Friday, May 19, 2006

5/19 Financial Markets' Increased Downside Volatility a Small Dress Rehearsal? "Blame Game” Not Working

"The run on the dollar is largely being ignored by Washington and Wall Street"--WSJ Op-ed, 5/18

May 19--Yesterday's WSJ has an op-ed titled “In Gold We Trust” by two principals of H.C. Wainwright. Some of its points are similar to those made in my recent previous two posts on “The Silent Dollar Crash” link and “Dollar Weakness Getting Too Big to Ignore” link.

Quoting from this WSJ op-ed: “What we are facing is a money crisis: an alarming outbreak of inflation and all its consequences. It's silly to blame the rise in commodity prices on foreigners. … The real culprit is the precipitous decline in the world's mightiest currency, the dollar, which has lost more than 60% of its gold value in just four years … When the dollar price of gold is on the rise, the dollar prices of oil and other commodities have historically kept pace … [gold's sharp rise] represents an equally sharp decline in the confidence of investors in the likelihood that Washington will pay back its mounting obligations in undepreciated money … Gold is the barometer of public confidence in fiat money, and it is difficult to rebuild confidence in a currency once it has been allowed to slide … The dollar's collapse is nothing less than a body blow to capitalism.”

I will deal with the very provocative last line of the above quote in the last section of this article. Since the WSJ is the journalist bastion of so-called "free market" capitalism, this op-ed might help make it possible to discuss the dollar without being dismissed as too alarmist, cynical, etc. It should be noted that the WSJ editorial board has had a pro-gold bias since the Reagan era of Robert Bartley and Jude Wanniski, both deceased. My own biases and interests are indicated by my blog's name and long tagline link.

Not Just Oil, Real Estate Perhaps Best Indicator of Dollar's Loss of Purchasing Power

My favorite example regarding the loss of purchasing power of the dollar is not the price of oil discussed in this WSJ op-ed, but rather that of real estate. A $700,000 fifty-year old ranch on a slab foundation on a postage-stamp lot on a treeless, sun-baked street on a fault line in Silicon Valley, which has lost about 20% of its jobs this decade, says less about its actual value and more about the value of the dollar, with it taking twice as many inflated dollars to buy real estate, which most view as a store of value and ATM, from a relatively short time ago.

In what seems like a classic case of closing the barn door after all the horses have run out, yesterday Fed head Bernanke "said lenders needed to be careful when providing "non-traditional" mortgages such as interest-only loans and option adjustable-rate mortgages, which accounted for 30-40 per cent of approvals last year. He said the Fed expected to release guidelines for non-traditional mortgage lending in due course. This guidance could result in a tightening of bank lending procedures that would further cool the housing market. "We do have some concerns about the non-traditional mortgage lending."" link

"The New Fed Chairman Faces the Same Old Dilemma" -- Bloomberg, 5/18

The issues raised by the WSJ op-ed above are long-term in nature. Due to the length of this post, I can not treat in detail here the very real and very legitimate current concerns of investors re various financial markets, inflation, interest rates, leading indicators, consumer confidence, real estate, emerging markets, etc. With increased uncertainty about the Fed's next move and currency rates, it is difficult sorting out recent volatility in various financial markets, which are sometimes contradicting each other lately.

The FT's Philip Coggan market comment today (May 19) on the recent turmoil in financial markets downplays an inflation scare and lack of confidence in Bernanke, saying that "it seems more likely that the primary driver is risk aversion. Emerging market currencies, small cap stocks and commodities have taken the biggest hits.. Furthermore, volatility seems to beget volatility."

Regarding the recent economic data, for now I will refer readers to veteran journalist Caroline Baum's yesterday's (May 18) Bloomberg column, "The New Fed Chairman Faces the Same Old Dilemma" link. I.e. "what to do in the face of slowing growth and rising inflation. The economic indicators released this week pretty much encapsulate Bernanke's dilemma. Housing is falling fast, and core inflation is accelerating."

My guess on the stock market outlook on March 24 link said: “Although most investors wouldn't know it just looking at the major U.S. stock market averages, overall financial market euphoria is at one of the highest levels in the past twenty years, best indicated by extremely low credit spreads across the board (similar to stratospheric p/e's during the massive TMT equity bubble in the late 1990s). It perhaps wouldn't take too much to start the mass psychology pendulum downward in the other direction (unless the pendulum flies right off in another huge speculative blow-off, as occurred at the end of 1999 and early 2000). If normal seasonal and four-year presidential cycles still hold, then the U.S. stock market may top out in the next month or so, then decline, perhaps much more sharply then many might currently expect, into an October low. Whether a strong rally ensues from that low, as usually occurs to a high next year, would depend on the larger secular bear vs. bull debate.”

For the moment, late April has been a stock market short-term top. Hopefully I will have something to say on emerging markets in a post soon. I won't take up in my blog whether gold has seen an "island reversal" and commodity trading issues, sorry.

Could This Time be More Difficult for Dollar Then Early 1970s?

On May 10, Martin Wolf, the FT's well-regarded chief economics columnist, wrote: "the chances of a row even worse than the one accompanying the end of the Bretton Woods exchange-rate system in the early 1970s grow ever bigger."

According to a May 14 article in the "Guardian" titled "IMF acts to avoid markets meltdown" link, "the International Monetary Fund is in behind-the-scenes talks with the US, China and other major powers to arrange a series of top-level meetings about tackling imbalances in the global economy, as the dollar sell-off reverberates through financial markets. Amid tumultuous trading, which sent the dollar to its lowest level in a year against the euro in late trading on Friday and gave the FTSE its worst day for three years, the IMF was working privately to exercise its new powers to bring decision-makers together."

During the huge dollar crisis of the late 1960’s and early 1970s, another Texan, then Secretary of Treasury Connally, infamously said, “It may be our currency, but it’s their problem,” “they” being the Europeans at the time.

I don’t think that type of “benign neglect” (to be charitable) of the dollar is going to work very well this time around, should a full-scale monetary crisis develop again, in part because the potential financial/monetary problems are far worse after decades of hyper-speculative bingeing, in part because the global economy is now so much larger and key nations, such as China, Russia, India, Brazil (the BRIC), Saudi Arabia, S. Korea, Nigeria, Mexico, and others must be included in the solutions.

Currency "Blame Game" is Not Working

In a May 9 article titled “Global Game of Musical Chairs May End Badly,” Bloomberg columnist William Pesek Jr. (see link for this and his other recent columns) wrote:

“The tensions are over global imbalances. The rift is an old one, but like any disagreement that's allowed to fester below the surface, the risks it will become a huge problem are growing … As is often the case, the latest East-West flashpoint is currencies … All this is code for ``the world's economic imbalances aren't my fault, but yours.'' … the blame game that's become a common feature of the global economy is entering a new and more dangerous phase. What's even more worrisome is that there's no adult in the room in which this game is playing out. The G-7 can't act as referee because its members are part of the problem.”

The G-7 recently has passed the global economic imbalances hot potato to the IMF, which Pesek believes can’t handle it (although he omits that Asians don’t trust the IMF after the so-called “Asian,” what they sometimes call the “IMF,” financial crisis of 1997-98). Pesek notes: “The thread of truth that runs through each accusation was nicely articulated in Hyderabad by Li Yong, China's vice finance minister: ``We are all on the same boat. No one will escape if this boat sinks.''”

"The notion of a free market in currencies is in any case nonsensical"--WSJ editorial, 5/15

China's currency has been flirting with breaking through 8 to the dollar this week. The WSJ had another interesting take on the blame game, in a May 15 editorial titled "Currency Games." Responding to the Bush Admin mantra to let the "free market" determine currency rates, the WSJ said:

"The notion of a free market in currencies is in any case nonsensical: All currencies are manipulated, since governments print as many bank notes as they wish. Exchange rates are set by a central banking cartel. By pegging the yuan to the dollar, all the Chinese have done is outsource their monetary policy to the U.S. Federal Reserve [ital in original] ... As for the U.S. trade deficit, there is no guarantee that a weaker dollar (the reverse of a stronger yuan) would make any difference."

"The currency peg has been a rare anchor of stability for China, which has enticed foreign investors and allowed it to escape the serial devaluations that devastated other Asian economies in 1997." "Markets are already nervous that the Fed may have misjudged inflationary pressures, and a run on the greenback would only make the Fed's choices more difficult. As for President George W. Bush, the very last thing he needs right now is a dollar crisis."

A View from London on the "Blame Game"

A somewhat similar view re the "blame game" is in May 16 letter to the FT by a London-based well-known financial expert, Avinash Persaud:

“The critical problem is not that the dollar adjustment may prove too narrow tomorrow; but that the necessary policy measures are not being taken today - and do not look like happening soon. This is partly because too many economists have colluded with protectionists to blame China, a relatively poor country, for the policy mistakes of the world's richest economies. This not only morally questionable; it is a factual fallacy … [a large Chinese revaluation] would lead to deflation given China's near-zero inflation rate and enormous bad debts. Should deflation be avoided like the plague in the US, but considered an acceptable risk for China? Exchange rates have a secondary part to play in this act. But Sadakazu Tanigaki, Japan's finance minister, got the right balance when he argued that it is dangerous to overemphasise [sic] exchange rate realignments before there is the will to initiate the necessary accompanying domestic policies.” [itals in original]

What is already happening, as expected, is that the EU and Japan are complaining about the rise of their currencies, believing that they are once again being forced to bear the brunt of the dollar's depreciation that might choke off nascent recoveries in their regions.

Btw, I do not share the views of those I have quoted on the "blame game" with respect to the need for austerity in the U.S. With the average weekly real earnings of U.S. workers down 17% since 1972 and flat over the past five years, that is hardly fair, and it would threaten a global recession.

Just Signed "Investor" Tax Cuts Indicates to World U.S. Not Serious about Deficit Reduction

Because of the reserve currency status of the U.S. dollar, and because U.S. financial corporations and government essentially run the hyper-speculative global monetary/financial system, the U.S. has special responsibility to see that it works.

Rather, the U.S. seems to be trying to put the burden of adjustment on others via their currency appreciation. That is not going to work, dollar depreciation alone is not going to solve the U.S. current account and other global economic problems, as large dollar declines in the past have shown.

This is especially so if the world does not think the U.S. is serious about getting its own house in order. And it’s not, as most recently indicated by the tax cut bill for “investors” that Bush just signed, despite the fact that the U.S. capital investment which these cuts were promised to deliver have been sub-par during this business cycle. (see yesterday's 5/18 article by Bloomberg columnist John M. Berry, “Make-Believe, Deceit Are Behind Latest Tax Cut,” link)

The Bush administration has lost a great deal of its credibility, as shown in public opinion polls, earlier in the eyes of much of the world, and more recently in the U.S. Whatever one’s political views about Bush, etc., this loss of U.S. credibility is not a good thing, most especially if a severe monetary/financial crisis were to occur on Bush's watch, especially since the Democrats have offered little viable governing alternatives.

Cheney Pushing Bush Admin to Focus on Iran and Central Asia

Rather than adequately address critical economic issues, Cheney, in particular, seems intent on focusing the Bush Administration on Iran and now Russia. According to a front-page story in the May 18 FT titled, “Bush may cold shoulder Putin at G8 summit,” Cheney "is said to be leading the Washington charge for a tougher line towards Russia - as seen in his broadside launched from Lithuania when he accused Mr Putin of backsliding on democracy and using oil and gas for blackmail and intimidation. For Mr Cheney, according to administration insiders, the key issue is Iran. They say he is furious at Russia's arms sales to Tehran and its resistance to United Nations sanctions over the Islamic republic's nuclear programme.”

A May 16 article in the WSJ titled "Central Asia Emerges As Strategic Battleground" said it "is emerging with its oil and gas riches as the first strategic battleground of the "Multipolar Era" among the U.S., China and Moscow ... [on his recent trip] former oilman Mr. Cheney befriended Kazakhstan's Nursultan Nazarbayev and solidified his support for energy cooperation, including agreement in principle for a new pipeline across the Caspian Sea that would cut out the Kremlin. That in turn would help break Moscow's near-stranglehold on gas exports out of landlocked Central Asia to Europe. The trip followed a White House visit from Azerbaijani leader Ilham Aliyev, who is participating in energy projects of like motivation in the neighboring Caucasus ... The White House's embrace of Mr. Nazarbayev and Mr. Aliyev also marks its return in the region to realpolitik from the democratic missionary work."

I have not discussed Iran, nor North Korea, on my blog, which are difficult issues that must be dealt with very seriously on their own merits devoid of politics. However, Cheney does have a well-documented track record leading up to the Iraq invasion, which I will not dwell on, so his actions bear watching in terms of the impact of the Iran situation on global energy and other markets, especially if financial markets become more volatile.

No Viable Mainstream Alternatives Waiting in the Wings Should Markets Really Start to Unravel

But it is not just Cheney and the Bush Administration that sees the world through much different lenses than the rest of world currently sees the U.S. So does much of the foreign policy establishment, which almost universally overestimates U.S. economic/financial strength as the putatitve "sole superpower."

The following quote is perhaps representative of how the mainstream of the U.S. foreign policy elite currently views things, taken from the Introduction of a 2005 book “The Case for Goliath” link by Michael Mandelbaum, a leading IR professor. Mandelbaum presented these views to John Stewart's “hip” audience in an amicable interview on “The Daily Show” link, which I don’t watch.

“the United States has undertaken broad responsibilities that redound to the benefit of others … If America is a Goliath, it is a benign one … the United States furnishes services to other countries ... The United States therefore functions as the world’s government … the United States helps to assure global access to the economically indispensable mineral, oil … The American dollar serves as the world’s money … the huge American appetite for consumer products has helped to sustain economic activity the world over, especially in East Asia … Whether the United States continues to function as the world’s government depends on whether the American public continues to support the policies involved …The governmental services that the United States provides that affect the largest number of people—reassurance and enforcement—are the least controversial ... but also unappreciated; and they are unappreciated because they are invisible … Nor do the recipients and beneficiaries of these services manifest enthusiasm either for what the United States does for them or for the American power that makes the services possible.”

I will just note that the U.S. military accounts for half of world spending and has bases all over the globe. For another view, from an IR "realist" perspective, see the 2005 book by Harvard prof Stephen Walt, "Taming American Power: The Global Response to U.S. Primacy" link.

Most of Wall Street Continues to Ignore Increasing Potential Risks

As for Wall Street, as I've noted in my two most recent posts link and link, and as the WSJ op-ed quoted above notes, it is largely ignoring the potential seriousness of the current economic/financial situation.

To the best of my knowledge, only one macroeconomist at a leading investment bank consistently focuses on the price of gold as critical economic indicator. Another, Andy Xie at Morgan Stanley, whom I’ve mentioned in the past, is perhaps the only one who consistently incorporates the role of speculative finance in his macro-analysis, and has recently written pieces on China's real estate markets link , and its inflation and environmental costs link. Xie's colleague Stephen Roach of course has for many years focused on the dangers of global economic imbalances.

As for the U.S. population itself, its confidence, and hence how it will react to any potential future crises, is being strongly affected by the slowdown in real estate and the high price of gas and other things, both of which are well chronicled in the local daily press and newscasts throughout the country, now easily accessible on the web. Unfortunately, the real reasons behind the sources of people's financial stress are generally obscure in the mainstream media, though increasingly analyzed on the web.

"What If" Globalization Has Another Collapse as It Did in the Twentieth Century?

The WSJ op-ed noted above says: "The dollar's collapse is nothing less than a body blow to capitalism."

Obviously let's hope not. Mandelbaum, quoted above, does make a very important point. "The United States is the best source of global governance because, in the first decade of the twenty-first century, there is no other." How long that will last is not only up to the U.S. population, as he says, but also to how the rest of the world sees the benefit/cost tradeoffs of the "services" that Mandelbaum says the U.S. provides. Specifically, as I've noted before, how long China, Saudi Arabia and others are willing to finance the U.S. if they come to view its policies as too destabilizing.

Very few in both the elite and the general population currently believe that should hyper-speculative globalization start to collapse under its own weight of credit without a viable alternative in the wings, then things may become far worse then all but a very few, who currently might be considered crackpots, currently care to imagine. (I am pro-globalization, which in any event has been an inexorable trend since the beginning of civilization, just not of the current hyper-speculative version, hence my blog's tagline.)

For those who are understandably skeptical of how bad things might get should the current era of globalization run into serious trouble, just recall the horrors unimaginable beforehand that happened in the twentieth century when the earlier era of globalized capitalism badly faltered, leading to massive internal strife and a global "Thirty Years War" in the first half of that century, before there were nuclear and other wmd, and then another forty-five years of global Cold War and MAD (e.g., see Harvard professor Jeffry Frieden’s new book, “Global Capitalism,” link).

Given what happened in the previous century, no sane person wants to even slightly flirt with such possibilities once again, i.e., the potential stakes are extremely high, especially with wmd. Unfortunately, as in most potential deep crisis, it is once again getting very late in the game before the vast majority of people realize what might hit them, especially because their current leadership seems inadequate.

And as every successful person knows, one key is being as well-prepared as possible so that one can be singularly focused on rapidly changing reality. Perhaps this past week in the financial markets was a very small dress rehearsal of how rapidly reality might change sometime in the future.