perhaps Doug Casey is right: if trust in the dollar collapses, gold could be "going to the moon".

We need bad times

iTulip has just issued its latest email newsletter - I do suggest you subscribe, especially since it's free.

Their thesis this time is that the Dow will NOT continue to rise much, because the private investor isn't going to come in and be fleeced again. It's not just "once bitten, twice shy" but the fact that money's getting tighter (energy and food costs rising, etc) and the value of assets (especially houses) is in question. On the other hand, iTulip are not doomsters, either.

My view, for what it's worth, is that we have to wait for something unexpected to trigger a real correction, but the sooner it comes, the better. While our governments put off the evil day with borrowing and monetary inflation, our productive capacity is being exported. One firm I know is having an (atypical for here) bumper year; but whereas once their business used to be moving other people's machinery from one site to another, now they're shipping it abroad. How do you make a living if you sell your tools? Even administrators in bankruptcy can't force you to do that. But the economic folly of our rulers can.

In the British Midlands where I live, I've heard engineers complain (like Lewis Carroll's Oysters) about industrial decline ever since I attended a British Association for the Advancement of Science conference in 1977, but our leaders have plodded on, chatting comfortably to each other like the Walrus and the Carpenter, while the Oysters' numbers dwindled. I drive past new man-about-town city centre flats where only 17 years ago I was talking to a self-employed woman turning metal parts. The mighty Longbridge car plant is a broken shell, and the surrounding area is turning over to drugs, alcohol, crime, teenage gangs, domestic abuse and all the rest.

The system continues apparently unaffected, but I think it's a fool's paradise. Only last night, I watched a TV programme about India. The city of Bangalore (home to tech giant Infosys) is modernising and booming; its university aims to attract the world's best. When industry and learning have gone East, what exactly will the West have that anyone could want? We'd better start making it again now, and at a price that our trading partners are willing to pay. Or at least, make sure we have what we need to produce what we consume, as locally as possible.

Yes, currency devaluation means inflation and recession, but better that than a full-on, generation-long depression. We've got to take the nasty-tasting medicine while it can still make a difference. But who will force us to do it?

The US Presidential elections are still a year away, and the new President won't take over until January 2009. In the UK, we have a Prime Minister we didn't elect, who could choose to defer the next General Election right up to 2010. If we're going to get the right people to deal with the heavily-disguised crisis we're in today, the economic issues will have to break out into the open within the next 12 months.

In the meantime, investors must prepare for turbulence.

Sunday, July 29, 2007

Gold and M3 (US)

According to GoldPrice, gold today is going for $21,242.64 per kilo. The World Gold Council says that as of June 2007, the USA holds 8,133.5 tonnes of gold. So that means America's gold stock should be worth $172.777 billion.

This site says "as of early 2007, M3 is about $11.5 trillion", which is 66.56 times the value of US gold reserves. So if everybody insisted on having their money out in gold, which they can't do any more, they'd get about 1.5 cents-worth back for every dollar they were owed.

I suppose that's what inflation means.


Wikipedia says, "As of 2006 the required reserve ratio in the United States was 10% on transaction deposits (component of money supply "M1"), and zero on time deposits and all other deposits."

If reserves and loans were all the money we had, then using a ratio of 1:10 for all of it (and it's worse than that!), the nominal value of bank reserves would be something like 6-7 times what they could buy in gold at current rates. Surely I've got this wrong?

Bargain hunting

I've been looking for something to illustrate how you can take advantage of pessimism.

Here is a blog about Consett, a small town in the North of England that was shattered by the closure of its main employer, a steelworks. The writer says (28 Dec 2006 entry), "I came across a copy of the Consett Guardian from 1983 - the year when you could buy a house for just £10,000..."

I looked on NetHousePrices for houses sold during 2006, to get an idea of the cheapest in a whole 12-month period. A terraced house is one joined to other houses left and right: the lowest individual sale price I could find for last year was £42,000. Yes, it's much lower than the national average for such properties (£186,316 according to the 9 March 2007 article on this site), but had this house in Consett sold for that £10,000 in 1993, the new owner would still be looking at a capital gain of 6% compound per annum. The article just mentioned gives an average Northern terraced property price as £125,058, and the Consett street that had most (27) sales of such properties last year showed an average price of £127,733.

So what happened to Consett? Their MP Hilary Armstrong explains:

...contrary to predictions the people of the district did not let the town die. After the closure, Project Genesis was launched to revive the local economy and regenerate the town. New industries have arrived, such as Derwent Valley Foods and aerospace company AS&T and unemployment is now down to the national average level. The site of the Steel Works has been reclaimed with new housing, a retail park and environmental landscaping. There is still a long way to go but Consett is still very much alive and is now seen as a successful case study in regeneration.

Financial experts like Bill Bonner and Marc Faber have revealed their purchases of cheap agricultural property in selected areas around the world; and sure enough, there's people out there now in the US who have spotted the opportunity in depressed housing areas like Detroit.

The worst hasn't happened yet, in any case - but think of bargains, when others can only see ultimate defeat. Remember Sir John Templeton.

And another thing...

Surely, people who can't afford their mortgages don't have big investments. So aside from default losses impacting on portfolios, I don't see a great need to sell one's holdings (or a wonderful opportunity to buy).

But when the market is worried, private investors tend to get rid of their stocks, which as they drop in price are snapped up by the patient, crocodile professionals. Watch for data on the changing proportion between private and institutional holdings - please let me know when you spot it.

Pessimism overstated?

Seeking Alpha has a useful round-up of stats and news items on the US housing debacle.

I shall try out a contra-contrarian position here.

It's obvious that adjustable-rate mortgages (ARMs) will pose a problem for American borrowers as they emerge into a variable and now-higher interest rate environment. We are approaching a peak in this process around October/November and again, that's known about, so with all the belated hoo-ha in the media now it should be factored-in to the market.

The packaging of mortgages into collateralized debt obligations (CDOs) and their sale to perhaps naive institutional investors, is now better understood and has started a bout of worry that has spread to prime lending, too. So we have a reasonable dose of pessimism in the mixture, with Michael Panzner and Peter Schiff ensuring we're taking the medicine regularly.

One of Michael's posts last week included a detail of a "charming colonial" house in Detroit going for $7,000. Over here in the UK, somebody screwed a 0 to the side of our house prices over recent years, and if I was shown a residential property fund that would snap up streetsful of properties like the one in Detroit and wait for the turnaround, I'd be tempted.

When recession hit the UK in the early 80s, house prices plummeted in Consett, a Northern steelworking town where the local works - the main employer - closed and unemployment rose to 36%. Now the median price is £152,000. This was a working-class town, not a fashionable area, and at that time (1981) the national average house price was £24,188. So even if you'd bought a house in Consett at that price (and because of unemployment and deep pessimism, it would have been far less), you'd have made a 7.3% compound pa capital gain in the 26 years since - plus income from rent, less expenses.

I don't think the housing market runs the economy, it's the other way round. When we have a real economy, our wealth will be more secure. Perhaps the USA needs to wait for a fresh President who can take tough decisions early, in time for the fruits of his/her labours to show and be rewarded with a second term.

It's early days, but the pessimists in my Dow poll (see sidebar) have the upper hand. I still think there may be a small bounce by the end of the year, when we've digested all the bad news and are ready for a sweet. Please cast your vote!

Saturday, July 28, 2007

Who's got the gold?

According to latest World Gold Council figures (June), these are the biggest gold hoards held by individual nations and organisations, in descending order (countries not listed have less than 1% each):

United States, Germany, IMF, France, Italy, Switzerland, Japan, ECB, Netherlands, China, Taiwan, Russia, Portugal, India, Venezuela, Spain, United Kingdom, Austria, Lebanon.

The first 3 above account for nearly 49% of the world's stock, with the USA alone (since the dollar is the world's reserve currency) owning 26.77%.

The Central Bank Gold Agreement organises the buying and selling of gold by its member countries, to provide some price stability. Since the start of this year, the main change has been Spain's sale of 19.11% of its stock.

Figures are available from Q1 of 2000 onward. From then until now, here are the significant moves:

SALES (expressed as a percentage of each country's stock held as at Q1 2000):

Switzerland 50.19%
UK 47.25%
Portugal 36.94%
Spain 35.60%
Netherlands 29.71%
Austria 29.14%
ECB 14.14%
France 11.37%
Russia 4.95%
Germany 1.33%

On average, all gold-holding countries reduced their stock by an average of 9.89% over these 90 months; signatories to the Central Bank Gold Agreement reduced theirs by around 16 to 17%.

ACQUISITIONS (expressed as a percentage of each country's stock held as at Q1 2000)

China 51.89%
Venezuela 14.71%
Japan 1.55%

Venezuela has less than 360 tonnes; Japan hasn't added much percentage-wise. So the odd man out is China. China now has 600 tonnes and is in 10th place, rising from 395 tonnes (16th place) in 2000. It made major purchases of about 100 tonnes each at the end of 2001 and 2002.

Peter Schiff: US Treasury less creditworthy

Peter Schiff in FXStreet today mounts a vigorous defence of his record of warning us that subprime problems would spill over into other credit areas. The market appears to be waking up to this, but he says there's worse to come:

A much larger disaster looms for holders of U.S. dollar denominated assets in general. It will not be long before our foreign creditors realize that Uncle Sam is the biggest subprime borrower of them all and will similarly mark down the value of its debts as well.

Once again, why has Britain recently become the third-largest holder of American debt? Our exposure is now 3 times higher than about a year ago.

New Growth Theory and Friedman's "Flat Earth"

Here's an interview with Thomas Friedman in Yale Global Online (18 April 2005). Some quotes, with the issues I see in them italicised:

Lean thinking:

Wal-Mart doesn't make anything. But what they do is draw products from all over the world and get them into stores at incredibly low prices. How do they do that? Through a global supply chain that has been designed down to the last atom of efficiency. So as you take an item off the shelf in New Haven, Connecticut, another of that item will immediately be made of that item in Xianjin, China. So there's perfect knowledge and transparency throughout that supply chain.

International trade vs local social costs:

The consumer in me loves Wal-Mart... And not just me... Some lower-income people are stretching their dollars further because of Wal-Mart...The shareholder in me... loves Wal-Mart... The citizen in me... hates Wal-Mart, because they only cover some 40 percent of their employees with health care... [For the rest,] we tax-payers pay their health care. And the neighbor in me... is very disturbed about Wal-Mart. Disturbed about stories about how they've discriminated against women, disturbed about stories that they've locked employees into their stores overnight, disturbed about how they pay some of their employees. So... I've got multiple identity disorder, because the shareholder and the consumer in me feels one thing, and the citizen and the neighbor in me feel something quite different.

New Growth Theory issues:

What is the mix of assets you need to thrive in a flat world? Money, jobs, and opportunity in the flat world will go to the countries with the best infrastructure, the best education system that produces the most educated work force, the most investor-friendly laws, and the best environment. You put those four things together: quality of environment that attracts knowledgeable people, investment laws that encourage entrepreneurship, education, and infrastructure. So that's really where, in a flat world, the money is going to go.

And I don't really believe much in foreign aid because I think, at the end of the day, that's not how countries grow and get rich. But to the extent that you are going to give foreign aid, it should be to inspire, encourage, and help develop one of those four pillars for whatever developing country you're dealing with. But I do believe in trade, not aid. I think that axiom still applies, even more so in a flat world.


The flat world is a friend of Infosys and of Al-Qaeda. It's a friend of IBM and of Islamic jihad. Because these networks go both ways. And one thing we know about the bad guys: They're early adopters...

Trade, nationalism and peace:

...what I call the "Dell Theory" – you know, Dell Computers. The Dell Theory says that no two countries that are part of the same global supply chain will ever fight a war as long as they're each still part of that supply chain... here's what I predict: If you do go to war and you're part of one these supply-chains, whatever price you think you're going to pay, you're going to pay ten times more. Once you lose your spot in the supply chain because you've gone to war, the supply chain doesn't come back real soon. They're not going to. Fool me once, shame on you; fool me twice, shame on me. That's why you really risk a lot. And that's why these supply chains now really mean a lot. They're the new restraints.


The anti-globalization movement ... is basically dead today – because China and India have embraced this process and this project... The anti-globalization movement... [are] all still talking about the IMF and the World Bank and conditionality – as if globalization is all about what the IMF and World Bank impose and force on the developing world. Well when the world is flat, there's a lot more globalization that's about pull. This is people in the developing world – in China, Russia, India, Brazil – wanting to pull down these opportunities.

Intellectual property rights:

Look at what happened in [India] with intellectual property law... there's no question that we did want India to have intellectual property protection to protect our products... But what it turned out was that a lot of Indians wanted it as well because they become innovators themselves. They are now plug-and-playing in this world and they want the intellectual property protections for their innovations.

Failure of Western technical education:

There is a crisis. We're not producing in this country, in America, enough young people going into science and technology and engineering – the fields that are going to be essential for entrepreneurship and innovation in the 21st Century. So we're at a crisis – it's a quiet crisis, as Shirley Ann Jackson from the Rensselaer Polytechnical Institute says. If we don't do something about it, then in 10 to 15 years from now this quiet crisis will be a very big crisis. And that's why my friend Paul Romer at Stanford says – and I totally agree with him – is a crisis is a terrible thing to waste. And right now we're wasting this crisis.

New Growth Theory: should we pay handsomely to make ideas free?

When Tony Blair became Prime Minister, his slogan was "education, education, education". We thought he was merely reflecting our discontent with schools, but now I'm not so sure.

In 1994, Gordon Brown was quoting a new economic theory by - google him up - PAUL ROMER. Here is a 2001 interview in Reason Online with Romer. It turns out this may be to New Labour what Sir Keith Joseph’s espousal of monetarism was to Margaret Thatcher’s premiership. “New growth theory” is by Paul Romer, and bears on:
  • education (a key slogan in Tony Blair's election campaign)
  • skills training for workforces (a UK government initiative currently advertised on TV)
  • intellectual property rights (relevant to design and patent theft by foreign manufacturers)
  • free trade/globalisation
It has some intriguing aspects, but could also be a gift to the anti-big-business Left.

A core debate in this theory is the ownership of knowledge. Romer says that price is both an incentive to the producer, and a means of deciding who gets the product (or what product they choose). An example he gives in his interview is the life-saving treatment for children with diarrhea in poor countries:

...the efficient thing for society is to offer really big rewards for some scientist who discovers an oral rehydration therapy. But then as soon as we discover it, we give the idea away for free to everybody throughout the world and explain "Just use this little mixture of basically sugar and salt, put it in water, and feed that to a kid who's got diarrhea because if you give them pure water you'll kill them."

So with ideas, you have this tension: You want high prices to motivate discovery, but you want low prices to achieve efficient widespread use. You can't with a single price achieve both, so if you push things into the market, you try to compromise between those two, and it's often an unhappy compromise.

Ideas can be duplicated easily and cheaply, but they often cost a lot of money to come up with. For example, pharmaceutical firms do hugely expensive R&D - could they recoup the cost of successful solutions, and all the unsuccessful ones, via a prize competition? What happens if they go bust a yard before the finishing line?

What about areas where the humanitarian argument may be weaker? What if some Far Eastern car factory comes up with a tweak on, say, the Wankel engine design and goes into very successful (and low-labour-cost) production, paying nothing to the people who came up with 99% of the ideas? Sir Tim Berners-Lee (may we never forget his name) gave away the Internet, but should all hard-won knowledge be free?

And what exactly are the implications of a "knowledge economy"? Does State-organised education, with its top-down management, encourage the development of the creativity we need? Do we need 50% of our young people to go to college? Should they choose their subjects, or be told what to learn? Should they be given incentives to study in areas that are thought to be important? How far should we be prepared to fund research that has no immediately foreseeable practical application?

Romer is certainly right in saying that a smart workforce is an asset (and a smart management - we could do with some de-Dilbertising), and that there's lots of potential in continuous, incremental improvement. "Lean thinking" may buy us time in the destabilizing conditions of a globalized market - if we use our brains to improve what's in front of us at work every day, we may not go bust quite as fast as the doomsters fear.

But as the economist himself admits, it's a can of worms.

Friday, July 27, 2007

A Bluffer's Guide, Part Zero

The new British Prime Minister, Gordon Brown, has a reputation for being fearsomely intellectual. In a speech back in 1994 he referred to "post neo-classical endogenous growth theory", a shut-'em-up phrase if ever there was one.

Except with Members of Parliament, who are no strangers to bull, many of them having buffed up their chatter muscles at Oxford and Cambridge. Michael Heseltine (Pembroke College, Oxford), then President of the Board of Trade for the Conservative government, suspected Brown (Edinburgh) had gotten this showy material from his economic adviser, Ed Balls, and drawled, "It's not Brown, it's balls."

For in most cases, you can say it more simply. Or if you prefer, you can go ahead and hit people over the head with it, but be prepared to clarify if challenged.

So I've looked for relatively simple explanations of EGT (shall we who are now in the know agree to use this outsider-excluding acronym?). Here's what I've got so far:

Endogenous growth theory - from Investopedia

And here's something else worth reading, by Gladys We. It is a few pages long, but it explains it well enough so I can understand it - I think.

Politically, it seems EGT can be used as an argument against free trade and intellectual property rights. For the latter, see page 5, point 5; okay to steal someone's ideas, refine them and then copyright them. I'm sure there's Far Eastern firms that'd be fans of this policy; something to advocate amiably over the pre-prandial sherry in the Senior Common Room - until you put it into practice by plagiarizing the Master's work.

UPDATE (Saturday morning):

It's now called "new growth theory". EGT is so last evening.

October 1987 revisited

I'm trying to work out whether making an historical analogy with 20 years ago is valid.

Let's have a look at what has happened to prices. Cliff D'Arcy in The Motley Fool (22 May 2007) does a very informative comparison between houses and the FTSE 100. He reminds us that although the FTSE-100 dropped dramatically on "Black Monday" (19 October 1987), it ended about 2% higher over the year as a whole. If we take his figures for 1987 to 2006, house prices increased 287%, and the FTSE 263%. This would suggest that house prices and stock prices have increased about equally (though houses cost money to run, whereas shares pay dividends).

Are British people over-borrowed? This Bank of England research document from September 2004 says not, in relation to house prices. Yes, debt-to-income has gone up, but interest rates are now low. And despite its name, the latest survey from UK site HousePriceCrash indicates a general belief that house prices will continue to rise in the months ahead. (But recent first-time buyers will be more vulnerable, having little equity and probably a high income multiple for their loan.)

I find the monetarist arguments intuitively persuasive, but I'm puzzled by the disparity between prices and monetary inflation. Using the UK's M4 stats, over the 78 quarters from Dec 1987 to March 2007, the average annualized increase in the money supply is about 10.48%. Compounding that figure, we get about 7 times more borrowed money in the system today than in 1987. Yet houses and shares are only 3-4 times higher.

What does seem clear is that we have borrowed more in relation to income, and this makes it even more important not to lose your job, or be hit by high interest rates. It's worrying when you have to depend on things carrying on as they are, indefinitely.

2007 = 1987?

Greg Silberman in Safe Haven yesterday uses the chartist approach to suggest an analogy with the lead-up to the 1987 crash.

I don't know. Over the late '86/early '87 period I watched my little investment soar and began to wonder how everybody could get rich at the same time. I heard reports that people were borrowing against their houses to trade, and schoolboys were making money on the market. I don't read quite that degree of crazy optimism and greed today.

Maybe the difference is reflected in the degree of monetary inflation. In the UK, the 3 years leading up to October 1987 showed an average annualized increase in M4 of 18.59%, compared with an average 12.07% annualized over the 12 quarters to March 2007. And over here at least, people are much more leery of investments and pensions than they were then.

But there's loads more debt now. It could be that a drop happens, not because of a change in investor confidence, but on account of running short of spending cash.

Cycles and charts

For the analytical, here's an essay on Kress Cycles in Safe Haven.

This, together with Kondratieff cycles and other patterns used by market chart-interpreters, has one flaw to my not-quite-so-mathematical mind: predicting human behaviour involves feedback loops. If I secretly write down what I think you're going to do tomorrow, I could be right every time; but if I reveal my thoughts to you, that changes the situation. It's a sort of Heisenberg uncertainty principle: to observe is to be involved, and therefore part of the nexus of causes.

Having said that, human behaviour does have patterns, and I believe some have theorised that the growth of our brains is in response to the competition to predict the other person's behaviour better than he can predict yours.

Gold - or cash?

Brady Willett in Safe Haven (yesterday) warns us off some "bright ideas" for preserving wealth in a market drop. He notes that gold is a hedge when everyone wants out of cash, and that's been quite some time.

I guess his position is close to that of Marc Faber, who said recently that all asset classes are inflated and on the whole, he'd prefer to stand on the platform rather than get on any of the waiting trains.

Is the credit system cracking up?

Bob Hoye, in Prudent Bear (yesterday), discusses "the Unholy Trinity of central banking, derivatives and artificial rating of credit". He sees these as systemic risks - I'll say more about that when I come to Richard Bookstaber's interview on Financial Sense last Saturday.

Should US Treasury bonds be downgraded?

iTulip's President, Eric Janszen (Wednesday) goes over the now-familiar arguments for a coming period of US recession/inflation, caused by the trade, budget and fiscal deficits.

He also links to Paul Farrell's article in Marketwatch (Monday), which questions America's creditworthiness as a result of having to finance the war in Iraq. Maybe we're going around the same track as with Vietnam, which burned up money (I remember a contemporary American cartoon of a steam engine with dollars being shovelled into the firebox).

Has the UK tied one of its little boats to the anchor chain of the Titanic? I calculate its loan to Uncle Sam's Treasury to be worth $2,757.65 per capita (British heads), or £1,345.99.

My wife and I could have a nice little holiday on that, which would be more fun, or a day at the races, which might get us a better return.

Desperately holding down gold

Jim Willie of the Hat Trick Letter thinks that bank selloffs of gold are to make dodgy bonds look better than they are. If the mortgage bonds unravel, there's a lot of fast talking to be done by banks and brokers.

More on US housing woes

An informative piece in Dr Housing Bubble on the various factors that are turning the housing market upside down.

If I read the first graph rightly, there's a peak in the numbers of temporarily-fixed US mortgages that are due to come back onto the current variable rate in November this year, which suggests we may have a difficult autumn ahead. Further cutbacks in discretionary spending, presumably.

Bank of England investment in US Treasuries; gold

Let's combine the recent mystery about Britain's massive investment in US Treasury securities, with the worldwide asset bubble.

This is Doug Casey speaking to the Agora Financial "Rim of Fire" conference in Vancouver this week, on YouTube (thanks to "Daniel" for alerting me to it).

His view on American bonds? "A triple threat". Why?: (1) interest rates are very low and are going to become very high; (2) credit risk: he says he would not wish to be a lender now, with so much debt everywhere -he refers to a possible "financial credit collapse"; (3) currency risk - he says dollars say "IOU nothing", and compares them to the Argentinian peso 10 years ago.

So, why has the UK invested an extra $112 billion in US-dollar-denominated Treasury bonds, between June '06 and May '07? To dramatise this figure somewhat, let's look at the Forbes list of the richest people in America (Sep 2006): the top 5 billionaires are worth $155 bn between them. Britain is now into America for $167.6 bn. The increase in the last year alone is more than the net worth of Bill Gates and Warren Buffett combined. I wonder (rhetorically) whether they would bet their entire fortunes on US Treasuries?

We already know what Casey thinks about cash held in dollars, and he regards stocks and property as overvalued, too.

So what does he favour? Gold. "It's not just going through the roof, it's going to the moon". He's been a gold bull for the last 7 years. He picks mining stocks, but warns that they are very volatile, even more than Internet stocks. But there are other ways to own gold.

Meanwhile, is there anyone here in the UK who is willing to grill the supposedly independent Bank of England (it wasn't the British Treasury, after all, it seems) about the rationale for its vast punt on "triple risk" US bonds?

Let's finish with Bill Bonner's keynote speech at the same conference, on the difference between the real boom of the Far East and the Ludwig von Mises "crack-up boom" of our inflationary economies:

Thursday, July 26, 2007


Continuing the argument about sovereign wealth funds, what might this portend for US Treasury securities?

If foreign governments pull the rug out, there could be a run on the dollar on a scale that the US government wouldn't dare correct with proportionately high interest rates, seeing how indebted everyone is. The doomsters are probably right that it could happen, which is why everybody will make sure it doesn't.

And such a fall wouldn't be in the interest of creditor nations who still value the trade surpluses they enjoy with Uncle Sam. Many Chinese light manufacturing industries are working on narrow margins and don't want to see their profits disappear through foreign exchange movements (though their State is sufficiently powerful and ruthless to go that way if it wants to). I suspect that China will continue to develop towards heavier industries and gradually allow the trainer-stitching work to go to even poorer countries like Vietnam. Meanwhile, it's in no hurry to kill the US cow while she's still giving milk.

So here's my bet:
  1. For domestic political reasons, the US will not do what is needed to get the economy back on the level. It will continue to borrow but, fearful of its vulnerability to potentially unfriendly foreigners, lean on its friends for more finance.
  2. The US Treasury securities held by China will remain much the same, or even gradually increase in dollar terms, but "ally nations" will increase their holdings proportionately faster. There's not much an emotionally or politically vulnerable British PM won't do for a pat on the back at G8 summits, Bilderberg tie-looseners etc. Goodness knows how much of our future has been sacrificed to the last one's ego.
  3. Creditor nations will increase their sovereign wealth funds, favouring investments that are involved in the supply lines from their manufacturing concerns to our end purchasers. Marxism has moved on: you have to have control of the means of production, but even more so of the means of distribution.
  4. They will also invest in the lines leading towards their industries: energy, industrial metals and infrastructure. I also guess China will explore healthcare, energy-efficiency, food-oriented genetic research and environmental protection. And water. And foreign farmland (Bill Bonner and Marc Faber are really smart). City planning in all its aspects could become really important.
  5. If these countries were private investors, we'd be seeing their portfolios alter their balance between bonds and equities, in the direction of higher risk, higher returns. And like good long-term investors, they will get richer. Maybe eventually, as James Kynge says, demographics and healthcare will eat into this wealth, but it's not going to benefit the West much either way.
  6. In the US and the UK, our collective concern will be how to handle the social disruption in our own societies; our concern as individuals will be how to save and invest while we still can, and how to set up our own children in relative security.

Place your bets

The Dow Jones Industrial Average closed yesterday at 13,785.07. Where will it go? Please see the survey on the right.

Here's an idea: the doomsters may be correct in their analysis, but wrong in their prognosis. If sovereign wealth funds continue to grow, we may see a new type of massive institutional investor, one that has no plans to retire or die. So ownership of American, British and other Western countries' businesses will shift to the East.

Initially, this will seem to make little difference, except that the markets may become better-supported against falls and may trend upwards, long-term (in currency terms; I'm not so sure about inflation-adjusted terms). But the dividends on foreign-owned shares will not accrue to the host countries, and so the US and UK will bleed from two wounds: trade deficits and accelerating loss of investment income.

If small businesses are eaten by big businesses, and big businesses have been taken over by sovereign wealth funds of other nations, the result for us may be not only economic impoverishment, but a form of slavery, since we will have lost control of our means of production. All we will have left is our labour, and in world terms, you and I are grossly overpaid. There is an developing Eastern middle class that can and will do everything better, faster, harder and cheaper than you. Many of them speak better English than the English.

Look at the businesses these sovereign wealth funds are going for. China: $3 bn for a 9.9% stake in giant US hedge fund Blackstone in May this year, and now (with Singapore) 10% of Barclays Bank (UK); Qatar: Sainsbury's (UK supermarket chain). These investments involve commercial property, finance and retail distribution. I've recently relayed James Kynge's statement that Chinese manufacturing only gets them 15% of the end price; now they're after the other 85%. I shouldn't be surprised if we start to see acquisitions in marketing and advertising firms, too.

What to do? I think:
  • Work hard and earn as much as you can, while you can.
  • Look after your health. Better not to get sick in the first place, than hope for "healthcare" to put Humpty Dumpty back together.
  • Live simply and well within your means. Do you need a car? One that size?
  • Pay off debts as fast as possible.
  • Save and invest.
And if you have time and don't mind potential official surveillance and bullying, give your politicans earache about their incompetence, which is on a scale that to some might seem almost treacherous.

They are the masters now - or will be soon

The BBC Ten o' Clock News last night featured an article about China's purchase of a share in Barclays Bank. I have posted a video of part of Chris Mayer's speech at Vancouver (see below), where he discusses "sovereign wealth funds".

China, India and Japan have enormous surpluses of money from their trade. They have bought US Treasury securities (bonds, i.e. loans to the US), but this is a thing governments do to park money that they might need back in year or two, when the trading balance has altered. Since the US/UK (etc) trade deficits are long-running, these eastern countries can now start thinking like young private investors, in which case equities become attractive - offering income from dividends AND the potential for capital growth.

These countries are turning our debt into their ownership, like an old Punch cartoon where a plumber took his customer's house in payment for his work.

This issue is big.

Wednesday, July 25, 2007

Prohibition: Uncle Sam beat Eliot Ness

Don Boudreaux, of Cafe Hayek fame (see blogroll), writes that Prohibition ended, not because of popular demand, but because the US government was running short of tax money in the Depression.

It's an interesting theory. I have long thought that the UK government is more hooked on cigarettes than the smokers. If they really wanted to ban smoking, they'd start by cutting the tax, so as to wean themselves off financial dependence. But how would they replace the lost revenue?

Familar themes, and a sales pitch (not mine!)

This is NOT a recommendation, but you may be interested in the general trend of thinking it reveals: The Daily Reckoning features a sales spiel for a newsletter from Tim Price, which passes on pessimistic comment on the near future of the markets, and indicates four areas for investment:

"Portfolio insurance"
Infrastructure (e.g. roads, railways)

We are seeing these themes crop up again and again among the contrarians. Though I'm not quite sure what is meant by the first - unless it's futures and options, which make me nervous.

Chris Mayer at Vancouver, on China

"Daniel" has responded to an earlier post re rail revival, to say that Chris Mayer's speech at the Agora Financial symposium in Vancouver has now been put on YouTube. Here it is, with my thanks to Daniel:

Plunge Protection Team trying to keep precious metals low

An extraordinary (to me) comment by Michael Misunas, responding to Michael Panzner's post in Seeking Alpha today - do read it. He says that the US Government's "Plunge Protection Team" has not only punted huge sums into derivatives to support the stockmarket each time it falls significantly, but has recently been rigging the market against gold and silver.

Assuming that you can't buck the market forever, it looks like an opportunity to buy precious metals.

More on US Treasury bonds

Another concise overview by David Galland in today's Daily Reckoning Australia. Part of it goes like this:

Make no mistake, we are in uncharted water; it is unprecedented that the claims represented by the fiat currency of one government - that of the U.S. - have been accumulated in such massive quantities for the reserves of other governments. And we're not just talking China but virtually the world. And the world is getting nervous.

To quote Thai Finance Minister Chalongphob Sussangkarn in his recent address to the annual meeting of the Asian Development Bank in Kyoto:

"Should the financial markets lose confidence in the U.S. dollar, huge capital outflows from the U.S. could lead to a rapid depreciation of the U.S. dollar, and thus dramatic appreciation of other currencies."

This is why I am theorising that the UK's massively increased support for US Treasuries may be an emergency measure by the British Government. Though it has been pointed out to me that this money may have also come from hedge funds and conventional funds - the Treasury stats don't say that the purchases are official.

Another country that has significantly increased its US bond holdings is Brazil (145% up, from $33.3 bn to $81.6 bn). Maybe that's to do with its increasing oil exports. According to the US government's Energy Information Administration, Brazilian production is projected to rise long-term.

Coming back to the Treasury bond stats: of those who previously held at least 1% of total foreign-held US Treasury debt, the top five reductions are:

Caribbean Banking Centres

The top three in this list account for almost $50 bn of the total $72 bn that foreigners withdrew. I thought the conspiracy theorists believed Caribbean Banking Centres were part of the US government's secret plan for supporting the dollar? Perhaps somebody would kindly pay for me to go on a "fact-finding mission" to the Caribbean. Please.

Tuesday, July 24, 2007

UK, US Treasury securities, and blogs (continued)

Well, I've got some sort of response from Iain Dale's commentators, starting with an ad hominem accusation of being emotionally needy (scared, more like!).

Here's my main argument, however inexpertly expressed:

Over the last 12 months, 10 countries have reduced their loans to the US by a combined total of $72 billion; we've increased our commitment by $112 billion, moving us from 10th place to 3rd place in the list of America's creditors. And our own finances aren't that good, either.

America is in hock to foreigners to the tune of 2.18 trillion dollars and rising. Effectively, they're running up a very big credit card bill to maintain domestic living standards. The US Comptroller General has very recently commented that this indebtedness could be used against the US by unfriendly foreign powers.

Our greatly increased support for America's finances is at the cost of some risk to ourselves, because if the borrowing spree continues unabated, we may find we get repaid in dollars that are worth far less than they are today. Can we afford to keep bailing out a spendthrift?

The borrowing is a powerful economic stimulus to China which, despite its relative poverty, is the second biggest creditor to the US. By sending the money back to America in the form of loans (purchase of US Treasury bonds), they avoid having their own currency appreciate. So their wage rates remain fantastically low and they continue to take business and jobs from the West - us included. Think of the transfer of the Swan Hunter shipyard to south India, or the purchase of Rover by China (don't tell me they're desperate to create long-term employment in Birmingham, when the average per capita wage in China is less than £1,000 per year). We're seeing a shift from higher-paid industrial work to lower-paid service jobs - perhaps the economic profile and geographical distribution of the readership of this blog means that it isn't obvious to them. China and others are hoovering up world resources in the dash to industrialise, right down to our iron manhole covers. James Kynge's "China shakes the world" is easy to read and very enlightening about what's going on.

Japan, America's greatest creditor, also buys US bonds to keep excess money out of its own system, so its interest rates are low, so the yen stays low and protects its well-established export markets. Also, a lot of money powering the world's stockmarkets is cheap money borrowed from Japan and invested elsewhere - the so-called "carry trade". All right if it goes on forever - but it can't. You cannot live for the rest of your life on borrowed money.

If currencies were responsibly managed, the trade deficit would cause the US to start to run short of cash, US wages would go down and exports back up, and trade would eventually (if painfully) come back into balance. But the Americans - and others, including ourselves again - respond by increasing the money supply (mostly through bank lending - up another 13% this year on both sides the Atlantic), which leads to price inflation, hence the rise in house prices and the stock markets. But borrowed money has to be repaid someday and then the tide will go out - but this time, we'll be left without much industrial capacity.

There's a fear that to prevent a 3os-style Depression, governments will print money even faster, but this leads to hyperinflation and eventually no one wants the currency at all (cf. Germany in 1923). So we could well have both a slump and high inflation. It may sound dull and technical, but then money is boring - until you haven't got any.

An American Congressional committee recently grilled the chairman of the Federal Reserve (like our Bank of England) and at least one Congressman admitted he realized he didn't understand inflation; the only one who seemed to was Ron Paul, who said that if we can make a living by printing money, we should all quit our jobs and do that. Most of Ron Paul's own investments are in gold and silver; the world's richest investor, Warren Buffett, has been sitting on many billions of dollars of cash for a long time and has recently disclosed that he's hedged by buying into a foreign currency, to protect against financial loss from a falling dollar.

If the value of the dollar (and possibly the pound) starts to collapse through overproduction, we really will notice - it's not just going to be bargain fares to Disneyworld. Americans - rich, expert ones, who manage big funds - are sounding the warnings loudly, clearly and angrily.

The collapse hasn't happened yet, partly because the dollar is the world's standard trading currency. This is changing; already, Iran is demanding payment from Japan in yen, not US dollars. When more countries start to impose similar conditions, the demand for the dollar will drop significantly, and so will its exchange value. China is beginning to de-link from the dollar, in favour of a wider basket of currencies; meanwhile, it's widened the range within which its currency (the renminbi, or Chinese yuan) can move against the dollar. They're not in hurry to appreciate their money, for reasons of international industrial market share; but that's the way the pressure is building.

Although our economy is much smaller than America's, we have (to some extent) similar problems ourselves. Yet here we are, lending money to our bigger cousin. I don't think we can sub him indefinitely, and I don't think we have begun to address the question of our own economic future. Without that, there'll be lots more hoodies to hug.

Michael Panzner relays the alarm

Michael Panzner's latest post discusses a warning from David M. Walker, the nation's chief accountant, about America's vulnerability to potentially unfriendly foreign creditors. This confirms me in my feeling that the recent purchases by the UK of US Treasury securities is extremely significant (see recent posts on Bearwatch).

I have attempted to elicit interest in various quarters, including Iain Dale's influential political blog ("Tuesday open thread", 24 July) but so far I seem to be speaking to the profoundly deaf. Today I submitted the following comment to Iain's Diary, but without much hope of a response - as I have said in an email to Michael Panzner today, the Brits add apathy to financial ignorance:

Okay, one last Cassandra-like call and then I'll admit defeat:

Does it really not matter to your sophisticated political readership that the UK (presumably the Treasury under Gordon Brown) has recently purchased an absolutely massive amount of American Treasury securities, most of it in the last nine months, which quite probably will lose us many billions of pounds through currency depreciation? We have gone in one wild leap from 10th largest holder of American debt, to third place.

The potential downside from this crazy investment (I think it has already lost the equivalent of the first year's interest) worry me less than the implication, which is that the US is using its "special relationship" with the UK to defer (for a short time) the end-stage of a US debt-fuelled global inflationary spiral, with the prospect of a deep economic depression and possibly a wealth-destroying hyperinflation. The problems this would give us make the current floods seem a minor inconvenience.

Or is it that everybody here knows already, and is merely filling the time in the rattling tumbrils with political chit-chat and mutual insult? Is it aristocratic insouciance, or financial ignorance? Surely not the latter, when Americans are discussing their economic problems so openly and extensively.

Monday, July 23, 2007

The rewards of "honest money" and interest-free lending

Some things are so simple that it takes a while to understand them. For me until now, one was the question of how anybody could lend money and not expect interest - for centuries, usury was forbidden under both Christian religious and civil law. In France, interest was illegal until after the Revolution in 1789 - see here.

And then the penny dropped, so to speak. If the supply of money is fixed, and the economy gradually becomes more larger and more efficient, then money gradually becomes more valuable, as The Mogambo Guru explains here. So if real GDP grows at the rate we seem to expect (on average, about 2% per year), then with a fixed money supply, a depositor would earn 2% in real terms, as would a lender. All you would need is adequate security for the return of capital.

Banks would have to cover their running expenses (I believe Swiss banks already do charge depositors for holding their cash really safely), but this would be need to be in the form of explicit costs, which might therefore be better restrained. Borrowers would have no reason to keep switching loans; in fact, the need to charge arrangement fees would act as an incentive to remain loyal to the existing creditor.

But it looks to me like it would mean the end of fractional reserve banking, inflation and periodic banking crises, not to mention the permanent and pervasive importance of money lenders.

Would that really be so bad? If so, then "if you can't beat 'em, join 'em" - would you and other like-minded readers care to join forces with me and start another bank? It seems to be the only game in town.

More on UK purchases of US Treasury securities

I have sent the following email to George Osborne, the shadow Chancellor:

"Please find attached a document from the US Treasury website, detailing major foreign holdings of US Treasury securities (web address top left of document). I emailed this document to the Daily Mail newsdesk yesterday, in the fervent hope that somebody might take an interest.

Between June 2006 and May 2007, the UK has leapt from being the 10th largest foreign holder of American debt to 3rd place (behind Japan and China, both of whom, although increasing in dollar terms, have actually reduced their overall share of foreign commitment to the US).

We have contributed an extra $112.1 billion, i.e. around 55% of the $205 billion total increase in investment by foreigners over that 12 month period. To put it another way, 10 countries have reduced their holdings in dollar terms, by a combined total of $72 billion; we have covered these withdrawals and added another $40 bn.

For comparison purposes, the UK's increase in US Treasury securities is equivalent to some 50% of the £104 billion budget for the NHS for next year (http://www.timesonline.co.uk/tol/comment/columnists/article2039584.ece)

The effect for the UK has been to more than triple its exposure to US Treasury instruments, at a time when the dollar is dropping - and some predict it will fall much further. The potential loss of our national wealth easily matches (and will quite possibly dwarf) that from the sale by Gordon Brown of much of our gold reserves some years ago."

Sunday, July 22, 2007

News: huge investment by UK in US Treasury securities

Never mind the conspiracy theorists and the rumoured use of "Caribbean Banking centres" to buy US Treasury bonds; look at this document from the US Treasury, dated 17 July 2007. It shows that in the last 12 months, holdings by foreigners increased by 10.37%, but the UK's holdings shot up over 202% in the same period, from $55.5 billion to $167.6 billion. And the dollar has dropped against the pound at the same time. Can our little island afford such generosity?

Open secrets about banks, credit and inflation

There are things about money that are well-known to some, but not known and understood by all.
  • In the USA (and the UK, I understand), notes and coins represent only 3% of all money; the rest is, in effect, various types of IOU.
  • Most money is simply created out of nothing, by private banks, as bookkeeping entries.
  • Banks lend out money, and also charge interest.
  • Since the banks haven't created enough money to cover the interest, they demand it from the borrowers.
  • If the total amount of money in the economy stays the same, and banks always charge enough interest to make a profit, then someday banks will own all the money in the world.
  • So banks create and lend even more money. Some of this new money is to provide for the interest they have charged on earlier loans.
  • Therefore, banks have caused inflation, and as long as they create new money, they will create more inflation.
This is so simple, but so hard to believe. It's like standing up from a game of Monopoly to find that you've been playing for real. And when you read others who explain the money system in these terms, you get the same emotional sequence:
  1. amused, complacent toleration
  2. a growing sense of unease
  3. dawning, half-incredulous understanding
  4. appalled outrage
So it is with one of the latest of these explainers, Ellen Hodgson Brown. But there is a world of difference between diagnosis and prescription. Here is hers, and halfway into here is a riposte from Richard Daughty, aka The Mogambo Guru.
Please note that Daughty is not contradicting the diagnosis, only the proposed solution. He is permanently at stage (4) in the above sequence.
Now, what do we do about it? Daughty's usual response "We're freakin' doomed!" reflects his pessimism about attempts to save the system as a whole, but is generally accompanied by recommendations for individual financial survival, namely, investment in commodities such as gold, silver and oil, merely to protect against end-stage inflation.

Saturday, July 21, 2007

Michael Panzner on financial liquidity and asset prices

Writing in Seeking Alpha yesterday, Michael Panzner (author of Financial Armageddon - my review here) comments on an article by Yale economics professor Robert J Schiller, which discusses the notion and possible consequences of excess "liquidity" in the world economy. For Panzner's own website promoting his very bearish view on the American economy, see here.

Peter Schiff on US monetary policy

Peter Schiff's latest commentary (today in Forex Street) pours scorn on the Treasury Secretary's professed commitment to a strong dollar, and points out that Ben Bernanke's reasons for a stronger Chinese yuan (renminbi) also imply higher interest rates AND higher consumer prices in the US.

Schiff concludes with the same recommendations as in his book, Crash Proof (my review here): buy gold (he's selling Australian Perth Mint Certificates through a dedicated website) and selected foreign (i.e. non-US) equities.

Fragility of the stockmarket

Ben Steverman in Business Week (20 July) gives reasons to worry about the US stockmarket, one of them being the amount of borrowed money powering it, which is something Richard Daughty also comments on (see link in previous post). A credit contraction could trigger a collapse in stock prices.

My comment: this might sound like a reason to hold cash, but the hyper-inflation scenario espoused by some is predicated on what they expect will be the response of the government to the threat of a depression.

The Mogambo Guru agrees with Jim Puplava

Richard Daughty submits another gonzo rant to GoldSeek, coming to the same conclusion as Jim Puplava at Financial Sense: buy gold, silver and oil.

Puplava on inflation, commodities

Financial Sense, July 14: Jim Puplava discusses inflation figures and the management of our perceptions of inflation.

The effects of expanding the money supply must, he feels, eventually spill over from assets to consumer prices. He sees three scenarios:
  1. A credit contraction, leading to recession.
  2. An inadequate credit expansion, resulting in consumer price inflation.
  3. A change in public perception of inflation. If people expect their money to become progressively worthless, they will eventually try to get rid of it as fast as possible, in exchange for tangible things.


  • Cut unnecessary living expenses, shop smarter.
  • Avoid bonds.
  • Because there is no sign of (1) or (2) above happening, we are heading for a US hyperinflationary depression, perhaps starting around the same time as the oil crisis, i.e. 2009. So invest in tangibles: gold, silver, oil.

By the way - some thought-provoking replies to listeners:

  • Puplava agrees that Israel may be sitting on a valuable oil field!
  • He says creditor nations in Asia may have a deflationary depression, while ours will be inflationary.
  • He notes that Iran now demands payment from Japan in yen, not US dollars.

Puplava on debt and credit

Financial Sense, 14 July: Jim Puplava notes that there is a US credit contraction underway. Real incomes are falling by 6% per year; bank credit is going down; the quality of loans is worsening.

Consumers appear to loading up their credit cards to maintain living standards, but this is more expensive than mortgages; the Federal Reserve is buying Treasury bonds to keep the interest rates down, hoping to prevent a real estate recession from becoming a depression.

Consequently, Puplava anticipates lower discretionary spending and a cut in interest rates by the end of the year.

Puplava on the coming oil crisis

Jim Puplava's Financial Sense, 14 July (3rd hour transcript): this leads with the coming energy crisis, especially in oil. Puplava's programme features an interview with Basil Gelpke, who has made a documentary on oil called "A Crude Awakening".

Demand is rising, and will continue to do so even if there is a world economic slowdown, because the developing world aspires to Western standards of living; supply is not keeping pace, as exploration and extraction become more difficult and expensive. R&D in alternatives has been inadequate. The crunch could start as early as 2009.

Jim draws two broad conclusions:
  1. Prepare to live in a world where energy is much more expensive. There are obvious implications for your transportation and housing.
  2. Invest in energy stocks.

Wednesday, July 18, 2007

Book Review: "China shakes the world" by James Kynge

This is a very well-written book: easy to read, vivid, informative and thoughtful about future trends. James Kynge has spent 19 years in Asia, half of that reporting from China, latterly for the Financial Times. His direct experience may be the most valuable aspect: he gives a sense not only of what the Chinese are doing, but their motivation.

This is an interpretive, sequential and selective summary, and I do suggest you buy the book - US Amazon link here (hard cover), UK Amazon link here (paperback).

It opens with the widely-quoted narrative about moving a steelworks from Dortmund, Germany to the Yangtse delta in China. The Chinese labour much longer and with less regard for health and safety than their European counterparts, shifting the plant in a third of the time originally expected, together with many tons of paperwork (rapid transfer of know-how is a major theme).

The purchase of the works was completed equally quickly, at a time when the Germans suffered high taxes because of reunification, world steel demand was depressed, and South Korea was undercutting their prices. But Kynge notes that had the owners waited until 2004, the recovery in the market would have made the works profitable again, even in Dortmund. A battle lost through failures of nerve and foresight?

The new owner, self-made billionaire Shen Wenrong, had now bought himself a ready-made plant at scrap cost. This got him into production faster, but also with less debt, an advantage which will tell when the next downturn comes - which Shen expects to happen soon.

The Chinese economic reforms that started in 1978 have seen many rags-to-riches stories. The Party hadn't officially sanctioned private enterprise on such a scale, but local officials turned a blind eye for the usual reasons - corruption and ineffective central control are other motifs in this story.

China has leapt from village and farm to city and factory at warp speed. This means that there is a vast pool of eager, cheap labour for its new industry. There is also a great and growing demand for resources, not only for manufacture but also for city construction, road and rail development, and energy production.

The move from handwork to brainwork means education is very valuable - a later chapter gives an example of identity theft merely to secure a college place, which then helps the thief into white-collar work and a far higher standard of living. For the Chinese, elitism is the way to excellence; Kynge writes of a Shanghai school principal's amazement at Britain's assaults on selection in education. Chinese who can afford it are buying the best foreign private schooling - Dulwich College has opened subsidiaries in Thailand and China.

China has a huge population, with a per capita income of slightly over $1,000 a year. Although its people are racing to catch up with our living standards, demographics will impact on the economy: by 2040 one-third will be over 60 years of age. Kyng says, "It may be that China grows old before it is rich." Like Alice and the Red Queen, China has to run just to stay put - the country has to create 24 million new jobs each year, or face the social and political consequences of a stall.

So the pressure is on. Many companies have copied designs and technology e.g. from the Japanese, and then from each other, setting up rival concerns and increasing production to the point where the profit margin disappears. But the result is not bankruptcy - the government has decided that employment is more important than Western-style financial probity. Besides, there's lots of money available for commercial lending: Chinese people save around 40% of their incomes. Since the domestic market is oversupplied, the Chinese look to make a profit from exports, deflating the global market in manufactures.

Intellectual property rights are not a priority in this scramble. The author visits Yiwu, a great market for pirated goods, and when he calls the anti-fakes hotline he gets the runaround.

What about the quality originals? He visits Prato, Italy, to see the ancient textiles centre; it's been hit hard. First, Chinese arrived as cheap immigrant labourers; then Italian firms began to import materials from China; then they started to get the work itself done over there; finally, Chinese firms set up and took over, appropriating pattern books that took centuries to develop.

The tale is the same with silk, in Como, and jewellery, in Chiasso. "In many areas of manufacturing, European companies cannot compete in the longer run - no matter what counter measures they or the EU may take." White collar workers are not safe, either: their work is also migrating to India and China: "...accounting, law, financial and risk management, healthcare, information technology and several other service areas."

European workers cost too much: pay, healthcare, unions. And their governments are too expensive: Chinese state expenditure as a percentage of GDP is less than 50% of German levels. But European countries are democracies, so tough economic action is politically difficult; whereas in China, it was possible for them to lay off 25 million workers in state-owned enterprises in 1997-2002, and 120 million migrant workers receive no welfare at all.

To the USA: Rockford, Illinois, the centre for machine tools. The Chinese government is overwhelmingly composed of engineering graduates, and they want Western tools, blueprints and know-how. They bought Ingersoll Production Systems and used the firm to try to acquire Ingersoll Milling Machine, which has key technologies for rockets, nuclear power stations and stealth bombers. The US government and its intelligence services were quite unaware, until tipped off by locals. Now, American machinists who used to earn $16/17 per hour are working in retail for $7 per hour, with no pension.

Eric Anderberg of Dial Machine tells the author how the world is not flat, but tilted against America: China has an undervalued currency, little welfare for workers, no labour unions, cheap credit from the state banking system, loan defaults without consequences, VAT rebates available to exporters but not US companies, lax environmental emission controls, intellectual property theft and little enforcement of IPR rights, state-subsidised input costs such as electricity and water. And then US bureaucracy and legislation adds some 20% to American business costs.

Kynge learns all this at the local annual Chamber of Commerce dinner, where Al Frink, the US President’s manufacturing “czar”, is to speak. The dismayed audience then hears Frink talk in favour of outsourcing. The author notes that what hurts Anderberg suits the big US corporations, who earn 25% of their profits from foreign subsidiaries; for example, IPR theft saves on overseas R&D. Anderberg remarks that “Lenin said that America would tear itself apart from the inside through greed.”

Kynge turns back to a coal mining area in China, to illustrate her difficulties. Industrialisation is creating health-wrecking air and water pollution. There is a shortage of usable land, and the deserts are advancing. China is gobbling up resources and commodities, especially oil. There are environmental limits to growth: using the measure of a “green GDP”, i.e. economic growth minus resource depletion and environmental degradation, Shaanxi province has made virtually no progress in the last 20 years. Besides, China’s vast population can never have a standard of living like present-day America – the world does not have the resources.

The pressures are breaking down the bonds of mutual trust and obligation. Identity theft; bogus police; cash-stuffed envelopes for journalists; corrupt and immune officials; sexual infidelity; lethal, fake baby milk powder; HIV-infected blood plasma. And from the West's standpoint, there is an image of political oppression, unfair terms of trade, supposed worker exploitation.

So China has a brand image problem that affects its foreign trade. But if China can crack this, she will enjoy another great leap forward. For the worst exploitation of its workers is not by the Chinese themselves: "... all of the work done in China - the sourcing, manufacturing, transportation and export - rarely qualifies for a return of more than 10 or 15 per cent from a product's sales revenue." Most of the money is being made in advertising, marketing and sales., and when the foreign consumer no longer thinks it uncool to buy openly from the Chinese, the latter will reap much greater benefit from their labour. (Perhaps there are some questions to be asked about the markups and fees of Western middlemen.) We shall have to see how the Olympics changes perceptions. Meanwhile, established brands are being used as the marketing wrapper for Chinese work, e.g. Lenovo's purchase of IBM.

Doubts about China are not merely a matter of perception. The country is trying to move to a capitalist economy, but retain centralized Party control. So when companies get stockmarket listing, typically they float less than a third of share capital, keeping ultimate control for their own management. There are lax disclosure rules and company figures have not infrequently been falsified. The "big four" banks are State-owned, run by Party officials and burdened by bad debt. Kynge guesses it could cost up to $500 billion to clean up the financial system. There is also corruption - he gives as an example oil wells in Shaanxi, developed by private investors and then arbitrarily confiscated by local officials, who may well have benefited personally; but appeals to the local courts are pointless, since the judges are appointed and paid by the same officials. There is some hope: in March 2003, the national Constitution was amended to give private property the same status (in principle) as Party property - but government accountability is still in its infancy.

The author concludes with a chapter on China's relations with outsiders, which are coloured by the events of the nineteenth and twentieth centuries. The desire for economic progress is sometimes in conflict with impulses of national pride, power and prestige. Now that she is becoming mighty, China is choosing her own friends, and is in uneasy relationships with neighbours such as Taiwan and Japan. As America's balance of trade worsens, China may have more than one reason to give more weight to its own need for economic development than to harmonious foreign relations.

Tuesday, July 17, 2007

Why commodities are the future

Martin Hutchinson, writing in PrudentBear yesterday, explains why he thinks commodities are in a long-term bull market: the developing world wants the "white goods" and other consumer durables that we already have and take for granted.

Peter Schiff - corrosive effects of debt

Peter Schiff has revamped his site, and is generally increasing his media profile.

His economic commentary reports that the US has sent an official to China to ask them to buy into mortgage-backed securities! (The man will deserve a medal if he succeeds.) But it's not only subprime loans that are risky - Schiff says that many home valuations were inflated for mortgage purposes, and foreclosures realize less than half such values.

Turning to government debt, he says Treasury bonds will be hollowed out by a gradual devaluation of the dollar (by maybe 50% over the medium term), plus soaring interest rates. Further ahead, he sticks to his Crash Proof prediction of hyperinflation.

Monday, July 16, 2007

Future opportunities in the subprime market

Following on from the last post, I feel Mr Schultz could well be right, though the timing is important. There are going to be many people with an impaired credit history after this debacle, who want to have another go at owning their own home; and presumably houses will become more reasonably-priced, too. A specialist lender could get good returns from servicing carefully-selected customers, in much the same way that after a natural disaster, fresh insurance companies enter the market on a better footing, while the outfits that were already committed are still struggling.

As Wavy Gravy said at Woodstock, “There’s always a little bit of heaven in a disaster area.” Though of course, I'm sure he didn't mean it in quite that way.


Having written that last bit, what do I read (in Saturday's Free New Mexican) but that some of the hippies who set up communes in New Mexico eventually became realtors!

US subprime fallout

Credit rating agencies seem on the brink of downgrading CDOs, according to last week's New York Times; GE has dumped its subprime portfolio, accepting $160 million losses; the Wall Street Journal reports on the exposure of mutual funds to subprime lending; Fannie Mae and Freddie Mac are getting choosier; official guidance is being issued to brokers; borrowers are starting to sue lenders; the dollar is dropping against the Euro, in advance of expected bad figures on consumer spending and borrowing; builders are quitting, going to law or offering special financing deals.

Among loan arrangers, 15,000 of 500,000 jobs (3%) have gone; Guardian Loan Company has escaped collapse by the skin of its teeth, because eager new firms were squeezing it out of the niche market and back towards standard mortgages - but like General MacArthur, chief executive Stuart Schultz promises a return: "If I were a rich man, I would buy the largest subprime business in the country, because it will be back."

US mortgage difficulties to continue next year

There are now forecasts that mortgage defaults and foreclosures will continue into 2008; comparisons are being made with similar drops in the early 1980s and 1990s. Peter Schiff reminds us that the biggest losers will be the lenders, but to the individual mortgageholder that won't seem comforting.

US house price bubble has been deflating for some time

Tim Iacono in Seeking Alpha (July 5) reexamines the housing market to check underlying trends at different price levels, and finds certain sectors have been dropping for some time. As in the UK, the overall average has been skewed by way the high end has held up; a more detailed examination suggests the decline for ordinary houseowners is well under way.

Sunday, July 15, 2007

UK housing market also a bubble

The conventional view is that house prices are still rising in the UK. Merryn Somerset Webb, editor of Moneyweek, begs to differ (25 June) and the index to which she refers is here; Michael Hampton (Financial Sense, July 5) is also pessimistic.

For those who want to know what prices houses have actually fetched, see Nethouseprices.com, which gives much other useful information.

Marc Faber on the world bubble and his own investments

I have already referred today to Faber's interview on Minesite.com and would like to pull out one or two strands:

Faber thinks "...all real estate markets around the world are in cuckoo land and that they will all correct at some stage meaningfully even if you print money".

Asked whether he has real estate himself, he says, "I own properties in Asia, in New Zealand and in Vietnam in particular and in Thailand, and Indonesia and some in Switzerland; but ... I never borrow money to buy my properties, I pay cash ... I also own gold, and I also own some shares of course, I’m just diversified; but in general, I am very liquid at the present time... I’m holding a lot of cash at all times."

Re precious metals and inflation: "I tell you, the US has no other option but to print money. And they’ll go down like the Roman Empire in a huge hyperinflation. " He is bullish on silver and gold (especially gold), though he notes the danger that in a crisis, the government may simply expropriate investors' holdings of precious metals, as has happened in the US before.

Faber also notes that the expansion in the money supply in the West is not matched by increases in GDP, which is why we have speculative bubbles and a stalled standard of living: "...in the 50s and 60s and 70s if you increased your debt in the United States by $1 you got essentially also a dollar's worth of GDP growth. Now in the last 5 years, total credit market debt in the US has grown by $13 trillion but GDP by just $2.3 trillion." By contrast, in the East, living standards have risen: "I moved to Hong Kong in 1973. When I came, Taiwan, South Korea were very, very poor countries, as well as Singapore was like a dump at that time. Today, Singapore is the richest country in the world and, you see that the standards of living of people, has over the last 30 years, improved very dramatically in these countries. Whereas in Switzerland I go there, back, a few times a year I don’t see any meaningful improvements in the standard of living."

I think I have to speak personally now. What worries me, since I'm not rich and live in a large ex-industrial city, is not how to profit from the crash, as Peter Schiff advises, but what my life is going to be like when my neighbours and their children are strapped for cash, unemployed (or in Mcjobs) and increasingly resentful. Shouldn't we get our noses out of the financial press and start to become concerned about the social cost of the folly and cynicism of our banks and governments?