16 December 2008

Tech predictions for 2009

Here are my predictions for the technology industry and the economy in 2009.

Almost all of my predictions stem from one thing: 2009 will be the year when the global recession bites hard, and all companies begin to see major sustained impacts from the resulting severe economic slow-down.
  • Emerging markets will see an even bigger decrease in electronics/technology consumption than developed ones. (e.g. China and India will each see actual negative economic growth by the 4th quarter, not just a slow-down in over-all growth)
  • Mobile phone sales around the world will be very sluggish for the first half the year and actually wind up in contraction by year end, making 2009 the first year in over 20 years with over-all flat sales.
  • The fastest (and perhaps only) growth area in mobile phones will be in pre-paid plans, and dirt-cheap handsets lacking any smart-phone features. This will largely occur as consumers try to save money by jettisoning expensive phone and data contracts.
  • Apple will report significant contraction in sales (particularly iPhones and iPods) as consumers cut-back in spending, and will see its stock in the $40 range.
  • Google growth will continue to slow in the first and second quarters and will report an outright contraction in business by the third quarter as advertising revenue gets hammered. Google stock will be in the $150 range by year end.
  • RIMM will see a contraction in revenue, and see its stock in the $20 range.
  • Virtually every tech firm there is will see contractions in business in 2009, and almost everyone will have hiring freezes if not actual lay-offs.
  • Not one tech firm will go public in 2009. VC funding of start-ups will be 90% lower than in 2008.
  • 2009 will be the year of tactical IT spending. Unless there is a provable 6 month ROI, or the existing systems are literally breaking, many companies will opt to conserve cash and forego any kind of up-grades, or long-term efficiency improvements. The products that succeed will be ones that show the customer will realize a benefit very quickly.
  • Paradoxically, companies become less efficient when faced with economic business uncertainty. It is only during prosperous times that most organizations are willing to consider significant investments to improve over-all productivity.
  • There will be a huge increase in sales of outsourced IT services, which allow customers to pay for usage. Companies will be very eager to control their costs as business changes in an unpredictable economic environment. Instead of hosting e-mail servers internally, just use an outside e-mail service that allows you to easily ramp up, or down, as your needs dictate. Why pay for unneeded capacity if you don’t have any orders next month and need to lay-off half your staff? This is not to say that every software service will succeed, but those that are tailored well (with the right pricing models) will see a big jump-start as more and more companies opt for pay-for-usage pricing models.
  • Hardware prices (e.g. memory, displays, storage, PCs) will fall faster than they have in decades, as all tech firms find that they are over-producing when demand slackens dramatically, forcing them to slash prices to unload inventory.
  • Investment in hardware R&D spending, and new product introduction will slow substantially. There will be far fewer new hardware standards, or technologies, emerging (e.g. wireless USB has almost stopped, now that most of the start-ups that were its driving force are finished). This will wind up having a knock-on effect of having fewer reasons for people to upgrade to new systems (i.e. because the technology isn’t improving as quickly as in the past).
  • The portion of sales of “value” tech products (i.e. products targeted at the lowest price-points) will become a far bigger portion of over-all sales, with a dramatic contraction in “premium” products.
  • The US dollar will defy all expectations and appreciate significantly against most other currencies. The Euro will see a significant loss in value as fractures begin to appear amongst EMU member states (e.g. with nations like Greece, Spain, and Italy spending profligately angering Germany and other “rich” nations). Emerging market currencies will be eviscerated, losing 50% of value vs the dollar or more.
  • Interest rates will remain extremely low, but it will be hard for businesses to get any credit since the private credit markets will remain frozen and chartered banks will be unable to make up the difference.
  • Oil will drop to the $30 dollar a barrel range by year end.
  • Global stock markets will close be 40% lower at the end of 2009 than they were at the beginning of the year.
  • Global stock markets will see incredible volatility throughout 2009 with rallies and crashes that break records. We will see at least one rally (that lasts more than 1 month) that sees the Dow Jones rise over 30% (only to lose it all again in a big crash).

12 December 2008

Altruism v. Benevolence

At a Liberty Fund conference this last weekend, the discussion touched upon the role of informal institutions on cultural behaviour and, separately, why there seems to be a decline in honesty among the youth. After some thought, I postulated that the two subjects might be linked.

As our society increasingly emphasizes, both in theory and in practice, that one person's need implies an obligation of others to share. If somebody has less food, we should feel guilty that we have more and donate. If somebody has less money, we should pay higher taxes so that they can have a minimum of comfort. We use euphemisms for our guilt, like "paying it forward," or "giving back to society," when really we simply mean a morally mandatory redistribution of wealth.

Worse yet, we downplay greatness and achievement. Many of our schools, even private ones, offer financial aid on the basis of need alone while even their top students of any given year receive not a farthing in scholarships. Bill Gates, Rockefeller, and Carnegie, rather than being praised for realizing the American Dream by producing incessantly better products that improve the lives of millions at steadily declining prices, we vilify them. Instead, we worship volunteerism and pop stars who ask us to ask our government to help poor Africans.

Among this orgy of selflessness, is it surprising that students have less and less respect for the answers and property of others? If those who have less of anything have almost a right to receive from those who have more, why is copying wrong? Why is stealing wrong? If the government is morally justified in taking from the wealthy and giving to the poor, why shouldn't the private redistribution of wealth be equally justified? What if Johnny has a better brain than Jane, shouldn't Johnny have to share his intellectual wealth with the less endowed?

We have replaced benevolence, the voluntary, discriminate giving by one person to another whom he finds deserving, with a cultural obligation to engage in indiscriminate giving by all who have more to all who have less. Whereas benevolence engenders profound satisfaction on the part of the giver and gratitude on the part of the receiver, institutional altruism engenders resentment in the giver and entitlement in the recipient. Where weakness is rewarded and achievement scorned, we should expect life to once again become nasty, brutish and short.

02 December 2008

Commodities tell the story

These charts are some of the best I have seen which illustrate how our current economic contraction compares to past eras. The chart comparing the Dow to commodities is particularly interesting, showing that massive drops in commodity prices have accompanied every major depression since the 1700s. The charts inverting commodity prices are also very intriguing, by illustrating quite graphically that what has really been happening lately is an appreciation of the dollar.

Since the summer of 2008 we have seen one of the most severe crashes in commodity prices ever. These charts show how big price corrections in commodities have an uncanny correlation to downturns in stocks, and the economy.

By the way, Elliott Wave International (the group that put this data together) is my favourite bunch of analysts anywhere. They have been about the only ones out there calling for a deflationary bust, even during the height of the bubble.

28 November 2008

the case for deflation - why stimulus spending won't help

At first blush, it would appear as if all the government bailouts and stimulus (to address the financial crisis) will wind up massively increasing inflation. After all, with government putting trillions of new dollars into the economy, how can this do anything other than to cause prices to rise and the US dollar to drop in value?

Unfortunately, this seemingly logically interpretation of government spending is flawed. Rather the causing inflation, government spending will contribute to the exact opposite result. An increase in national debt is DEFLATIONARY. It sucks money out of the rest of the economy, causing asset prices to decline even more (i.e. “deflation”).

The key thing to keep in mind is that debt is deflationary, and is not the same thing as printing money. At some point debt has to be repaid. Sure, increasing debt can also increase the money supply, but it also will lead to a contraction as well (i.e. when the debt is repaid). If the government was actually just “printing” money, instead of borrowing it, then I would agree we might be headed to a period of high inflation. But this is not what is happening.

Also, it is important to keep in mind that all this increased government spending (and the debt to back it) is a drop in the bucket when compared to the amount of debt creation which has VANISHED from the private sector. The global credit markets have been operating in the tens of trillions of dollars range for years ($40 to $60 trillion per annum), and this spigot of debt creation has virtually ceased to exist over the last 10 months. All the increased stimulus/spending of the world’s governments doesn’t come close to making the difference.
Consequently, this leads us towards deflation, since the velocity of money is contracting at a furious rate.

Even the people who are railing on banks to start lending more completely miss the point. As a matter of fact, the world’s banks have INCREASED their lending dramatically this year. The problem, however, is that it just doesn’t make up for the loss of the private credit markets. But this phenomenon is very opaque, and difficult for people to understand.

A given bank may actually be initiating a lower total volume of loans this year, but a FAR higher percentage of those loans are staying on the bank’s books. Over the last 20 years banks have begun to HEAVILY rely on the private credit markets to goose their lending capacity. A bank may lend $10 million to a company wanting to expand it’s manufacturing capacity, and then turn right around and re-sell that loan to mutual funds on the private market. In this way the bank becomes little more than a retailer, making a commission for the initial under-writing and on-going servicing of the loan. The actual loan itself, however, is owned by a 3rd party, and isn’t on the bank’s books at all.

Many companies became reliant on going directly to the private credit markets themselves, and side-stepping banks altogether, to get credit. Many firms became reliant on constantly selling their receivables as asset backed securities, and continuously rolling over that debt with new receivables every month. Unfortunately, this has almost completely ceased to happen over the last year, driving borrowing costs for these firms up enormously as they now have to go directly through banks (which always charged higher rates than the private markets).

In the last year, however, banks have had to place almost all the loans they write on their own books. The total loans the banks have on their books area increasing dramatically, but the actual value of the loans that they issue is down.

This is why we are facing deflation. The global credit markets are MASSIVE, and the virtual disappearance of them is a problem that no amount of stimulus or government spending can replace. The US government could undertake another $5 trillion in stimulus spending and it still won’t help. The Japanese government attempted to spur inflation with massive stimulus during the '90s, but that clearly didn't work either.

It’s possible the world’s governments could “print” money to stoke inflationary fires again, but doing so would pretty much destroy a national currency overnight. The days when governments can print money for months, or years, before the negative impacts are felt are over. Technology ensures that the markets will know when governments start printing and act swiftly.

The printing press (and electronic equivalent) is similar to having an arsenal of nuclear missiles during the cold war. In theory these missiles could be launched in a war, but the reality is that no leader will ever be willing to press the button on global thermonuclear war.

26 October 2008

Central Banking Exacerbates Credit Crises

Some of the clearest analyses of banking principles come from the 19th century, when a general awareness of various banking options still existed. Today, with the nationalization of note issues and the ubiquity of fiat currencies and central banking, few remember the alternatives or understand the implications of our current system. A French economist, Charles Coquelin, wrote a number of lucid works, including a comprehensive analysis of credit and banks (in French).

In a shorter article by the same author explaining the role of credit in economic crises, Coquelin explains that only economies that use credit experience periodic crises, and that such crises are acerbated considerably in economies with central banks. While in 1864, the possibility of fiat currency didn't cross his mind, he could still see that the central banks of his day (e.g., Bank of England & Banque de France) distorted credit markets by their privileged status. With specific privileges beyond all other banks, central banks were considered more secure than private banks, and could both borrow and lend at lower rates of interest than their private counterparts as a result. This left largely riskier borrowers for the private banks and led inexorably to de facto national currencies which linked problems with one bank to those of others.

While there will (and should) always be periodic bank failures, as in any other industry, it is important that the full risks and losses of such failures be left with the investors and depositors of such banks so as to avoid taxing healthier banks to support their less healthy neighbours. In a free market, marginal institutions fall first and as their assets liquidated, healthier banks can buy them at discounted prices and shore up their own portfolios. This leaves the healthiest institutions standing at the end of the crises.

Alas, we have adopted the exact opposite policy in the current crisis. The weakest banks that fall first are bailed out by governments, along with every subsequent bank until the government can no longer issue more promises against future tax revenue. At that point, all of the "salvaged" banks fall at once when the government defaults on their debt obligations. Perhaps Coquelin was right in suggesting that the whole process is less painful if left to the free market.

Private Money = Stable Money

The monetary turmoil now underway is, in part, due to the fact that countries have adopted monopoly currencies and then proceed to abuse them without immediate consequences. The euro is about to collapse, as regional manipulation of interest rates and government deficit spending leads to the logical consequence. The solution is the anti-Euro, private, competitive currencies.

National and inter-national currency monopolies lead governments to eventually move to fiat money backed only by their threats against those who refuse to accept it and ability to tax the people to give it value. Currencies founded on intrinsically valuable specie money are always extinguished by central bankers. Once a monopoly fiat currency has been established, central banks proceed to over-produce bills, and entering into excessive debt, sustainable only through continued inflation.

In a private, competitive monetary environment, however, any private mint indulging in debasement of their coin would be punished by the markets. Their currency would trade at a discount, to the degree that it traded at all. Banks issuing banknotes bearing their own bank's name would, likewise, only put the issuing bank at risk for their value. An over-exuberant note-issuer would find their notes quickly discounted by the markets, forcing them to reduce their circulation or face a run.

Monopoly currencies are too tempting for governments to not leverage them as tools of indirect taxation. Once such currencies have been extensively over-leveraged, they collapse in an inflationary spiral. Only healthy currency competition between privately competing currencies in a free market can effectively discourage currency mismanagement.

12 October 2008

Savings: Outdated idea?

It is easy to blame greedy bankers and Wall Street for the depth of the current financial turmoil, but the primary source is the encouragement of debt and discouragement of savings by the U.S. government. Inflation of the currency, both by blatent printing and debt expansion, always discourages savings, but the list is not limited to inflation-related incentives:

1. People are taxed on capital gains from their savings and investments, after paying tax on the original principle. If they just spend their money instead of saving it, they might even be able to deduct such purchases as business expenses.

2. "Profits" on long-held investments like homes are not adjusted for inflation, so even if the house lost money in real terms, it could be taxed heavily for capital gains due to inflation.

3. Idle cash must be invested or spent simply to keep up with the inflation rate. Cash balances lose money by default. Often even basic savings rates are lower than inflation rates, encouraging savers to seek higher yield, higher risk investments merely to keep from losing their principal.

4. Mortgage interest is deductable from income tax, encouraging people to borrow money for their home and discouraging renting.

5. There is an unlimited allowance for capital gains and income that is taxable, but only $3,000 in losses may be deducted per year. If you make $1 million one year and lose $1 million the next, the full $1 million will be taxed the first year, but only $3,000 may be deducted from taxes the second year. Even if you save the residual income after taxes from the first year, you cannot cover the loss of the second.

6. The arbitrary nature of breaking the tax year into specific segments. All expenses within a given tax year are deductable, but if profits are saved over a period of years to pay for an expense in cash, those profits are taxed every year before the ultimate purchase. If, however, money is borrowed to pay for an expense up front, its cost can be amortized over many years.

7. Richer people, who have more discretionary income to save, are taxed much more heavily than poorer people. The poor don't have much extra money to save to start with, so if we tax away the would-be savings of the rich, we impoversh our capital supplies.

8. Inheritance taxes encourage the consumption of accumulated wealth during one's lifetime rather than inter-generational savings and investment. If you know that a large portion of your life savings will be taken upon death, why not spend it now?

In short, the government creates considerable incentives to borrow and spend, especially via the various effects of inflation, and thus discourages savings. Any society that neglects savings long enough is sure to ultimately find itself with a lack of real capital, leading to a depression when the credit pile crumbles. A society which values savings is one with slower economic growth, perhaps, but fewer economic surprises.

08 October 2008

Another Rate Cut, Another Failure

At last! The Federal Reserve, along with many other central banks around the world, have cut interest rates. This is what the markets have been waiting for, everything will be fine now. After all, the previous rate cuts over the last year have done so well that its obvious that a globally coordinated rate reduction will do wonders.

This is clearly poppycock. Interest rates are already at historic lows but that hasn't helped the economy. Lowering the cost of borrowing further won't do anything to encourage people to borrow more, or prevent a further decline in the value of assets. Japan has been trying to almost GIVE money away for nearly 20 years and that didn't re-ignite their economy, and there is no reason to suppose this recent rate cut is going to help anyone either.

Interestingly, rate cuts are one of the best sell signals an investor can find. Stocks almost always head lower in the weeks, and months, following a rate cut. This only makes sense, of course, since rate cuts are always made when central banks are concerned about the health of the economy. Ironically, the time to buy is when central banks start raising rates.

Actually, raising rates isn't as crazy as it sounds. Low interest rates themselves are a significant contributor to the economic crisis. It is difficult for anyone to make money lending at such ridiculously low rates. Why even bother making a loan at 5% when there is barely enough income to cover your costs, let alone compensate for the risk of default (which is greater today than at any time in the last couple decades)? I vote for a co-ordinated global strategy of raising rates, and ceasing mortgage subsidies (i.e. Fannie, Freddie, FHA, etc).

Such a policy of higher interest rates would absolutely hurt the economy in the short term, but it would help restore health to the financial system by making it profitable to lend once again. Unfortunately, no policy makers seem to be willing to accept any short-term pain, even it it will help reduce the depth of our coming depression.

Oh, and let us not forget that it was abnormally low interest rates which were a major cause of the economic mess we are already in. Central banks did indeed prevent a severe recession in the 2002 by lowering interest rates to historic lows, but wound up contributing to the blowing of asset bubbles all over the place with a crack-up credit boom. Alas, there are no more bubbles left to blow, and there is no one left with a clean enough balance sheet to take on more debt.

05 October 2008

The Comfort of Conspiracy

The tin foil hat wearing conspiracy theorists, convinced that dark forces have made secret plans to control events, may not be the paranoid anti-social mal-contents most people assume. In fact, it is quite possible that the belief in (unproven) conspiracies is a perfectly rational response when the world around us feels out of control. It is far preferable to think that the bad, or seemingly unexplainable, events that occur are the result of devious plots by nefarious persons meeting in dark rooms than to accept that terrible things happen all on their own.

It shouldn’t be any surprise, then, that conspiracies tend to be particularly popular amongst the people most alienated or marginalized in society (be it ethnic groups, or just the average social outcast). These people are desperately seeking ways to explain just why it is that life has handed them a raw deal, and a conspiracy is a handy way to explain it.

Most of these conspiracy theories contain the seeds of their own disproof right in their very premise, yet the adherents will swear by them nevertheless. In recent years, for example, there has been a great deal of speculation amongst many gold investors that government intervention was artificially deflating the value of precious metals. But if this were true, why then did gold prices rise so dramatically in the years up to 2008? As soon as gold prices began to decline in 2008 there was a lot of talk (once again) about how this might be due to the collusion of global central bankers. However, if gold prices have been pushed down by a cabal of central banks in 2008, then why did they allow them to rise so breathtakingly fast since 2005?

The same flaw can found in the theories proclaiming that the credit crisis of 2007/2008 was engineered by big Wall Street bankers. Most of those banks actually wound up going bust, and having their shares made into worthless scrip. If there was a conspiracy it would seem to have been a singular failure. It’s particularly telling that most conspiracy theories are designed to explain “bad” things: no one ever considers that the good things that occur were the results of plots.

Of course, conspiracies do sometimes occur. In many cases they aren’t even all that secret, with governments or policy makers openly declaring their intent to manipulate currencies or economies. However, these actions are rarely successful, and most often fail quite spectacularly.

The one thing that remains constant with all good conspiracy theories is the firm belief that it IS possible to control events. By grasping at the belief that somehow things are controllable, we can then feel that at least life could get better if only the “right” people were pulling the strings.

Iceland: The Land That Credit Created

Iceland may be suffering now, as the credit crunch bites deeper than it has almost anywhere else, but in a few years it may prove that the swift decline and massive wave of defaults (as virtually everyone in the nation defaulted on their debts) was the best solution to the calamity. Other nations, with deeper resources (like the US) are delaying the inevitable with massive bailouts, which may ultimately do nothing more than prolong the pain.

The swift decline of Northern Europe’s economic superstar is a graphic illustration of the hollowness of the economic boom the world has seen over the last 20 years. It wasn’t long ago that Iceland was hailed by business magazines as an amazing success, to be emulated by others. The similarities to those Americans buying multi-million dollar McMansions with negative amortization financing, while driving around in SUVs purchased with home equity loan extraction is striking.

The fall from economic grace may be hard on Icelanders, and leave them a much poorer nation with limited economic growth for decades to come, but they may wind up better off than the larger economies that are digging themselves deeper holes in vain attempts to prevent the necessary reckoning from the Great Credit Binge. The irony is that while smaller nations may find their options limited when facing national economic ruin, the fact that they were forced to deal with their problems head on will be to their benefit.

Any who still think that the credit crisis is only an American problem really need to examine what is happening in places like Iceland closely. This is a GLOBAL calamity, that will leave many other nations in even worse shape than the USA before things have run their course.

04 October 2008

Will Government Force Banks to Accept Bailout?

One question that has me perplexed by the (latest) government bailout plan is exactly which institutions would want to take the treasury department up on its offer of buying dud assets? My understanding is that in order to tap into the government funding the lenders will have to 1) agree to executive salary restrictions and 2) offer warrants to the government (there is even a provision in the bill that allows the treasury to demand stock in exchange for the financial help, but it isn’t clear if the treasury will exercise this right).

With terms like this, which financial institution would really want to avail itself of government help? Any CEO who accepts this deal will essentially be ending their career and the shareholders likely won’t be too thrilled with the potentially dilutive impacts of the warrants. Logically, it would seem as if most financial firms would rather just hang onto their toxic assets, and hope that the bailout ends the crisis and markets for these dubious goods return (at prices they like). After all, if the government manages to put a floor on prices for shunned credit instruments then why does it matter if they sell them or just keep them on the books, the end result is the same (i.e. they book the same price either way)?

This all assumes that the treasury was even willing to offer near full value prices for these assets in the first place. If the government somehow tries to offer a significant discount from face value (albeit still above actual market prices) then virtually no one would be interested in the bailout. For most institutions accepting any kind off significant price cut would render them immediately insolvent.

It all boils down to this: accept the bailout and lose your job and accept the potential of wiping out shareholders or hang on hoping that somehow markets recover. This really doesn’t seem like much of a choice. What manager would take the altruistic stance that it was ultimately in the best interests of the economy to restore the company to health even if to do so would hurt themselves (and existing shareholders)?

So what’s the government to do? Are they going to have to resort to forcing struggling financial institutions to accept the bailout?

Of course, even if the demand for access to bailout money is substantial, we have no guarantees that the credit markets will unfreeze. No bailout will change the fact that tens of millions of Americans can’t afford their debt payments and that default rates will continue to increase. Until all those defaults have run their course the underlying asset prices (e.g. mortgages, credit card and auto loan receivable securities, etc) will continue to fall, which will force lenders to continue ratcheting up lending criterion and terms. Why accept 10% down for a mortgage when there is a good chance the home will drop another 10% in the next year?

Original Sin

In all the rush to crucify the "greedy" Wall Street bankers and lax regulators for the current financial crisis the actual offender is going unnoticed.

It doesn't take a Nobel Prize winner to identify the underlying cause of the credit crunch as stemming from over-investments, which has left a glut of unproductive assets (e.g. real-estate around the world, factories in China, etc) that are dragging down the global economies. This mal-investment binge is so obvious that some pundits have even suggested a whole-scale demolishion of homes as a strategy for fixing the economy.

But what caused this horrendous buying (and construction) binge to begin with? Fortunately, we don't have to go far to find the underlying disease.

It is no cooincidence that real-estate prices have been appreciating at an historically abnormal rate after the Great Depression and World War II. The big changes that made this resurgence of real-estate possible are obvious: mortgage tax deductions and government subsidized mortgages (i.e. Fannie Mae, Freddie Mac, FHA, etc). Prior to the 1930s these government programs to foster home-ownership didn't exist.

It is these


Any last hopes that the latest government financial bailout would stave off the economic downturn and cheer investors was put to rest when the stock markets tanked immediately after the bill was signed into law. This bailout can't possibly succeed, and will fail just as all the others have over the last year, but that hardly matters. The real goal of this bailout is to absolve the government of responsibility for the real troubles that lie ahead, and at this it succeeds in spades.

Had the policy makers not enacted a major intervention then they would have nothing to say for themselves months from now, as the economy continues to crumble and increasing masses of people lose their jobs. Instead, the nation's leaders have now absolved themselves of any responsibility for the disaster in the offing. When the Dow is below 8000, and home prices have dropped another 30% the US leadership can say, with a straight face, that they did their best to stop it. After all, the government spent $800 billion of tax-payer money in a valiant effort to stop the bleeding. Is it their fault that the bailout didn't work?

To be fair, I am sure that many policy makers actually doing what they thought would help, but for many others the cover this legislation gives them is well worth the tax-payer money they are spending, and more.

Of course, its not as if the government can do anything to stop the depression, but that won't stop the world's leaders from spending as much of their fellow-citizen's money as they can to make it look like they are trying.

03 October 2008

Blame The Little People

While its certainly true that Wall Street bankers (and their colleagues in London, Tokyo, Shanghai and elsewhere) bear some of the blame for the financial mess the world is currently in, the average consumer bears a huge portion of responsibility as well. After all, it was individuals who were agreeing to buy homes and all manner of goods for loans that far exceeded their earning capacity.

I have little sympathy for the vast majority of people who are losing their homes on the coast of Spain, Northern Ireland, or California when it was their irresponsible borrowing that led them to this sorry state to begin with. Sure, the bankers never should have given such large mortgages that couldn't be justified by incomes, but that still doesn't excuse the individuals from digging themselves into a hole.

The credit bubble that created this economic crisis required collusion by all parties: the central banks who kept interest rates too low, lenders who just wanted to pump out loans for commission, ratings agencies who threw common sense to the wind, and the investment banks that packaged mortgages into securities for investors hell-bent on chasing yield regardless of risk.

To now blame the whole mess on "Wall Street" not only over-simplifies what happened, but it also avoids taking responsibility for our own actions and connivance. Let's not lose tears for those "greedy" mortgage holders who gambled on appreciation to bail them out (and make them rich).

23 September 2008

the banking business model is dead

In the upside-down economic universe America finds itself in these days, banks can no longer be viable businesses. Due to the government intervention in mortgage finance (e.g. ownership of the Governmental Special Entities like Fannie/Freddie/FHA) it has become impossible for private finance to compete with the artificially low interest rates that the government has on offer. Who would want to get a mortgage from a private bank for 8% when they would qualify for a government backed loan at 5%?

Banks simply don't have access to capital as cheaply as the government, and are therefore unable to lend at a profitable rate. The only market left to banks is lending to those who wouldn't qualify for a government loan, which pretty much means people who are virtually certain to default (i.e. even people with 620 credit scores can get 3% down FHA backed loans).

Sure, US banks are still making loans, but if you look closely the vast majority of those loans are government backed, in one way or another (GSE/FHA). Banks have simply stopped putting their own money at risk. Why should they, since they can't possibly get the rates they need that is commensurate with the true risk? This leaves banks with nothing much more than a transaction fee.

It is hard to see how any banks can possibly heal themselves, restoring their balance sheets, as long as the government continues to subsidize lending.

Ironically, the more the government bails out, or seizes, struggling financial instutions, the more difficult it becomes for the banking industry make money and establish a firm footing.

22 September 2008

The Hunger That Never Ends

The Paulson plan to relieve hundreds of billions in seriously de-valued assets from the financial industry can’t possibly succeed. The more successful the government is in purchasing “toxic” assets, the more they will be squeezing private money out of the global economy and preventing the natural discovery of market prices and the re-allocation of resources to where they will be productive.

Instead of stopping the collapse in house and debt instrument prices, this massive bail-out will instead speed up the deflationary process by hovering up whatever capital still remains. For every dollar the US government raises by auctioning off a treasury bond for the bail-out that is one less dollar available for raising capital and purchasing assets in the private market. Banks will find it even harder to raise additional capital (which would enable them to lend more freely) than it already was since the US government is sucking all the capital out of the system. Which pension fund, sovereign wealth fund, or central bank, will want to participate in a CitiGroup share issue in such an uncertain economic environment when they can buy safe t-bills?

Of course, this assumes that this super-sized bail out will even succeed in acquiring the troubled assets it is designed to consume. It is far from clear that this bail-out entity will be willing to offer sufficiently high (above market) prices that the lenders need. There is no way financial institutions will sell their defunct assets at anything close to market prices since doing so will render them immediately bankrupt. It’s possible the government might be willing to pay the high prices these institutions demand, but that is far from clear right now, and we won’t know until the final details emerge.

Worse, even assuming that the bail-out entity does buy derelict assets at inflated prices, the government will further be forced to hang onto foreclosed properties in its portfolio indefinitely, keeping masses of vacant properties looming over the market. Selling these millions of homes at the actual market clearing rates will further drive down prices even more, causing greater financial disruptions (requiring the bail-out entity buy even more over-priced assets), and cause political problems when it becomes apparent that tax-payers will be taking a bath on their investment after-all.

And none of this is even mentioning the difficulties with other forms of toxic debt assets beyond the scope of real-estate. Will the US government also be purchasing GM and Chrysler bonds that have dropped in value?

The more the government buys, the more prices will drop forcing the government to buy even more assets, which keeps the cycle going. At some point the whole bail-out concept will come to an ignominious end.

21 September 2008

Competition: The Key to Restaining Government Power

The famed balance of power between the three branches of the federal United States government is often credited with the success of the American government experiment. While this healthy competition between government powers certainly has some restraining powers, it constitutes only one of the many levels of competition which have slowed the usurpation of power by the government.

At the highest level between governments of countries. A government with poor policies encourages its citizens to emigrate. A sure sign of poor leadership comes in the form of restrictions on emigration. This constraint on poor government is only as effective as the quality of foreign countries willing to accept immigrants. It is also constrained by the natural inclination of citizens to "suffer, while evils are sufferable." Abandoning family and community is not something undertaken lightly.

Competition between government jurisdictions does not always require families to move. Businesses can take some of their operations, like the manufacturing and call centers, abroad without necessarily taking their employees. Such outsourcing is quite simply the result of foreign governments outcompeting ours to attract business. The solution is not laws forbidding such competition between countries, but rather to create a more competitive business environment at home. Government regulation against businesses moving operations abroad, like communist laws against emigration, indicate an unwillingness to accept the hard fact that jobs are leaving because the domestic environment is uncompetitive.

Below the federal level, there is competition between local city and state governments. A poorly run city government is easily evaded by moving outside the jurisdiction of the offending city. The same is true at the state level, albeit a little more inconvenient to move between states than cities. At an even more local level, there is competition between public schools, as families vie to find homes associated with quality schools. Companies shop around as well, looking for the most favorable environment for both the company and its employees.

By removing their ability to create money, the Constitution forces local governments to pay for their decisions through explicit tax revenues, be they immediate or delayed through bond issues. Cities with favorable trade and tax policies, like those of Hong Kong and Singapore, prosper as a result, without any substantial natural resources. Competition between cities, like the competition for Boeing's new headquarters in the early years of the 21st century, is healthy.

The most local level of government, the individual, is perhaps less controversial. That individuals should be judged by those with whom they interact based on how they govern themselves is fairly well accepted. If individuals can't find jobs or spouses, they need to work on themselves, to become more competitive rather than blaming others.

The sharing of power in the United States between the federal and local governments (all the way down to the individual) is a vital competition that has long kept the federal government from expanding as rapidly as it might have liked. Alas, this competition has been breaking down since the Civil War, when the federal government made it clear that secession, another form of peaceful government competition, is not allowed. Instead, the federal government extensively expanded its powers, beyond the intended limits, to include national railroads, national bank charters, fiat paper money, and conscription. In more recent times, the federal government has further eroded competition by increasingly adding social programs and getting involved with traditionally local issues like K-12 education.

Freedom, by definition, is the retention of decision-making power as locally as possible. In the upcoming U.S. Presidential election, it is important for voters to remain vigilant in not only seeking candidates who have noble intentions, but who want issues to be dealt with at right jurisdictional level. May we vote to localize power and maintain domestic competition between jurisdictions. May we vote for freedom.

Fascism: A Cure-all?

As diverse as the dissatisfaction with the economic, environmental, government status quo might be, there seems to be general agreement in the continued strengthening of central governments. The only disagreement lies in whose desires this power should obey. Virtually nobody suggests that strong central power will always attract a variety of powerful interests willing to pay to access that influence.

The environmentalists rejoice at the idea of using this power to force environmental legislation more universally upon the populous. They dream of invisible wind farms forests, and solar panel lakes, funded by government grants and subsidies, which are then funded by suffocating taxes on conventional nuclear and carbon-based power generation. Were such changes economical, they might happen in a free market, so implicit in these desires is the fact that they will reduce our quality of life, and must thus be achieved through via an enlightened, powerful government.

Likewise, a wide variety of conspiracy theorists, ranging from gold bugs to Lyndon LaRouche believe that big business interests control our current regime, but their solution is not to reduce government power, but to centralize it even further and put it in their enlightened hands.

The status quo major political parties also want more centralized power. Fascism, with a powerful central government exerting extensive control over private citizens and companies is the undisputed mainstream government of choice. The dominant parties differ only in how they propose to use that power and how enlightened a despot each leader claims to be. Though they may not have a complete plan for recreating utopia, they generally favor of bigger government, regulating more of our lives in everything from investment banking to education and health care. The resulting potpourri of policies are concocted with the intent of trying to please a wide variety of interest groups. A dollop of environmental legislation, a pinch of business deregulation, and a spoonful of income tax mollification.

Rather than continuing to dream that centralized power can avoid attracting power-mongers of all colors, perhaps we should consider allowing the markets to function. We can count on governments doing nothing efficiently and selling their influence to the highest bidder, so let us return government to its proper role defined in the Declaration of Independence. Alas, governments seldom willingly relinquish power. Any cure to encroaching fascism will likely involve war, revolution and depression. Let us hope, against most historical precedents, that the governments which follow such upheavals will protect our natural rights and freedoms, leaving market competition to bring sustainable prosperity to ourselves and our posterity.

Reining in Government: Sound Money

The United States Constitution is a marvel to behold for its clarity, brevity and limitations on government power. Some of its unfortunate compromises, like the protection of slavery, are understandable given the context in which it was written, but others are perhaps less comprehensible. In the case of money, the founders understood intimately the dangers of issuing paper money, stating that, "No State shall...emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts." Such restrictions were unfortunately not placed on the federal government, allowing the Congress the vague rights to "To coin Money, regulate the Value thereof, and of foreign Coin," which have become (mis)interpreted in conjunction with the elastic "necessary and proper" clause to allow for the creation of fiat paper money.
While it is understandable that the founders were frustrated with Britain's restrictions on coinage in the new world and the general shortage of coin that resulted, they neglected the market alternative of allowing private mints to competitively create coinage. In a competitive currency environment where merchants have the freedom to accept or reject any form of currency, there is a natural incentive for mints/banks to create reliable, quality currency so as to not have their currency rejected.

In any monopolistic currency regime, the temptation to use the monopoly to tax users of the currency via inflation and debasement of the money supply is irresistible for the monopoly issuer. The main restrictions on such inflation, revolution, emigration and foreign currency competition, have delayed and muted effects proportional to the size of the domestic economy. Large economies, like that of the United States, can force domestic acceptance of the national currency, thereby taxing the substantial domestic wealth. Debtors, who benefit from inflationary monetary policy, then provide democratic support for the perpetuation of such policies, along with the largest debtor of all, the government.

Sound money favors prudence and saving, punishing excessive risk-taking and debt with bankruptcy and failure. While sound money does allow for periodic fluctuations in the value of currency, be it through changes to the supply of precious metals, wars or other exogenous events, such fluctuations are minor in comparison with the rampant inflation caused by fiat money. Small fluctuations are even healthy because they can be both inflationary and deflationary, rewarding the prudent and punishing the over-extended.

Without access to the ability to monetize debt, governments are unable to bail out industries as the U.S. government recently did with Fannie Mae, Freddie Mac, AIG and the bad debt purchases. Indeed, such industries would never have been allowed to become so insolvent without the rampant encouragement of debt possible in a fiat monetary system.

Unfortunately, rather than calls to return to private, competitive money, the general cry is for more government inflationary and regulatory intervention. Regardless of the outcome of the upcoming U.S. elections, the resulting regime will surely comply, inhibiting market forces in the financial markets until such time that the necessary re-alignments lead to depression and revolution. Is there an alternative route?

20 September 2008

Capitol Hill beats physicists to create black hole

The more I hear about the US government plans to accumulate bad loans and "toxic" assets from financial institutions the more it sounds like an astronomical phenomena: a black hole.

Not only is this new bail-out entity supposed to suck any tainted assets within its gravitational pull, but these assets will somehow be placed into an alternate universe, permanently removed from human contact. It is not enough to just buy these assets at above market prices to prop up the financial system, but it is also critical that the underlying assets (e.g. foreclosed homes, etc) never come on the market to be sold at cut-rate prices. Doing so would drive down other asset values which would in turn make even more assets insolvent (continuing to undermine the health of the financial system).

This is NOT a Resolution Trust Corporation 2.0. The intent of RTC 1.0 was to quickly dispose of seized assets in an orderly fashion. The purpose of this bail-out is to magically transmogrify vacant real-estate into nothingness.

This sounds very much like a black hole to me. Perhaps the $700 billion going towards the bail-out will result in the creation of the biggest under ground super-collider ever seen, running from Maryland and Pennsylvania to DC and Virginia. Who would have thought our politicians would beat all the world's physicists in creating a black hole?

19 September 2008

it's official: depression just ahead...

The US government’s decision to step in and acquire hundreds of billions of dollars worth of bad loans at above market prices pretty much guarantees that what was already looking like a dismal economic future will be an out and out disaster. I do not use the word lightly, when I describe the virtually certain outcome as a depression.

As much as policy makers have attempted to avoid repeating the mistakes of the past (e.g. Messr Bernanke is an expert on the ‘30s depression) they have wound up following the script of past catastrophes to a T. Just as Hoover and FDR fell over themselves to attempt to bail-out the economy as dark clouds mounted, the global governments are doing the same thing today. In the feverish effort to stop the immediate pain, we are actually making it increasingly harder to come out the other side.

Not only have we not learned the lessons from the Great Depression, but we haven’t even learned the lessons from the .com bust of 2001/2002. Recall that in order to avoid a significant recession the Federal Reserve dropped interest rates to historic lows, and pumped masses of short-term liquidity into the financial system. The policy makers succeeded in preventing any serious economic contraction but wound up blowing another bubble into the real-estate and M&A sector --the mess of which we are dealing with now. What Bernanke et all failed to realize in their studies of the past is that when the apocalypse is staring you in the face, policy makers will always cave-in and try and attempt to bail things out. The only real choices occur in the decades before the crisis hits.

The irony is that every bail-out and intervention merely drives more good money out of the system, ensuring that more bail-outs will be needed. Every government subsidy, or bail-out, makes it that much harder for the private sector to be profitable on its own. Who would want to get a 30 year fixed mortgage from the private sector at 12% when they can get a government guaranteed loan for 5.5%?

There are so many bail-outs and interventions under way that I don’t even know where to start, and I am sure this is only the beginning. To take just one bone-headed idea, let’s look at the decision to ban short sales of financial stocks. This is tantamount to killing all the “repulsive” carrion beasts to prevent them from dis-respecting the deceased. Unfortunately, the dead animals are still with us and will just take MUCH longer to finally rot away. This is just another superb example of how the desire to stop short-term pain only makes things more dire.

Perhaps the most maddening thing of all this is how utterly ambivalent the public is to all of this. Hardly any voices are raised in protest. Expert after expert chimes in with agreement that all these interventions are simply “necessary”, albeit regrettable. Does no one realize that all of these interventions come at the price of shackling the global economy in even more red-tape and regulation? The politicians will want their pound of flesh in return for their help, in the form of extensive (and muscular) new regulatory regimes that will hold back economic growth for decades. Even the Wall Street financiers who ought to know better are begging for government help in their hour of need.

It’s like some medieval village that begs a Knight to defend them from a barbarian horde headed towards their town. The knight and his pals may well defend the town, preventing mass rape, looting, and death. The price, however, is that the goodly Knight will henceforth treat the villagers as his chattel, forever taking away their freedom. Sometimes rape and pillage is preferable to the cost of temporary salvation.

Yes, the governments of the world might succeed in delaying the onset of severe economic distress through their interventions, but they will ultimately push us even deeper into a long, dark, abyss. It would be far better to allow the real pain to be felt through the economy now, thereby allowing it to start recovering quickly thereafter.

17 September 2008

Government Bailouts Reinforce Irresponsibility

The recent bailouts of Fannie Mae and Freddie Mac, not to mention AIG, are indicative of a government determined to keep foolish investers from learning the necessary lesson about the risks they took when the bought into these companies. In fact, the bailouts rescue the most foolish of the investors, the ones who didn't get out earlier when it was clear that there were problems.

While it is not new for the U.S. government to use taxpayer money to bailout the creditors of failing companies, it is a trend that needs to stop if we don't want to strengthen the existing moral hazard. No company is too big to let fail and there is no "optimal" moment in the economy to let companies fail.

It is understandable that the government wants to avoid letting big financial institutions fail in the hopes of stemming a trend, in order to bail out foreign investors (especially foreign government investors), and in order to avoid letting the derivitives on the books of some of those institutions establish the new market price by which comparable derivitives on the books of other institutions must be measured. All of these reasons are short-term delays in the inevitable purging of over-extended companies and poor investments. Such interventions serve the political imperitive to postpone the inevitable pain of foolish investments, but may well make it worse and more prolonged in the process by deepening the moral hazard.

The standard response in times of crises of "we need more regulation" doesn't address the more fundamental problem of not letting investors bear the full risk of their investments. No matter how much regulation there is, if investors can count on being bailed out by the government when things get bad, they will make risky decisions assuming that the government will never force them to bear the full risk of their investments. There is only one clean remedy, let poor investments be liquidated automatically by the market.