Intermission

The FTSE has just closed at 5,414.40, about 1,150 points down from a recent high (10 December 2007) of 6,565.40.

But the gyrations have gone on for much longer. The FTSE bust UPwards through 5,438 on 29 October 1998, heading for nearly 7,000 by the end of 1999; popped and went through 5,417.60 in a DOWNwards direction on 29 August 2001; hit bottom (3,287) on 12 March 2003; rose back UP through 5,358.60 on 2 November 2005 - and here we are again.

Except we haven't factored-in inflation, so each later revisiting of the 5,400 level represents a further loss in real terms.

Meanwhile, let's take a look at what we might do to preserve what little wealth we have.

Residential property: costs about double its long term trend (3x income). But Mrs S isn't keen on a caravan, not even, as I suggested, "if we get a nice horse".

Stocks: the S&P's long-term trend p/e ratio is a little under 15, so to get back to that it should fall by 25 - 30%. Looks like we're partway there. Emerging markets have boomed, but as that sage Christopher Fildes said many years ago, the definition of an emerging market is that is is a market from which it may be difficult to emerge.

Bonds: a painful subject, with CDOs and the like. Hard to tell quality from rubbish at the moment, and if the credit contraction forces interest rates up, the capital value of bonds will have to fall to match the yield available on other kinds of loaned money.

Commodities: some markets such as gold are small enough to be manipulated by speculators (and sales from stock) - and much of the investment in them may be leveraged, which brings in extra uncertainty because the credit crunch could force sales to cover cash calls. Others, such as oil, may be affected by reduced demand in a recession. So commodities are not a no-brainer for the amateur investor. How many will know when they've reached the top of the price spike? Agriculture might be interesting, though, as I reported a while ago and as Jimmy Rogers says now, according to Contrarian Investor.

No wonder Marc Faber said last year that he saw bubbles everywhere. He has since gotten into gold, among other things, but he is a very smart, quick-moving trader. If I had any serious money, I'd rather use him (and others like him) than try to compete with him.

What else?

Some governments offer their own instruments for matching inflation - Index Linked Savings Certificates in the UK, TIPS in the USA, for example.

I suppose that if you expect food and fuel to rise in price, you might stock up - though a John Denver-type petrol store is probably unwise, if not illegal. And even tinned food, rice and dried pasta will only stay in good condition for so long.

And not everything is likely to go up. We look as though we're in for an odd combination of inflation and deflation. Houses, stocks, maybe bonds, maybe some commodities, may present buying opportunities sometime. And how about those consumer durables - the cars, computers etc you may want to renew or upgrade sometime? So cash really doesn't seem that bad to me, so long as you make sure you're maximising your rights under local depositor protection laws.

And then there's the bigger picture. Douglas Adams, author of The Hitchhiker's Guide To The Galaxy, observed of unhappiness: "Many solutions were suggested for this problem, but most of these were largely concerned with the movement of small green pieces of paper, which is odd because on the whole it wasn't the small green pieces of paper which were unhappy." My point is not that money is unimportant, but that it won't be enough to see ourselves all right - we still have to live with our neighbours. It's important to get the economy straightened-out, because when others are unhappy and insecure, we shan't be safe, either. Perhaps there's a selfish element in altruism.

It's pretty clear how things are now, and there's no need to keep the sirens going when you can see the fire. All I hope is that concerted, imaginative action will minimise the damage. A wilder hope is that we might reform the system - especially our rotten currencies and remote, self-centred politicians. I've learned much from joining in the debate, but don't think I have much more to contribute at this stage, so I think I'll be better off giving my ego a rest and reading you, instead.

My final guess, for now: it'll be time to get back into the swim in the Spring of 2010.

Wise after the event

I'm stung into a rant by an article I've just read. A classic example of mainstream journalist wisdom here - and only one of very many similar now available, I'm sure.

I'm don't know what the economics editor of one of the UK's most successful papers earns, but I'd be happy for him to earn double if he could tell us all this "it was so obvious" stuff BEFORE the crisis.

Not that it couldn't have been foreseen. In the late 90s, I was so concerned at US debts and the massive zoom in tech stocks driving the FTSE and Dow into the stratosphere, and so apprehensive of what I thought would be the inevitable aftermath, that I warned clients not to get into the frenzy, reminded them they had an option to switch into cash, moved my wife's pension savings into cash, and (despite the awfulness of modern British schools) resumed teaching as well as holding onto the financial advice business.

Am I wise? No, I listened to what many others were saying, and wasn't blinded by greed. But I wouldn't have learned it from the papers.

And the smugness! "Above all, the current crisis will force us to relearn one of the oldest lessons of all, one from neither the Seventies nor the Thirties but the wisdom of the centuries: that what you owe, you must one day repay." The credit bubble was created by banks, permitted by regulators and governments, and exploited by financial engineers and intermediaries - yet it is the private debtor and the taxpayer that will pay. Don't hold your breath waiting to see unemployed bankers selling the Big Issue.

Back to 2003

Karl Denninger thinks we're on course to lose all the gains of the last 5 years:

I am updating expectations for this Bear Market; I no longer believe 1070 on the SPX will hold, and have now moved to the camp that sees the potential for the S&P to retrace all of the 2003-2007 Bull Market's gains, taking us back to around 800 on the SPX.

In the UK, the FTSE closed at 3,287.00 on 12 March 2003.

Forgive us our debts, Part 2

A very stimulating response from "Caronte" to the earlier post on debt reduction, so I've taken the liberty to bring the argument out front here.

Caronte, you say:

Suppose it is believed with absolute certainty that every 50 years, say every year divisible by 50, all debts are forgiven. There would follow a bunching of loan demand as the forgiveness date nears, while willing lenders would simultaneously vanish. The market would no longer match credit demand and supply, total welfare would suffer. Debt forgiveness would only avoid this problem if it was done by stealth, unpredictably, once and for all and never again. Like forgiveness of tax evasion or illegal buildings. Difficult to persuade debtors, (or builders, or taxpayers), that forgiveness would not occur again. Lots of people would be encouraged to borrow beyond what they can afford (or evade tax) – the moral hazard implication. Unsustainable indebtedness would multiply rather than disappear. Moreover, a defaulting borrower does not need forgiveness if she genuinely cannot pay: can’t pay, won’t pay, period. If the defaulting borrower has some residual wealth, though less than the outstanding loan, who is to deprive the creditor of that? What legal or moral right would support state action without creditor compensation?

Would “debt cancellation (or rather, reduction) … be a suitable punishment for the principal offender”? True: “the relationship between mortgage lender and borrower is unequal. You have to live somewhere, and if you don't buy, you have to rent - and rents will tend to reflect the purchase price of houses.” No more than the relationship between employer and worker. There are various way to reduce this inequality, workers can form Trades Unions and cooperatives, and borrowers can found building societies – until New Labour wickedly de-mutualised i.e. privatised this form of social property which was not theirs to privatise. But the main reduction of the inequality comes from competition among lenders (and among employers).

“By adjusting the ratio of deposits to loans as it suits them, lenders can multiply the money supply”. True, there is a credit multiplier at work when banks re-lend their deposits and get some new deposits as a result. If they were prevented from re-lending – by law or by contract – they would act solely as custodians (as in the early days of gold-money) and would charge depositors for the service instead of paying interest. And any act of individual saving would instantly reduce total demand by the same amount and cause unemployment. Besides, the ratio of deposits to loans is regulated by law and is variable at will only when it is higher than a prudential limit. And banks face the consequences of their bad loans, they can go bankrupt and their shareholders can lose all their capital. That’s punishment enough. As long as they are competitive, there is not much of a reason to “punish” them by forcing them to remit those bad loans that still have a residual market value.

“Rather than prop up the worst of the lenders, let them go down. Why should the taxpayer assume the burden?” Absolutely right. “Pay off the depositors” – if the bank can, or if there is a state guarantee. But why “shrink the lending book” by debt remission? If mistakes are always to be automatically corrected ex-post when they are revealed as such, the market disappears and with it all the conceivable advantages that it brings.

An Australian economist whose name now escapes me once wrote an article mocking the theory of general economic equilibrium – with its complete system of futures markets – by imagining a system of “past” markets in which economic agents could undo their past transactions that with the benefit of hindsight turned out to be a mistake. Just imagine. Debt remission would have some of the same effects.

I say:

Caronte, welcome, and many thanks for the length and thoughtfulness of your response. I don't pretend to have your economic expertise, but I still think there's a debate to be had. I'll try to tackle some of your points, not necessarily in strict order.

I suppose that in ancient Israel, the economy was not so monetised as today, so the advent of the year of Jubilee may not have been so disruptive as it would today. I don't really advocate a periodic debt cancellation - though I'm beginning to wonder about the necessity of charging interest. (Isn't it the case that some Swiss banks do in fact charge you for looking after your money securely, instead of making investments with it or lending it out to others?)

Competition between lenders may help keep down interest rates, but it's the ballooning of asset prices - and the consequent increase in the size of mortgage required - that causes the damage. So many are now locked into monster mortgages that a significant rise in interest rates - which otherwise might be appropriate for tackling inflation - is politically very unfeasible.

I argue that the price of houses is pretty much beyond the buyer's control, except that there's a point where a purchase is either not affordable (we seem to have reached that stage) or, as with subprime, fudged at the outset with disastrous consequences later. So I suggest the expansion of credit (for which, as you say, regulators also share responsibility), and the terms set by fee-hungry lenders and intermediaries, are more to blame than the family that wants a roof over its head it can call its own. Finance for cars and consumer goods is something else; a house is a necessity, and surely, owning one is not an unreasonable aspiration.

Banks should be, but are not being made to face the consequences - look how governments are propping-up Northern Rock and Bear Stearns.

Debt reduction does not seem unreasonable to me. If a life insurance company fails, the book of life business can be passed on to another provider, who is only required to underwrite 90% of the outstanding life cover. So why not for lenders who (through greed and stupidity) have gotten their sums wrong? A 10% reduction in the capital only represents a couple of years' interest. Better a borrower who repays a reasonable proportion of the loan, plus interest, than simply mail back the keys and leave the bank with illiquid stock it doesn't know how to manage.

This is not a problem limited to a single bank -and anyway, there are far fewer these days, and they are much larger, so one failure could really rock the boat. At worst, we could now be facing the prospect of mass bankruptcy, the crash of the credit system and general economic carnage. It's worth coming up with some fudge to keep borrowers and lenders going.

Here in the UK, you can enter an agreement with creditors and as long as you keep up the scheduled payments, interest charging stops altogether. Maybe that would be another way forward - the monthly repayment would be lower and the borrower would see his equity in the house increase over time.

We've been watching enslavement by money-owners who have been licensed to print almost unlimited amounts of their own money, but the poor man only feels it going past and can save none, so remains in debt-bondage. Better any reasonable rearrangement, than "I owe my soul to the company store".

Market timing

A very useful piece by John Mauldin considers long-term returns. He quotes findings by Ed Easterling at Crestmont Research, about what would have happened had you retired and invested $1 million to take $50,000 a year, rising annually with inflation. He looks at 78 different 30-year periods since 1900 and works out whether your money would last as long as you:



The forecast price-earnings ratios of the S&P 500 for 2008 range from 18.69 to 22.20. This does not bode well for long-term retirement investments made now. If the p/e ratio from the current c. 20 to 16, this would imply a share price decline of 20%, and even then you'd outlive your income in 30% of cases. A p/e of 12 requires shares to drop now by 40%, and that still means a one-in-five chance of running out of cash.

It looks as though, rather than fear a major crash, we should hope for one - as long as we're in cash or something else that's relatively safe and liquid.

Forgive us our debts

In one version of the Lord's Prayer, the word "debts" replaces "trespasses", and this is in keeping with the etymology of "redemption". The ancient Jewish law forbade perpetual debt-slavery for fellow-believers, and even provided for ceremonial debt forgiveness every 50 years (which, I imagine, had a feedback effect on the terms and length of loan agreements).

"Hatfield Girl" gives a very vivid picture of our slow slide into dingy, shabby poverty, and it has to be every sane person's earnest wish that we (or our fellow citizens) don't return to the conditions so many suffered before the Second World War. Yet what is causing all this but the heavy chains of debt?

A disclaimer: I often feel that I not only know nothing, but never shall know anything, despite much effort. Then I see how the world is going, and wonder who knows better.

Having said that, I'm trying to work out why, as Karl Denninger says, we don't make the banks eat some of the debt they laid on us. In the comments to the Hatfield Girl piece linked above, "Caronte" refers to "moral hazard", a point I entirely accept. But I say that debt cancellation (or rather, reduction) would be a suitable punishment for the principal offender.

In our society, the relationship between mortgage lender and borrower is unequal. You have to live somewhere, and if you don't buy, you have to rent - and rents will tend to reflect the purchase price of houses.

So what determines the price of houses? Supply and demand. And a major element of demand is how much money is available. By adjusting the ratio of deposits to loans as it suits them, lenders can multiply the money supply, as everyone knows (I say everyone, but actually I don't think the public is fully aware of the simplicity and enormity of this scam). Since 2000 or so, the money in the economy doubled, and so, un-oddly I think, did the price of houses.

The lender can decide how much to lend into the market generally, and consequently influence it; the buyer cannot decide, on an individual basis, to halve the value of the type of house he wants in the area where he needs to live.

So by what right should lenders inflate asset prices, fix on them loans of money they created virtually ex nihilo, then deflate asset prices by reducing lending in difficult times, and expect the borrower to bear the full weight of the consequences?

The borrower may have colluded with the lender to take on an unsustainable debt (or one that exposed the borrower to excessive deflation risk), but for reasons already given I suggest it was a shotgun marriage (or a mass marriage, like those Moonie wedding rallies) with the lender handling the Purdey. For subprime borrowers, I think it's fair to argue that the class of people involved means that the lenders had far better knowledge of the implications, and so are far more culpable.

Rather than prop up the worst of the lenders, let them go down. Why should the taxpayer assume the burden? Pay off the depositors, but shrink the lending book - which is mostly funny money, less substantial in its origins than candy floss - a drop of ink on 80-gram paper.

To quote the inscription on the statue of Justice above the Central Criminal Court, "Defend the children of the poor and punish the wrongdoer." The trespasses of the mighty are less to be forgiven.

The silent watchdog

Yet another important post from that heroic toiler (an oxymoron for classical Greeks), "Tyler". He looks at the economic implications of our ageing population and demonstrates that public expenditure cannot continue as projected.

The long-serving Comptroller Generals, both in the USA and here the UK, have recently retired. The difference between them is that the American, David Walker, has spent two years on an increasingly well-publicised Cassandra mission to warn the public of future dire financial dislocation, because of unfunded liabilities such as medical care and pensions. I may be doing a disservice to Sir John Bourn, but I can't remember any media fuss about him going on such a tour here.

Looking at the website for the National Audit Office, I see that in the FAQs, the spelling of "comptroller" comes second, after a dry summary of the NAO's role. However, the "find" option on my Windows toolbar can find no occurrence of the following words in that web page:

disaster
bankruptcy
poverty
IMF
inflation

Some barking from its kennel would now be most welcome.

In the know

Marty Chenard states something I've suspected, which is that a bear market is when the experts sell to the amateurs. This article seems to confirm that we are indeed in a bear market; on the other hand, Clif Droke thinks "an interim bottoming process is well under way". I like that "interim" - there's a hedge, if you like.

Housing stall, after all?

Looking at the economy now, we have to go well beyond subprime, and consider the general value of housing. Karl Denninger repeats that, in the long term, average house prices are three times income, but at the same time observes that they are "sticky". No-one wants to crystallise a loss, and you have to live somewhere, so why sell now?

If the financial victim next door has to sell his house at a 50% discount, that's all the more reason for you not to sell yours. If no-one sells voluntarily, how do you determine a real, as opposed to forced-sale value? So one effect of the housing drop could be a general slump in sales - with maybe a rise in home swaps for those who need to go to a different geographical area, perhaps for job reasons.

But what about people caught in negative equity? Here in the UK, ditching the house for less than the outstanding loan could leave you being chased for the balance, for years, unless you opt for bankruptcy. However, in the USA, many mortgages are on the roof but not on the borrower, leaving the lender short if the homeowner mails the keys back. Denninger has said more than once that borrowers need to consider this option solely on its financial/legal merits, as he thinks many lenders lost the moral argument when they knowingly advanced far too much to people who they knew couldn't maintain the loans. Now this could really upset the applecart.

Michael Panzner features a piece by FT columnist Martin Wolf. Wolf wonders what may happen if a high proportion of negative-equity homeowners default. The economic impact may be closer to Nouriel Roubini's $3 trillion, than to Goldman Sachs' more sanguine $1 trillion (the latter itself is a massive increase on the sort of figures bandied about before Christmas). Wolf sees two options:

There are two ways of adjusting the prices of housing to incomes: allow nominal prices to fall or raise nominal incomes. The former means mass bankruptcy and a huge fiscal bail out; the latter imposes the inflation tax.

But either option is so unattractive that (despite Denninger's image of paddling furiously as we head for the waterfall) there is a very strong incentive for fudge and delay. We've seen central banks pump many billions into the system in the last few days; and the ratings agencies seem to be trying their best to help maintain the status quo by not downgrading lenders as quickly and severely as some think they deserve. But again, housing is intrinsically illiquid, and houses aren't turned over rapidly like shares, which is why we have "mark to model" instead of "mark to market". What's the rush to crystallise a terrible loss now? Better a Micawberish hope that "something will turn up" than a grim Protestant insistence on an immediate collapse which would benefit very few people.

Assuming wages continue to rise over time, the gap between prices and incomes will lessen. If the homeowners can somehow be reassured that the government is determined to support house prices, then the sell-to-rent speculators could be caught out in their attempt to "short" the housing market. Can they be sure that, having sold their nice house, they can buy another such in the right area for much less, later? What will they do meanwhile?

The real threat is this "jingle mail", and the potential consequences seem so dire that something creative may be done. Bankruptcy rules might be modified to protect lenders; maybe portions of recent loans may be written-off. How about part-ownership, part-rent, as with UK housing associations - having escaped the trailer park, many first-time homeowners may want to keep their foot on that first rung of the ladder. Not everyone will want to pour engine oil into the carpet and trash the light fittings.

So I think we will have fudge, delay and attempts at more creative solutions, and a long stall in the housing market. Unless there's another hammer blow that the system simply can't take, such as an explosion in the financial derivatives market, as arch-doomster Marc Faber expects and (in his inherited Swiss Protestant way) hopes. In that case, every sign we've seen so far is that our governments will run the money-presses white-hot rather than face major deflation. We all have an incentive to paddle away from the brink.

Put your hand in a parting wave

Frank Barbera discusses the implications of Elliott Wave Theory for the current stock market and concludes, like Karl Denninger, that there's at least as much bad news ahead as we've had already.

Unbelievable, unimaginable

The problem with looming economic disaster is that you look out the window and since what you see is normal, you wonder what that mad Cassandra is wailing about.

Michael Panzner reproduces an article by Paul Farrell in MarketWatch about the absolutely enormous international derivative market, currently estimated at $516 trillion. Those numbers are beyond imagining, but if 2% goes bad, that's equivalent to 20% of the world's annual GDP up the chimney.

Lessons from Japan

Krassimir Petrov looks at the Japanese experience of deflation - 17 years and counting. A monetarist view would require the following steps to end it:

• Condition 1. Bad loans made during the boom years must be written off as losses during the bust. This cleanses the banking system from the toxins of the boom.

• Condition 2. Weak businesses should be liquidated during the bust, rather than propped up by the government or the banks. These bankruptcies and liquidations shift scarce resources to more productive uses

• Condition 3. Finally, Interest rates must rise sufficiently to restore proper valuations in the capital markets, and therefore allow stocks and bonds to fall in value relative to consumer goods. This realigns properly the price ratio of capital goods to consumer goods.

Now, I suppose, it's our turn.

Money has poured out of Japan over the years, looking for better yields elsewhere, but Petrov is not at all sure that when the "carry trade" reverses, the Japanese market will rise. He thinks a more interesting bet is on the rise of the Yen in the foreign exchange market. And that's a poker game I don't have the confidence to join.

Pure gold

Karl Denninger offers a couple of very valuable insights today:

1. He thinks that we're only part way through the stock market decline:

Have you ever noticed that the "crooners" on Television never tell you to get out at or near the top, and call it a "buying opportunity" all the way down? Well gee, the last time they did this it only took 7 years before you were back to "even", and of course that's before price inflation ate up all your money.

I think he's right - mostly, the financial sections in the papers seem to me hardly better than celeb gossip.

2. Following on from this, he offers a technical tip on spotting turning points between bull and bear markets

... you buy the SPY (or a S&P 500 mutual fund such as VFINX) when the 20 week moving average crosses the 50 week moving average by more than 1%, and you go to cash (or treasuries) when the 20 week moving average crosses the 50 week moving average in the downward direct by more than 1%.

Being in the right asset class at the right time, as judged by this measure, beats those who stay in the market all the time. Denninger does warn that although it's been true for the last 20 years, it may not hold true forever.

Why safe investments aren't

Michael Panzner's latest explains a point I've learned and repeated here before: "refuge" investments like gold are not as safe and predictable as you might assume. Borrowing money to invest boosts prices, and then when credit becomes tight, forced sales can deflate prices just as rapidly. We're all in a bouncy castle, like it or not.

Property slump or stall?

Karl Denninger says house prices over the last 100 years have averaged three times income. What's the implication for us?

This BBC survey says the average semi (a standard unit of housing, one would think) is "worth" slightly over £200,000; official statistics put household income at £33,492. So houses cost around six times earnings.

That suggests a 50% drop is due. But as Keynes observed with wages, house prices tend to be "sticky downward": no-one is in a hurry to realize a big loss on their home equity. Death, divorce and redundancy may force some sales; others may choose to wait, or go for house swaps.

Or wages could double. Up till recently, it was a standard assumption that "inflation" would run at 2.5% p.a. and wage increases 2% above that. Using the "Rule of 72", it would take 16 years of 4.5% wage increases to double nominal incomes.

Whether wages will always rise in real terms, is another matter. One of the effects of globalization is to hold down wages in the developed countries; and food and energy costs look as though they will continue to rise as the rest of the world gets richer and more populous.

Marc Faber speaks on the crisis

Video here on Bloomberg. Summary and comment on Contrarian Investor. Some points he makes:

Bernanke's policies will destroy the dollar; he should have gone to Zimbabwe. Property assets in a bubble, but bonds (except maybe for some carefully-researched junk bonds!) also likely to be a victim of inflation. Emerging markets worse than the Dow. Deflation may hit the dollar through devaluation, rather than the nominal value of US equities. Commodities (e.g. gold) were at an inflation-adjusted 200-year low in the late 90s, so even after the recent rises they're not overvalued. Derivatives (NOT the packaged ones) will blow up in the next 3 - 6 months. He hope a major bank will fail and reintroduce discipline into the system.

Have you noticed how cheerful gloomy types get when disaster hits?

Another toiler in the vineyard

Safe Haven features an article by "Randy", who predicts that the American economy will go haywire. The good news is that, within a generation, poverty will make the US economically competitive again.

That's not an ironic comment. It seems to me that America's most precious heritage is not her wealth, but her love of liberty and her distrust of power. She has been seduced by Mammon and Empire, and the undoubted difficulties we face may turn out to be the last-minute rescue, the ram caught in the thicket.

Cash is king

Robert McHugh confirms my feeling: sit it out, hold cash.

Deus ex machina

You know you're in trouble when you have to appeal to the Great Leader to do something. Karl Denninger publishes an open letter to the President, the Presidential candidates and others.

1. He complains that 23A exemption letters and the recent TAF facility are being used to hide the scale of banking problems from the public.
2. He points out that over the last 100 years, local house prices trend to 3 times median local income (work that out for your own house).
3. He lists action points to make the system transparent and honest - even though some lenders will be immediately destroyed, like the little slips of flash-burn paper used by spies in Sixties movies.

Being right is not nearly enough - work it out for yourself:

1. Imagine the conversation between interns on receipt of Denninger's fax;
2. List the not-to-be-published reasons why nobody who could solve the problem, will;
3. Compose the official reply.

Now, head for the tree line.

Another Ranter

Alex Wallenwein goes schlock Gothick:

Employment figures, the Thornburg collapse, Carlysle Group troubles, sky-high oil prices, rampant inflation, the dollar-crash, and neverending Fed bailouts of fast failing super banks are pounding the stake deeper and deeper into the global debt-vampire's heart. He will find his much-deserved rest before long. Unfortunately, the portfolios of careless and gullible retail investors, consisting largely of Dracula's debt-spawn, will die along with their master.

I'd give him a "Highly Commended" in the Sackerson's Prose Prize competition for that first, rolling sentence. But he gets pretty apocalyptic, too:

The next Dow-bottom will plumb depths not seen since the early 1990's, maybe even the 1980's!

The early 90s saw the Dow around the 3,000 - 5,000 range. Eat that, Robert McHugh.

Then he shoots for the moon:

... gold can easily go past $3,000 per ounce this year

- and makes a reckless recommendation:

If anyone still has money in any stocks or mutual funds, it's time to exit.

Overstated, I think - but completely wrong? Maybe not.

Another 42 stars?

"Deepcaster" continues to hint at the operations of "The Cartel". His theory is outlined in this post of August 11, 2006. In a nutshell, there's a plot (a) to dissolve the US and make a new entity by combining it with Canada and Mexico, and (b) ruin the dollar in order to replace it with the "Amero", presumably to recommence the thieving by inflation. So it's like what some think the EU project is about.

Except I don't think the EU or its North American equivalent are driven by sinister motives; just venal ones. Concentrating wealth and power makes very juicy opportunities, provided you can simplify the command structure. All that consulting the common people and getting their agreement is so tedious.

America grows. She acquired 29 states in the nineteenth century and five in the twentieth. Where next? Canada has 10 provinces and 3 territories; Mexico has 31 states and one federal district; Greenland is owned by Denmark but has been granted home rule. But Canadians, Mexicans and Greenlanders may have their own views about assimilation.

Democracy is inconvenient, by design. I think the thirteen stripes on "Old Glory" remain there, not just as a historical quirk, but to remind the Federal Government that it's very important to say "please" and "thank you". Even in the first go at making the nation, Maryland, Delaware and New Jersey chose to delay the ratification of the Articles of Confederation, until certain issues had been resolved to their satisfaction.

Here's to the awkward squad.

The Grand Union Flag of 1775, flown by John Paul Jones

Survivalism

Michael Panzner finds another useful article, this time by Laura Coffey on making contingency plans for losing your job.

I sent a circular to my clients in the late 90s, urging them to take out redundancy insurance, because I thought the coming stockmarket crash would be followed by recession; but of course I didn't anticipate that the government would use monetary inflation to defer the reckoning (and, I now fear, make it worse). Articles like Coffey's are straws in the wind, I think.

Diversity, dispersion and disconnection

Karl Denninger continues his heroic (it's always lonely out in front) campaign to call the banks and the regulators to their reckoning. As he points out, we're all tied together, and instead of making it better, that makes it worse, as non-Americans will find out:

The dollar will bounce around before starting to take off. So far, we've not seen people figure out the "rest of world will be f***ed", but if you think the exchange rate problems won't lead to that, you're sadly mistaken. Beware.

The bigger they are, the harder they fall

Michael Panzner refers us to a Financial Times article on the (overdue) dwindling confidence among our youngster trading community. The piece includes this paragraph:

Unlike past housing crises, the banking sector is far less well equipped to cope with the fallout because of the wave of banking consolidation in the last decade. [...] This means the pain has become concentrated among a small handful of institutions, all of whom play a crucial role in keeping all markets liquid.

I recently quoted this Contrary Investor article, which includes a graph of the ballooning exposure of American banks to credit default swaps (CDS), under which arrangement everybody insures everybody else. The risk is 99%+ concentrated into only SIX banks.

Who benefits from such concentrations? I commented on Panzner's site:

Concentration of finance into an ever-smaller number of giant banks is inherently dangerous. You reduce the risks of small hazards, but you increase the potential damage from a Black Swan / fat tail event. Systemic safety is in diversity, dispersion and disconnection.

There is increasingly a conflict of interest between those who benefit from concentrations of power and wealth (think of the bonuses and cushy jobs), and the general populace. Wasn't the US Constitution itself specifically designed to prevent such concentrations?

In my view, the sub-prime contagion is not only spreading to other sectors of the economy, but beginning to call into question how big government, high finance and monstrous companies impact on the fundamental values of our (systematic and real in the USA, ramshackle and sham here in the UK) democracies.

It seems to me that small-scale democracy-cum-economy is not only an historical reaction to the centralist authoritarianism of George III (who meant well, I am sure), but a kind of imitation of Nature, which has endured the most massive disruptions (a planet encased in ice, or burning from a massive meteor strike) because of my alliterative trio of survival traits: diversity, dispersion and disconnection.

Ten years after the stock market bounce

The FTSE is currently at 5,664.60. It stood at 5,782.90 at the end of trading on 6 March 1998. Has your wealth kept pace with inflation?

There's lots of ways to figure inflation. Monetary inflation is like pumping up an air bed (or a Space Hopper): if you squmph one end down, another part will swell, and that makes it hard to estimate the effect in any particular sector. So let's go back to the major source of inflation, and assume M4 (bank lending) has increased by an average 10% p.a. - I don't think that's far off.

According to this article (which also predicts even lower returns in future years) the total return on equities over the last 100 years has averaged 10.1%. That'd be nice. Now let's assume dividends averaged 3% - and let's assume you kept it all, instead of what really happens, which is you pay much of it to intermediaries, stockbrokers, fund managers and the taxman. To get the rest of this monetary-inflation-matching total return, we'd have to see 7% p.a. capital growth.

7% compounded for ten years makes 96.7%. So if you had bought the FTSE ten years ago, it would need to be worth around 11,375 today. After taxes, fees and charges. And then it would have to be worth even more, to make up for the fact that you don't keep all of your dividends, either.

Oh.

From soup to nuts

Steve Moyer gives a pretty clear (occasionally a bit aerated) potted history of the woeful train of events, over the ten years from the start of the technology stock boom to the popping (and it's only just started) of the real estate bubble.

Nobody had to invest in tech stocks, but we all have to live somewhere. A bubble in housing is really pernicious, because it has implications for almost everyone.

Low interest rates inflated property prices, which led to much larger mortgages. Deflating valuations by raising interest rates would trap many mortgage-holders who have taken on big loans and kept up a good credit history so far.

Therefore, unless the government is willing to deal with the political pain of accelerated mortage defaults, interest rates must now stay low-ish for a long time. So I guess that credit risk will be adjusted not by price, but by access: it will simply get harder to find a willing lender. If there is less lending, then that (it seems to me) is deflationary.

I don't believe that the burden of the monster mortgage will be reduced by rapid general inflation of both wages and prices as in the 70s and 80s. Increased world demand for food and energy will inflate prices, but globalisation means that for many - especially the poorer sort - wages won't keep up. The cost of housing will be a generation-long millstone around the neck.

Inflating the currency won't help. It will reduce the wealth of savers, but if we are importing not only luxuries but (increasingly) necessities, inflated wages will be gobbled up by inflated import prices.

Some may argue that currency debasement will make our exports more competitive. But for a long time now, manufacturing industry has been disappearing like snow in midsummer. Even if our export prices should become more competitive because of foreign exchange rates, domestic productive capacity has shrivelled: whole factories and shipyards have gone abroad, and the related human resources have withered, too. You can't reconstruct the proletariat and their workplaces overnight. Gone are the days when the Midlands engineering worker tinkered with metal in his garden shed, showing his son how to use the tools. Half a mile from where I live, one of the big engineering plants set up by the Birmingham-based Lucas family was taken over first by the Italian Magneti Marelli, then by the Japanese super-corp Denso, and now it's been stripped of its machines and will be demolished to make way for... housing. Goodness know how the mortgages on them will be paid.

I think Karl Denninger is right: the banks must be made to eat some of the debt they fed us. Either they will be ruined, or we shall be.

They knew it was coming

Karl Denninger looks at the cash-rich balance sheets of non-financial companies, many of which could now pay off all their bank debts from the kitty. Whatever they may have been telling you, it looks as though they've been voting with their wallets.

Succinct

See this and more in Chris Puplava's piece.

Eat what you cooked

Karl Denninger comments on the proposals to make banks write down some outstanding capital on loans, to secure what's left of the banking system. Painful, but it might save the day.

I wouldn't say it's impossible. America has more resilience and capacity to renew than its envious enemies wish to believe.

Good luck.

Subprime hitting GSEs

Karl Denninger comments trenchantly on a new scheme by "Fannie Mae", the government-sponsored mortgage lender: "Homesaver Advance" takes the borrower's missed mortgage payments and puts them into an unsecured loan, thus "healing" the credit history so that home lending can continue as if (as if!) everything were normal. Denninger sees this as a signal to "short" Fannie Mae.

But over a period, Denninger has moved on from trying to exploit such market weaknesses, to urging his fellow citizens to protest about the corruption of the financial system. His tone is now getting darker - like Jeffrey Nyquist, he's beginning to worry about international relations, for example the way that China's population pressure may threaten Russia's land. Lhasa 1950, Khabarovsk and Irkutsk when?

Which crank are you?

In turbulent times, we get an increase in prophets, astrologers, clairvoyants, magicians and mountebanks. Perhaps we can place more reliance on the significance of their appearing, than on the things they have to say.

"Deepcaster", who I think of as the Nostradamus of finance, often refers to a shadowy clique he calls The Cartel; if only one could identify them - or him! But there is some basis for the paranoid - for example, who owns the Federal Reserve does indeed seem to be a secret; though I doubt the chairman strokes a white cat. Here are some of Deepcaster's tips for economic survivalism:

Keep a significant portion of your wealth in tangible assets including Precious Monetary Metals (in amounts subject to timing considerations) and Strategic (e.g. Crude Oil) and select agricultural commodities which the public needs and regularly uses...

Attempt to make, although it may be very difficult, an evaluation of counterparty strength. Regarding options, for example, are they clearing house guaranteed? And how strong is the clearing house?

“Go local” in banking, and commercial, and essential goods supply relationships. “Self reliance” and “local reliance” are key goals...

Develop an investing and trading regime for certain key tangible assets markets to minimize or avoid the impact of Cartel-initiated takedowns...

Stay informed...

Since we're going back to the Seventies, here's Al Stewart's 1973 cult Nostradamus lyric (from Past, Present and Future). There's always a little frisson in old mortality. Speaking of which, Jeffrey Nyquist returns to his Cassandran theme of America as ancient Athens on the brink of the Peloponnesian catastrophe.

I shouldn't laugh too much at all this. The vibrations of the First World War were, I think, felt in the art and music of the years before it; and the millennarian gloom of Eliot's Waste Land (1922) was also only a few years ahead of economic, social and military turmoil. The current flock of seers and chanters may be like the restless sheep before the earthquake.

A pound to a penny

Adrian Ash points out that against gold, the British pound is now less than 1% of its value in 1931.

Why there are no customers' yachts

Hedge fund and investment trust managers sit on a big pile of money and a small percentage creamed off still means a handsome living. But Daniel Amerman maintains that's not the biggest advantage they have over you. As he shows with worked examples, shrewd use of the rules of the game can turn a real investment loss into a substantial gain.

By borrowing money at preferential interest rates, and writing-off the interest as a business expense, they can multiply the amount invested, reduce taxation and massively boost the return on the original capital. All is well as long as prices go up, and Amerman sees this a huge incentive to continue the inflation in financial assets: the system demands it.

His conclusion, in general terms, is to ignore the usual fairytales told to the small investor, work out how the con really operates, and exploit it. He thinks you should be in tangible assets, and understand the implications of taxation and inflation for your portfolio .

Michael Kilbach echoes that with respect to commodities, though like me, he thinks there'll be a step back before the next jump:

In the long term we believe prices are heading much higher and we are therefore looking for pessimism in the precious metals market before adding to our positions. We sell into extreme optimism. We understand that we could miss out on an opportunity to have more invested for a short term move higher, and we are willing to risk losing that opportunity. Rather than trying to catch up to the current markets move we try to anticipate the next markets move.

Don't take on gunslingers

A client raised an important point some weeks ago: when he decides to sell or switch his holdings in a collective investment (e.g. an insurance bond or pension), the company wants to receive the authorisation in writing, by which time it could be too late. The traders can act straight away, on the price they see on their screens.

Paul Lamont echoes this in SafeHaven:

The Wall Street Firms will know if the Ambac deal fails long before investors. We commented last April: "As the editor of The Commercial and Financial Chronicle in November of 1929 reported on the Great Crash, 'the crowd didn't sell, they got sold out.' The trading desks of the Wall Street Firms will cash out as the panic develops, the lady in Omaha will be stuck on the phone with a busy signal... To avoid this, investors should be moving now to financially healthy institutions and buying U.S. Treasury Bills."

You can't outdraw the fast hand, but you can get out of town when you hear he's coming.

Creak... squeak... pop!

This and more is in the latest ContraryInvestor piece on SafeHaven. Almost all of the above is concentrated in a mere five banks.

The tone is not doomster:

The world is not about to come to an end. Through adversity is born opportunity for those prepared both emotionally and financially.

As with Northern Rock, I expect that when calamity strikes, the bank directors and financial regulators will still have good payoffs and pensions. What a tolerant society we live in.

What the rubber mat said

I sat in my clients' office yesterday afternoon, waiting for them to arrive. The office had lovely new desks; as it turned out, not new, but taken from another business that has recently closed.

The reason for the delay - at least for one of the directors - was a last-moment requirement for tico rubber, needed next morning for anti-vibration matting under a five-ton machine that was being re-sited. The usual supplier, a major international concern, has recently shut down the closest depot to Birmingham. Rationalisation. Outsourcing. Globalization.

So while waiting, I tried to help my client find the material somewhere else. Googling away, we found it in the far north of England, or Cornwall; too far. Maybe just possibly in Market Harborough or Leicester? On calling the nearer companies, specifications and stock levels were doubtful.

My clients' business is contrarian: they move machines, and although originally that meant from one UK site to another, more often now it involves sending them abroad. As the decline of British manufacturing industry has accelerated, they've been very busy recently. For obvious reasons, the bonanza will end sometime.

But back to the matting. Once, suppliers of components you needed would be close at hand. Now we could be looking at journeys to the ends of the country - meaning cost, delay and maybe, sometimes, a lost contract.

The Pearl River in China is now home to myriads of small manufacturers, and the synergy improves everyone's productive capacity. Like it used to in Birmingham, "city of a thousand trades". But now in the UK, we could be dropping below the threshold of economic viability for manufacturing industry.

That's what the mat said to me.

What's your house worth?

Home prices WILL contract so that the median house is 2.5-3x the median income

says Karl Denninger. Now do your sums.

Some interesting comments and suggestions (including my usual twopenn'orth) on this post at the Capitalists@work blog - people seriously discussing inflation hedging and survivalism, here in the UK. We're getting beyond ivory-tower discussion.

Beyond gold

This blog by Thomas H. Greco looks interesting. The author, an American, has taken the trouble to address a convention in Malaysia on currency issues,and you'll recall that they're trialling the gold dinar in the province of Kelantan.

Greco thinks that modern technology may let us keep accounts of exchanges without having to resort to traditional forms of currency. I suppose this could be similar to Local Exchange Trading Systems. It's also interesting that he's featured and commented on Ron Paul's proposal that currency systems should be allowed to compete. Greco even looks at Air Miles as one candidate!

Going down

Another grizzly, this time Captain Hook:

You should know that when banks begin to fail in the States, and they will, things could spiral out of control to the extent controls will to need be placed on both digital and physical movement. Transfers between banks will cease up completely, debts will be called in (so pay them off now), systems from food distribution to medical care will break down, and Martial Law will be the result as the population retaliates. Life will change as you know it.

[...] Japan has never really escaped the credit crunch that gripped their economy back in the 90's after bubblizing the real estate market. That's the tell-tale-sign a bubble economy is on its last legs you know - when master planners need resort to bubblizing the real estate market. Generally it's all down hill after that on a secular (long-term) basis because this is a reflection of not just a turn in the larger credit cycle; but more, and the driver of credit growth in the end, this is the signal demographic constraints have turned negative. [...] It's a simple numbers game, where an aging population is less prone to take on debt.

He considers the possibility of a Japanese-style asset deflation, which gels with my earlier thoughts regarding a generation-long UK property slump.

Place your bets

Peter Navarro lays out three global economic scenarios and their effects on different asset classes. The grid looks a bit like the betting board for roulette, or possibly craps. At any rate, a good tool for helping you decide.

To me, decoupling seems the least likely at this stage; I don't feel the rest of the world has yet built up demand sufficient to be unaffected by the loss of the American consumer. But what do I know.

I'm guessing the first scenario for a while, followed by the third when governments panic.

... and I thought I was a bear!

My position is firm, that the US banking system has been irrevocably destroyed, unfixable.

See the above and more in this from Jim Willie - and thanks to John East for the link.

The end of democracy

Simon Watkins and Helia Ebrahimi in The Mail on Sunday (p.58) give a graph showing that sovereign wealth funds (SWFs) purchased over £20 billion worth of British business in the last three years, and report a prediction that SWFs will own £6 trillion of world assets by 2015.

Wikipedia estimates the world's stockmarket capitalisation at $51 trillion and bonds at $45 trillion. Taken together, in sterling terms, that's about £49 trillion. So in seven years' time, sovereign funds are expected to control 12% of the market. This is significant: you'll recall that and EU countries require declarations of shareholdings at various levels between 2 and 5 per cent (3% in the UK), as seen in Appendix 5 of this document, and anyone owning over 1% of a company's shares has to declare dealings if the company is the subject of a takeover bid.

My hazy understanding of democracy is that it includes two crucial elements, namely, the vote, and the right to own personal property. We're losing both. What is our freedom worth when collectively, governments not only employ large numbers of people directly, but many more of them indirectly, through ownership of the businesses for which they work?

What does the vote matter? Here in the UK, we have had a coup by a small, tightly organised (and unscrupulous, even if and when principled) group who have realised that what matters is the swing voter in the swing seat, and nothing else. "What works is what matters" - a slogan that, superficially, seems simply pragmatic, but actually slithers away from identifying the principal objective: you can only tell if it works, when you know what you want it to do. And under our first-past-the-post system, with constituencies determined (how? and who is on the committee?) by the Boundary Commission, I could vote for the incumbent or the man in the moon, but I'm going to get a Labour Party apparatchik in my ward.

And I don't think the system will be reformed if "the other lot" get in, either: "Look with thine ears: See how yond Justice rails upon yond simple thief. Hark in thine ear: Change places, and handy-dandy, which is the Justice, which is the thief?" Structural issues matter: we are cursed by the psephologists, spin doctors and databases.

And as for property, when sovereign wealth funds go from being the tail that wags the dog, to becoming the dog, multinational businesses will be less concerned to satisfy the local shareholder, who may also be an employee. Big MD (or Big CEO) will have his arm around the shoulders of Big Brother.

We worry so much about wealth, and forget what it's for: not just survival, but independence, respect, liberty. Now, the peasants are fed, housed, medically treated, given pocket money, have their disabilities catered for, their children taught, and their legal cases expensively considered. So many of them are fat, enforcedly idle, addled with drink and drugs, chronically ill and disabled, negligent of their offspring and familiar to the point of contempt with the legal system. Despite (because of) their luxuries, they suffer, like the declawed, housebound cats in some American dwellings.

What matters is what works; these outcomes don't matter, except that they work for a class - which I think is becoming hereditary - that seeks, retains and services power. I have said to friends many times that we are seeing the reconstruction of a pan-European aristocracy, disguised as a political, managerial and media nexus.

The American Revolution was about liberty, not wealth, and it is one of the few major nations where the mice did, for a long time, succeed in belling the cat; there was a period here, too, when Parliament could call the King's men to a rigorous account. Now, even in America, the abstract networks of money and power are turning the voters into vassals of the machine that sustains them. As here, the political issues there will soon be welfare, pensions, Medicare and other elements of the badly-made pottage for which we sell our birthright.

As for Bombardier Yossarian in Catch-22, the first step back to our liberty is to stop believing in the benevolence of the system.

BTW: the man who wrote "The Anarchist Cookbook" later converted to Christianity. The one thing not to do with the system is to try to smash it - you'll only get something worse.

Flat Broke and Berserk

Stagflation? Who can say?

Paul Kasriel says no to seventies-style stagflation, for two reasons: oil supplies aren't being choked off, and unions are weak. He may be right.

But I understand that the Saudis are keeping oil production at an unsustainably high level, even though this is damaging the quality of the remaining underground reserves. In French wine-growing terms, this is known as "faire pisser les vignes". And given the Peak Oil issue, we're going to find that countries like Russia and Iran may use their energy supplies to further their own agendas.

As to union wage demands, yes, the brothers are no longer so united; but the voters may yet get together behind a politician who promises to maintain living standards. I predict this will be achieved by writing checks/cheques on the future, i.e. inflation. That's after the current bout of monetary deflation, of course.

Which brings us to currencies. It's a good week for readers of Julian Phillips: here he discusses how in rural India, the rupee is on a flexible gold standard to avoid the depredations of taxation and bribery; and here he looks at possible plans by G7 nations to place your money under house arrest, to prevent it fleeing the country.

Is this back to the 70s, or the 60s? As Wikipedia reminds us, "In the summer of 1966, with the value of the pound falling in the currency markets, exchange controls were tightened by the Wilson government. Among the measures, tourists were banned from taking more than £50 out of the country, until the restriction was lifted in 1979. "

Pursuing my "sell up and get a (possibly horse-drawn) caravan" theme, I note it's a tradition of the Romanies to collect large pieces of Royal Crown Derby pottery - beautiful, thickly patinated with gold, easily identifiable in the event of theft, and impossible to melt down. Soon it'll be time to join the raggle taggle gypsies, O.

Until then, I have to have a replacement car (they tell me Fiat stands for "Fix It Again Tomorrow"), so I'm off to a second-hand auto supermarket today. Let's see if there is any real sign of recession hitting big-ticket items.

The low interest trap

The UK's residential housing stock is now worth an estimated £4 trillion. But this valuation is powered by £1.2 trillion in mortgages, an average first time buyer loan of £140,000, a loan/income multiple of 3.61 and the base interest rate at 5.5%.

In 1987, the average first-time buyer borrowed £25,000, with a loan/income multiple of 2.1 and the base interest rate at 10.5%.

So the modern housebuyer now takes on 72% more debt in relation to income. Interest rates (and house values) may go up and down, but the amount borrowed is a hard - and now heavy - number. All this for the same thing we had 20 years ago - a safe place to sleep.

One might think that the true value of our housing is the gross less debt, i.e. (4 - 1.2 =) £2.8 trillion. That approach would work, if each house had the same proportion of debt. But it must be far less than that, since most of the debt is on the shoulders of the young(ish) - if they halved their initial borrowing, there would have to be a severe impact on house prices generally.

What would houses be worth if no-one could borrow more than 2 years' income against them? What if there were no mortgages at all? What will happen - what will the multiplying effect be - when the housebuying generation finds itself so burdened with taxes and high food and energy costs, that it cannot afford to take on such large home loans?

In whose interest has all this money-lending operated?

In cartoon-caveman times, chasing the bear or sabre-toothed tiger out and seizing the cave would be a day's work. Now it takes 20-25 years (sometimes far more) to chase out the bank. Have we progressed?

Will sovereign wealth funds support the market?

BBC Radio 4 broadcast an interesting programme on sovereign wealth funds tonight. Is it not possible the oil exporting and trading surplus nations will be looking for a home for their capital, at the same time as private investors and overborrowed institutional investors are trying to cash out?

If so, the real story is not yet another impending market crash, whose effects may in any case be softened by an influx of new money that has political motive and so is not so narrowly focussed on a fair market price; instead, the major issue may be that, just as the West's industrial base has been hollowed-out, so its equity base may be attenuated in the same way.

In other words, our countries are like a man who has lost his job and is just about to find out that his pension scheme has been raided.

Laying it on the line

Some people will act beyond their self-interest. Karl Denninger is an expert investor, but is moved to be an economic prophet for his country and like other prophets, despairs of the passivity of his people:

This financial weapon of mass destruction is going to detonate.

It will make it impossible for the government to pay your Medicare and Social Security benefits.
It will result in double the tax burden you have now being laid on your children and grandchildren, OR MORE.

And when that happens, if I am still alive I'm going to spend MY MONEY on a full page advertisement in The Wall Street Journal (or whatever the "mainstream media" is at that point) telling your kids (who will then be adults) that you scr*w*d them on purpose because you were too much of a cheap j*ckoff to get on a plane and go raise h*ll in Washington DC to put a stop to this cr*p!

I wonder what their reaction will be to "Dear Old Dad" when they're living in poverty as a direct consequence of you fiddling while Rome burns?

I wonder if Moses used expletives when he came down off the mountain and found the people worshipping a statue of an ox?

Good man.

Cut and run?

Atash Hagmahani does pessimism in a flowery and Orientally allusive way, but the bottom line is familiar: stagflation is on the way, if not here already, thanks to financial imprudence and the offshoring of work.

His action points are interesting, including starting to save hard (and I agree that's technically possible, though many people might find this hard to sell to their life-partners) and (more controversially) not wasting money on a college education for your children:

They will spend vast amounts of money (much of it borrowed) on an education that is economically worthless; the jobs they could not get out of high-school will still be out of reach after college.

I think that recommendation needs qualification. It seems to me that in poor countries, the well-off are even better-off. Surely it's more important to ensure that your children, if capable and hard-working, either pursue courses that train them for well-paid work, or at least go to universities that raise their ambitions and help them make useful social connections.

But I think he's right to think that we'll soon find we're in a game of musical chairs with most of the seating removed. Another of Hagmahani's options is simply to quit the country. It's time to really think out of the box.

All our banks are sub-prime

The Mail on Sunday reports plans by the British Government to borrow money from the Middle East, on Islamic Sharia terms - that is, without, technically, paying interest.

Never mind the Islamophobic subtext: Islam is not the only religion to object to charging interest (which was illegal in France up to the Revolution of 1789). According to The Merchants' Magazine and Commercial Review by Isaac Smith Homans, William B. Dana (1849) (found by Google search here):

The Jewish law prohibited all usury between Jew and Jew, although it was allowed between Jews and foreigners. (Ex. 22 : 25 ; Levit. 25 : 36, 37 : Deut 23 : 19, 20. Compare Ps. 15 : 5 ; Ezek. 18 : 8, 13, 17, Ac.) The reason of this distinction, according to Father Ambrose, was, that God designed usury as one of the ways of making war upon the Canaanites and other heathen nations.

The Canon Law, as it is called, i. e., the ecclesiastical law of the Roman Catholic Church, pronounces the taking of interest, even the least, to be a mortal sin, and declares those who defend the practice to be heretics.

The interpretation of usury as a form of warfare is resonant.

There is also the unreligious technical point, that the money supply must increase to cover the interest charged. Either that, or ultimately all the money in the world will end up in the hands of the money-lenders.

This may not have mattered quite so much when the world was not so monetized - when we built our own houses, grew our own food, drew water from wells and rivers, and made our own clothes. It has to be said that none of it, generally, was as nice as today (though at least water didn't come in plastic bottles that took seven times as much water to make); but as more and more of reality nowadays has a price ticket on it, the inexorable demands of interest must either create unbounded inflation, or by seizing all our assets, enslave us. Perhaps usury is indeed a form of aggression.

Which leads me to wonder where money came from in the first place. How can you invent something, define the world with reference to your new creation (and possession), and use it to claim - to seize - ownership of the world? This is to make the money-issuer - originally the King or Emperor - lord of all the Creation he can control. So is power the only game in town? Maybe civilised life, the quiet enjoyment of one's own hard-won personal property, is merely an illusion, a time-out in the game. But impoverish the middle class and all bets are off - as Germany found out in the 20s and 30s. How foolish must a State be, to allow its mismanagement of finance to threaten the social order. Still, the Germans weren't entirely responsible for the WWI peace treaty that led to the total wreck of their economy; by contrast, look at this latest from Karl Denninger on the current, State-permitted mess.

The power of the State to coin money is nothing to the way the banks multiply it. Something like a mere 3% of all money is in notes and coins; the rest is deposits and credit - i.e. promises. Instead being charged a modest fee for guarding your cash (which is, I understand, the practice of the traditional Swiss bank), you're paid what you think is a nice rate of interest - but thanks to fractional reserve banking, your deposit can be multiplied and loaned out, at even higher rates. No wonder the banks always seem to have the nicest locations, including converted Tudor houses in little Warwickshire villages.

Swelling the capital within the economy ultimately pushes up prices, though as money-lenders become more cautious and call loans back in, the opposite happens; but meanwhile, the expanded money supply also builds-in massive future inflation, because interest must come back, as well as all the existing capital. Even if some of this fake capital is lost because of asset write-offs, the lenders will seek to make up for it by charging more interest on the loans that haven't defaulted. And the difference between the small interest paid out to you on your little deposit, and the larger interest demanded on the much greater loan base, pays for all the overheads and leaves over enough, and more than enough.

Meanwhile, the temporarily bloated money supply inflates assets, including assets that really you must have, such as a roof over your head. In the UK, the M4 measure of money supply has approximately doubled since 2000 - and house prices have done almost exactly the same. But I don't have the power to say, I don't believe in borrowing money so I won't pay so much for your house. And since you (quite understandably) will refuse my lower offer, I will have to rent instead - at a rate that reflects the price of houses. What would houses cost - what would rents be - if home loans were illegal?

So now, in the wake of sub-prime (and other, earlier financial bubbles), we're all clapping our hands to save Tinkerbell's life. The government pumps yet more funny money into the economy to shore up the confidence tricks of bankers, and in the case of Northern Rock, their own voter base. If we understood what this "Tinkerbell" is really like, and what she's been up to, perhaps we'd be better off letting her die.

Except the law's on her side, and she'd take us and our families down with her. After all, by agreeing to borrow, we fix an obligation in nominal terms, even if (owing to events beyond our control, but not necessarily beyond that of the money-makers, and money-fakers) the assets decline in nominal terms. In fact, by first expanding and then contracting the money supply, it is possible for lenders to take your assets and any additional capital that you personally contributed, then reinflate the assets later. Hey presto, they've grabbed your cash. No wonder some Americans trash the house before mailing back the keys.

I think that for those who have the liberty to do so, escape comes in two stages: get your cash out, then buy whatever you need so that in future, you depend on the money system as little as possible. You should also stay mobile - the State needs captives, and a house is an excellent way to tie you by one leg. And the licence plate on a car is the next best thing to a tag clipped onto your ear. Unfortunately, in an overcrowded island like ours, this doesn't seem realistic, but maybe that's why an Irish girl told me, years ago, that farsighted (and typically pessimistic) Germans were buying into rural Ireland. Perhaps in America, or some other land blessed with a lower ratio of population to fertile land, we may escape with the raggle taggle gypsies. Velvet-clad slavery, or freedom and poverty?

What care I for a goose-feather bed?
With the sheet turned down so bravely, O!
For to-night I shall sleep in a cold open field
Along with the raggle taggle gypsies, O!

UK public debt twice as bad as America's

David Walker, the US Comptroller General, reckons the debts and unfunded liabilities of the USA amount to some $53 trillion, which assuming GDP of $13.75 trillion means a debt-to-GDP ratio of 3.85. Mr Walker, now retiring, has taken his "Fiscal Wake Up Tour" round America for two years, warning Cassandra-like of the woe to come if things don't change soon.

"Wat Tyler" of the redoubtable blog Burning Our Money reckons UK debts and unfunded liabilities to be some £9 trillion, which assuming GDP of $2.472 trillion (c. £1.26 trillion today) means a debt-to-GDP ratio of 7.16. Sir John Bourn (74) is the UK's equivalent of David Walker, and recently left office after a tenure of 20 years. A Google news search using the terms "Sir John Bourn", "debt" and "warning" yielded nothing today.

We worry about mortgages, but according to this site:

"Recent figures from the Council of Mortgage Lenders (CML) showed average first-time buyers borrowed 3.24 times their income - the highest level ever recorded...Many lenders will calculate a debt income ratio, which as a rule of thumb should not exceed 40%. " (i.e. 0.4; my highlights)

Bonds: up or down?

Where's safe for your money? It's like a minefield: we seem to be zig-zag running between financial explosions. Housing? Overpriced, full of bad debt. The stockmarket? Due to drop when earnings revert to the mean. The commodity market? Distorted by speculation and manipulation.

How about bonds? Clive Maund thinks US Treasuries are due for a pasting as yields rise to factor-in inflation; but Karl Denning is still firmly of the DE-flation persuasion and thinks a stockmarket fall may be our saviour:

The Bond Market no likey what's going on. The 10 is threatening to break out of a bullish (for rates) flag, which presages a potential 4.20% 10 year rate. This will instantaneously translate into higher mortgage and other "long money" rates, destroying what's left of the housing industry.

There is only one way to prevent this, and that's for the stock market to blow up so that people run like hell into bonds, pushing yields down!

He also gives his own theory as to why the Fed stopped reporting M3 money supply rates:

The moonbats claim that The Fed discontinued M3 because they're trying to hide something. In fact they discontinued M3 because it didn't tell you the truth; it was simply NOT capturing any of the "shadow" credit creation caused by all the fraud (and undercapitalized "insurance" which, in fact, is worth zero), but it sure is capturing the forcible repatriation into bank balance sheets when there is no other when it comes to access to capital for companies and governments.

So, two elephants are riding the bond seesaw: fear of inflation, and fear of losing one's capital. I hope the plank doesn't snap. Antal Fekete reckons the bond market can take all the money you can throw at it - but what goes up will come down.

Cash still doesn't seem like such a bad thing, to me.

A secular bear market in housing?

It's now generally accepted that houses are overpriced. I think valuations will not only go down, but (notwithstanding bear market rallies) stay down for at least a generation.

Here's some reasons, some having a longer-term effect than others:

• house prices are now a very high multiple of earnings, choking the first-time buyer market.
• presently, there is increasing economic pessimism, which will further inhibit buyers.
• the mortgage burden now lies in the amount of capital to be repaid, rather than the interest rate; that's much harder to get out of, and will prolong the coming economic depression, either through the enduring impact on disposable income, or through the destruction of money by mortgage defaults on negative-equity property - and as valuations fall, there will be more and more of the latter.
• fairly low current interest rates allow little room to drop rates further to support affordability - and at worst, rate drops could sucker even more people into taking on monster mortgage debt. But interest rate reductions are unlikely to benefit borrowers anyway. The banks have survived for centuries on the fact that while valuations are variable, debt is fixed. They got silly with sub-prime, but by George they will remain determined to get all they can of their capital back, and preserve its value. The people who create money literally out of nothing - a mere account-ledger entry - are now tightening lending criteria and will continue to press for high interest rates; for now, they will content themselves with not fully passing on central bank rate cuts, so improving the differential for themselves, as compensation for their risk.
• food and fuel costs are rising, and given declining resources (including less quality arable land annually), a growing world population and the relative enrichment of developing countries, demand will continue to soar, cutting into what's left of disposable income.
• our economy is losing manufacturing capacity and steadily turning towards the service sector, where wages are generally lower.
• the demographics of an ageing population mean that there will be proportionately fewer in employment, and taxation in its broadest sense will increase, even if benefits are marginally reduced.
• the growing financial burden on workers will further depress the birth rate, which in turn will exacerbate the demographic problem.

In short, there will be less money available to chase house prices; and in my view, less to chase investments, too. It may be very similar in the USA - as Jim from San Marcos says now (repeating himself from last May):

A market goes up when more people want to buy, than those that want to sell. Well, all of these first time home buyers have no spare cash for the Stock Market. The Baby Boomers, sometime in the future are going to want to sell. The question arises, "Sell to Whom?"

Returning to houses, there are still those who think valuations will continue to be supported by the tacit encouragement of economic migration to the UK.

Now, although this helps keep down wage rates at the lower end (where is the Socialist compassion in that?), the government is pledging the future for a benefit which is merely temporary, if it exists at all. Once an incoming worker has a spouse and several children, how much does he/she need to earn to pay for the social benefits consumed now and to come later? State education alone runs at around £6,000 ($12,000) per annum per child.

And then there's the cost of all the benefits for the indiginous worker on low pay, or simply unemployed and becoming steadily less employable as time passes. And his/her children, learning their world-view in a family where there is no apparent connection between money and work. The government makes get-tough noises, but in a recessionary economy, I don't think victimising such people for the benefit of newspaper headlines will be any use. I seem to recall (unless it was an Alan Coren spoof) that in the 70s, Idi Amin made unemployment illegal in Uganda; not a model to follow.

So to me, allowing open-door economic migration to benefit the GDP and hold up house prices doesn't work in theory, let alone in practice.

Besides, I maintain that in the UK, we don't have a housing shortage: we have a housing misallocation. There must be very many elderly rattling around alone in houses too large and expensive for them to maintain properly. This book says that as long ago as 1981, some 600,000 single elderly in owner-occupied UK property had five or more rooms; the ONS says that in 2004, some 7 million people were living alone in Great Britain. Then there's what must be the much larger number of people who live in twos and threes in houses intended for fours and fives. Before we build another million houses on flood-plains, let's re-visit the concept of need.

Maybe we'll see the return of Roger the lodger - if he's had a CRB check, of course.

Would I buy a second home now? No. Would I sell the one I live in? I'd certainly think about it - in fact, have been considering that for some years.

Reversion to mean

Echoing recent comments by Vitaliy Katsenelson (also on Barron's), Jeremy Grantham thinks profit margins will decline towards normal and the Standard & Poor's 500 will head from its current c. 1334 to 1100 in the year 2010 - a drop of about 18%.

Grantham is emphatic that borrowed money is not a stimulant to the economy:

I have an exhibit that shows the 30 years prior to 1982 when the debt-to-gross domestic product ratio was completely flat at 1.2 times. Total debt is defined as government debt, personal debt, corporate debt and financial debt. Then in the 25 years after 1982, the flat line goes up at a 45 degrees angle from 1.2 times to 3.1 times GDP. Massive. In the first 30 years, when debt is flat, annual GDP growth is its usual battleship, growing at 3.5% and hardly twitching. After the massive increase in debt, GDP, far from accelerating, grew at 3%. So debt in the aggregate does not drive the economy. The economy is driven by education, man-hours worked, capital investment and technology.

That last sentence is really pregnant. I'm not sure about the man-hours (the closer we approach peasanthood, the harder we'll work), but I think that on both sides of the Atlantic, we've been falling down on the other three.

In Britain, our government has failed to distinguish between investing in education, and managing it - and where it has tried to do the latter, has pursued a Romantic-heritage political agenda. Capital investment? Going abroad. Technology? Ditto - and eagerly taken up (if not positively filched) by our Eastern trading partners.

I live in what used to be Car City; now, the vast Longbridge site is being redeveloped for housing and shops - in other words, open prison for the new ex-industrial underclass.

But Rome, too, kept control of its plebs with bread and circuses for a couple more centuries, before it fell.

Will monetary inflation be absorbed by the bond market?

In the previous post, I looked at the expectation that interest rates will rise. But it seems that freaky things can happen if the government tries to stimulate the economy by progressively cutting interest rates and pumping more money into the system.

Professor Antal E Fekete thinks that in a deflationary environment, governmental attempts to reflate by introducing more money will be thwarted by the ability of the bond market to soak up the excess liquidity. Higher bond yields result in lower bond valuations, so reducing interest rates inflates the price of bonds. Fekete says that halving the rate doubles the bond price, and since mathematically you can halve a number indefinitely, the bond market can absorb all the fiat money you can create. Therefore, you can have hyperinflation and economic depression at the same time.

This trap is possible because the abandonment of the gold-and-silver standard means that the dollar has no limit to its expansion. And bond speculators have their risk covered by the need of the government to return to the market for renewed borrowing. If the Professor is right, it would be a nasty trap indeed.

But maybe our conclusion should be that this explains why interest rates must rise.

A quibble on style: especially in England, money is regarded as dull. So financial commentators try hard to add flavour, and in the Professor's case, too hard - it has been difficult for me to detect the meat of the argument under its many-spiced similes. Byron's Don Juan comes to mind:

And Coleridge, too, has lately taken wing,
But like a hawk encumber'd with his hood,
Explaining Metaphysics to the nation--
I wish he would explain his Explanation.

Warren Buffett's misleading optimism

Jonathan Chevreau reports Warren Buffett's bullishness on the US economy, long-term; but the real gem in this piece is the extensive, but cogent and crunchy comment by Andrew Teasdale of The TAMRIS Consultancy, who analyses Buffett's real approach to equity valuations.

Teasdale points out that although interest rates hit 21% in 1982, there was less debt, higher disposable income and lower valuations: relative to disposable income, debt is a bigger burden today than it was 25 years ago. He summarises his position pithily:

It is also worthwhile remembering that not everyone holds a Buffet portfolio and not everyone has the luxury of a 220 year investment horizon. If I was a long term investor with no financial liabilities arising over the next 15 years equities would be my preferred asset class relative to cash and bonds, but I would be mindful of valuations in determining where I put my money.

Not all the bad debt has yet surfaced, and as Karl Denninger comments, even at this stage Citibank has recently been forced to borrow foreign money at 14%, and other banks at over 7%, in preference to the 3% Federal Funds rate, presumably to keep the scale of their insolvency in the dark.

Inflation is increasing, therefore money-lenders are going to want more income to compensate for risk and the erosion of the real value of their capital. For the yield to rise, the capital value of bonds has to fall.

So I read Teasdale's summary as implying that for now, it's cash rather than either bonds or equities.