SCM: More Datapoints

Yesterday was simply brutal for the broad U.S. stock market. The S&P500 index closed about 19% below its 52 week high, just shy of the 20% rule of thumb for identifying a bear market. A rising crude oil price may have been a factor, as well as the Federal Reserve Open Market Committee, which proferred a more hawkish rhetorical stance, while standing pat on its 2% fed funds rate target, a level that is still well below the rate of inflation. We continue to believe that over the next few years, our current policymakers are clearly going to have to relearn the lessons of the 1970s. It won’t be fun, but it’s important to keep in mind that market opportunities are born of extreme circumstances. 

One important data point from the GDP numbers that caught our eye was a continued and accelerating contraction in real private inventories at the end of 2007, something that’s been a notable feature of every domestic recession since the late 1940s:

Despite this latest piece of evidence, it’s not yet clear whether any technical definitions of a recession have been met, and the NBER’s pronouncement won’t come until well after the fact. 

In the meantime, stimulus payments from the U.S. Treasury are providing a crutch to domestic demand. Unfortunately, such measures are short lived and temporary by design. Getting back to basics, the critical objective for the long term health of any economy is productive investment, which in our current circumstances can only be achieved through concrete and lasting measures designed to lift the flagging competitive position of the U.S. as a destination for capital and talent. Higher taxes and cheaper money simpy won’t get the job done.

SCM: Economic Musings

Some random musings based on the week’s news flows…

First is two important economic datapoints from this morning, initial unemployment claims, and final first quarter GDP. Initial claims were largely unchanged, both week over week and four week moving average. GDP for the first quarter of the year was revised upward slightly. Financial firms actually turned a small profit in the quarter, while information technology and petroleum producers were the only profitable non-financial industries, despite the positive contribution of exports to GDP. Bottom line is that things seem to be moving sideways for now.

Second is a House Ways & Means subcommittee hearing on IRAs, in the broader context of retirement savings, social security, etc. This may be a positive development, and Congress is demonstrating some good intentions. We’ll have to dig into the final legislation to see.

Third is a big easing in expectation of USD monetary tightening, which appears to be putting a bid under inflation sensitive commodities and securities, and may also be contributing to the downward pressure on the broader equity markets. Other factors reported to be playing a role are analysts downgrades of some blue chip names, plus comments from Libya and from the President of OPEC that are supporting higher oil prices.

Finally, a speech by IMF Director Dominique Strauss-Kahn caught our attention, because it shows how the global political economy is harmed by policy errors in the U.S. (not to mention bad advice from the IMF), and how this contributes to international ill will:

"In many countries in Latin America where domestic demand growth has been very strong, existing policies risk amplifying the price shocks. Failure to act decisively now will increase the eventual output and social costs of adjustment," Strauss-Kahn said.

For this reason, he added, "social protection should not be used to justify a retreat into protectionism, or a delay in measures to cool domestic demand. Many countries in the region have painstakingly built up macroeconomic credibility over the past decade. That should not be jeopardized now." During discussions, many ministers emphasized the importance and the challenges of keeping expectations of inflation under control. [emphases added]

The two emphasized phrases are IMF-speak. What Strauss-Kahn is actually suggesting to the governments of Latin America is that to lower inflation, they (1) raise taxes and (2) allow their currencies to appreciate against the world’s major currencies. The underlying global context is that developed countries are growing more slowly than developing ones; and because legislators in developed countries are unwilling to commit to policies that would close this ‘growth gap’, they have to rely on their central banks to lower the value of their currencies in order to support flagging domestic demand. This creates inflationary pressures in other countries and regions, especially in those that lack the size and the institutional capabilities to run monetary policies independently of the U.S., the E.M.U., or to a lesser extent, Japan. Because of this, the IMF has a greater opportunity to dispense toxic advice to developing economies. The end result is a slower rate of overall global economic progress, the very thing that institutions like the IMF are supposedly pursuing. Instead, it ends up acting as a proxy for legislators in developed economies who seem increasingly unwilling to grant their subjects at home a bit more economic freedom.

The U.S. provides the best example at the moment (although Japan’s been at it for much longer, nearly two decades). Since taking office in 2007, Congress has steadily and persistently caused overall economic expectations in the U.S. to become more pessimistic–rising taxes, regulatory burdens, and trade barriers have been on the agenda since the ballots were counted in the fall of 2006, and they do not appear to have softened much. Occurring against the backdrop of an over leveraged and highly securitized consumer finance system, the results have not been pretty, as everyone knows. The Federal Reserve has ridden to the rescue by dramatically lowering the marginal cost (value) of the USD. The inevitable result has been global inflation, showing up first in raw materials, and now working its way through the price structure of the global economy. The greatest impact of inflation is being felt in places where those basic materials, especially food and energy, represent a large proportion of people’s expenditures or incomes.

This phenomenon is occurring because of a widely held but erroneous axiom of contemporary economics: that monetary and non-monetary policies are largely interchangeable. They are not. The effects of monetary poliy, as Robert Mundell and others have demonstrated (and as the world seems to have to re-learn every 10-15 years), are primarily global, while the effects of taxes, regulations, and trade policy have a more purely domestic impact. Of course, there are feedback effects from both that cause them to have both global and domestic impacts. But their fundamental differences should be very clear. And now the IMF is arguing, not that it’s the responsibility of the U.S. government to improve the long term economic outlook for the U.S. economy, but rather that the citizens of Latin American and other emerging countries need to shoulder much of the burden. That the usual rhetoric of growth and stability has to be tossed aside (or perhaps more accurately, covered up) when making such recommendations seems not be noticed. It seems clear to us that anti-growth legislators in large donor countries like the U.S. have more influence over IMF actions than the current and future well-being of its client countries.

Who really needs to shoulder the burden? Policymakers do, especially in the U.S. and Japan. That means that legislators and executives in both countries need to get off their butts and enact measures that will improve the economic prospects of their respective countries. At that point, monetary policymakers will be free to pursue the optimal objective of monetary policy, which is to keep the value of their currencies stable. In that scenario, we’d get the best of both worlds–receding inflation and higher growth.

Alas, it seems unlikely to happen for a few years. Yes, the Obama campaign’s red meat rhetoric has softened. And the House’s current focus on expanding the use of IRAs may portend a better direction for Congressional policy. But it’s still not much to hang our hopes on. Moreover, U.S. policies risk becoming less competitive with the rest of the world even by standing still. At some point, the American electorate may have to reshuffle the political deck before economic policies can take a decisive turn for the better. And that means that the social and economic costs associated with global inflation may be with us for some time. 

McCulley: Cure Inflation With Inflation

Sometime back around 2000 or 2001, I recall reading a friendly debate in the Irish press between Nobel economists and fellow ‘Chicago School’ heavyweights Robert Mundell and Milton Friedman. In  it, Mundell referred to a tenet of Friedman’s as "stupid". It certainly wasn’t because he thought Friedman was lacking in intelligence. Rather, it stemmed from frustration that someone as smart as Friedman could believe something that in Mundell’s view made absolutely no sense. Now I’m certainly no intellectual heavyweight, and I don’t know that Paul McCulley of PIMCO would hold himself out as one either. But after reading his recent missive–by way of John Mauldin’s website–I at least know how it feels to think that someone smart is being awfully stupid.

McCulley argues that a dovish monetary policy stance is required to counter a "real terms of trade shock". By that, he means that the U.S. has to work harder to acquire the same goods and services in trade; in other words, a unit of U.S. labor commands fewer goods and services in international trade than it did a few years ago. The example he cites is the cost of a barrel of oil in terms of hours worked, which has gone up nearly seven fold since 2003. He asserts that when such a shock occurs, a central bank must pursue a course of negative real interest rates** in order to prevent recession, or worse, depression. To which we can only say, "…Wow!"

Can a negative real interest rate ease some of the pain associated with a negative terms of trade shock? It can certainly soften the blow. But what are the long term costs? More importantly, what’s the effect when the proximate cause of the trade shock (higher oil prices, in this case) is NEGATIVE REAL INTEREST RATES themselves? Look at the trajectories of oil and other commodity prices when real central bank rates are negative, near zero, or positive, and the effects are quite clear. In the 1970s, real interest rates were negative before oil and commodity prices took off. They were very high before oil and commodity prices began a twenty year descent in the 1980s. And they were negative again beginning in 2003, when the current oil and commodity price boom began.

McCulley tries to work around this by claiming that the U.S. economy was more closed in the 1970s, and thus more prone to a wage driven inflationary spiral. That may be true (though in our view stagflation cannot occur in a closed economy, leading us to believe that globalization was an important factor in the 1970s). But for all intents and purposes, and in the immortal words of Bill Murray’s Tripper Harrison, "it just doesn’t matter!". The issue at hand is how well the rate on a new unit of money aligns with the marginal rate on USD supported investment, wherever those marginal investments may lie–Dubuque, Crested Butte, New York City, Dublin, Singapore, Prague, Swaziland, Shanghai, Timbuktu, or wherever else–anywhere that USD reserves can be used to finance investment***. 

So what happens when the Fed, in supporting the domestic economy, primes the monetary pump by keeping interest rates very low? It simply drives up investment in those parts of the world that are expected to grow fastest, and where said growth can be financed with US dollars, whether directly or indirectly. And the resulting overheating makes certain goods more expensive for everybody, even countries experiencing a major slowdown like the U.S. recently has. Combine the resulting inflation with an already high U.S. corporate tax rate and an expected capital gains rate hike and you have a recipe for domestic stagflation. But hey, it sure beats a depression (actually, that case can be made based on the historical data, at least over short to intermediate periods).

One thing that we agree with McCulley on is that a less inflationary monetary policy would mean more economic pain at home, assuming nothing elses changes. But McCulley’s proposed "solution" is likely to cause more long term damage than it’s worth. A serious decline in investment, chasing away productive, mobile assets like human and financial capital, and undermining the international credibility of its money are first steps on the road to any civilization’s decline. And in the case of the U.S., another crisis of confidence in the U.S. dollar, like the one that occurred from the 1960s to the 1980s, could impose huge long term costs on us, given that there is finally a legitimate contender  in the Euro that could further diminish the role of the USD as sole international reserve currency. That was definitely not the case in the 1970s, however closed or open the U.S. economy might have been.

So what can U.S. policymakers do to improve the real terms of trade, without imposing deflation and/or recession or depression? We’ve said it often, and we’ll say it again because it bears frequent repeating–it’s the policy mix, "stupid". Mundell articulated the right mix way back in 1961 while he was an economist at the IMF: lower the disincentives to activity in the real economy, and equalize the incentive to hold or invest US dollars, and both stagnation and inflation will recede.

The right policy mix ain’t gonna happen any time soon, unfortunately, and ideas like McCulley’s are going to hold center stage for a few more years, I’m afraid. But eventually the U.S. electorate will relearn the same old lesson: lower taxes and sounder money are the cure for both inflations and recessions. Hopefully its fearless leaders will catch on after awhile and follow.
 

** When a central bank’s target interest rate is negative, it means that dollars are expected to be worth less in the future than they are today; it is expected that such a condition induces people to spend and invest more today than they otherwise would.

*** We haven’t actually checked into how much USD driven finance occurs in all of those locales. They’re meant to be illustrative and, we hope, a little poetic.

Novak: McCain and Rep. Ryan’s Roadmap

Interesting report from Robert Novak on John McCain’s reaction to Rep. Ryan’s ambitious legislative agenda, "Roadmap for America’s Future":

…on May 29, the Republican presidential candidate might not have realized that he had just come face to face with an opportunity and a test. Ryan showed him his plan to reform the economy. McCain expressed interest and said he would turn it over to his campaign’s economists. That was truly ominous. If the Kemp-Roth tax cut had been handed over to economists three decades ago, it probably would have died in its crib and aborted the national and Republican revival…

It is hardly likely the Republican leadership will embrace Ryan’s daring agenda if it cannot even bring itself to temporarily forgo pork-barrel spending by passing a moratorium on earmarks. But Ryan represents a younger breed of reform Republicans who now have junior leadership positions.

…After what is expected to be another bad GOP defeat in the 2008 congressional elections, Ryan, [Kevin] McCarthy and [Eric] Cantor could constitute the party’s new House leadership… a campaign based on Barack Obama’s shortcomings may not be enough on Election Day. While Ryan says the people are more than ready for his strong medicine, McCain has not yet agreed.

The curmudgeonly Novak has some good insights here: John McCain is very unlikely to derail Barack Obama’s momentum, barring more innovative and substantive economic planks in his platform; the GOP is in a sorry state, and is essentially without leadership; and yet it has a small core of solid up and comers who stand ready to tackle some of the most challenging and important policy issues facing this country. 

Our current prediction is that we’ll see some historic rhyming in coming years: political markets indicate that the Democrats will win the White House and remain in solid control of Congress, and all indications are that economic policies overall will take a turn for the worse in such a scenario. That creates a strong possibility that either: (1) the GOP will be given control of one or both houses of Congress while Obama is President (the Clinton outcome), or (2) President Obama will not win reelection (the Carter outcome). It’s not clear which politician is capable of playing Reagan’s role in the latter scenario. At the moment, Rep. Ryan appears to be the only possibility. But whether he could garner the necessary party support (and whether he would be interested, for that matter) is unclear at this point.

‘Idle Drilling Leases’: Fact or Fallacy?

We’re fascinated by the power of informational networks, and by the vast increase in their scale and efficiency that modern communications technology has enabled. A good example is a political talking point that seemed to spread like wildfire after President Bush’s recent speeches imploring Congress to open the Intercontinental Shelf to coastal drilling. We’ve been unable to identify the source(s) of this argument, but it goes something like this:

 All told (onshore and offshore), 68 million acres are leased and sitting idle. Over 10,000 permits are currently ’stockpiled’ by industry. But still they want more.

Apparently, this sounds like a damning claim to many pundits and politicians, but it’s terribly ignorant of the underlying economic and financial realities. A business will not leave an asset idle if its employment (or its development, in this case) is expected to be economically profitable. In the case of drilling leases, energy companies are purchasing what the finance community terms "real options", or assets with an uncertain future value. And the critical point to understand is that while all options cost something, most options expire worthless (it’s also important to understand that the exploration and development of a drilling lease is both time and capital intensive).

Here’s a thought exercise, using market-traded financial options as an analogue. If you want to buy (or sell) an option on, say, the S&P500, the options exchanges will match you to a seller (or buyer). In that way, options contracts are created and destroyed according to the requirements of the market. But imagine that there’s only a single governing body with the authority to issue S&P options, and that it has declared an indefinite moratorium on issuing new options contracts. Let’s assume for simplicity that all options that were in the money have been cashed out by their holders, and that there exists a large number of outstanding options that are out of the money. Naturally, there would be an outcry from market participants to issue new contracts. Would it make any sense at all for the governing body to say that it will issue new contracts only after all out of the money options have been exercised? Of course not.

It makes even less sense in the case of drilling leases when you consider that: (1) leases provide ongoing revenue to the federal government, and (2) that an expanded pool of diverse leases, like a diverse basket of real options, can only improve the probability that domestic oil and gas production will increase, and put downward pressure on the prices of those commodities.

Insofar as the anti-drilling lease argument is based on the risk of environmental and other damages, it’s on reasonable ground, as fossil fuel production and consumption clearly have external costs. However, the ‘idle lease’ argument is an utter fallacy, and one that arouses some suspicion, as it seems designed to maintain the relative scarcity of existing drilling leases. It would be interesting to see how the ongoing revenues from existing leases are divvied up by the public sector. Perhaps there are some vested interests who would be harmed by a more plentiful supply of leases?

Getting back to the power of networks, some good counter points have been provided to the "68 million acres, 10,000 leases" mantra, including an op-ed from the American Petroleum Institute, "The Idle Oil Field Fallacy", and "Facts about Non-Producing Leases" on an energy industry website.

IMF to Vietnam: Raise Taxes

It appears that Vietnam, which has been one of the world’s economic success stories in the new century, has put itself in peril. We, echoing the sentiments of IMF employees, observed awhile back that the strong global economic growth of recent years had raised some doubts about the the IMF’s future. That doubt appears to be receding, as inflationary and currency management pressures mount on many emerging economies, thanks to a Federal Reserve that is committed to preventing recession in the U.S. no matter what the cost in global inflation.

Unfortunately, the IMF’s is dishing out the same questionable advice that got it into trouble in the first place (which was nothing compared to the trouble that many of their clients have landed in over the years). In a speech by the IMF’s representative in Vietnam in early June, several key points were outlined. Some of their advice is perfectly sound. The main problems with it are: (1) the IMF continues to believe that any country can ably manage a domestic currency and an external exchange rate regardless of its size relative to the regional and global economies; and (2) that in addition to stricter monetary policy, a heavier tax burden is a desirable means of lowering inflation. As an IMF economist, Nobel laureate Robert Mundell demonstrated the fallacy behind such a ‘policy mix’ in 1961. That’s 47 years ago!

Should Vietnam choose to follow IMF advice, it will quickly become a less attractive destination for capital, and at the margin, domestic activity will be chased from the above ground economy at the margin–a situation that will only aggravate the fiscal and monetary crises that their economy is encountering.

The Curse (and the Blessing) of Interesting Times

Investors are currently suffering the old curse of living in interesting times. Last week, Fed Chairman Bernanke finally drew a line in the sand under the USD, only to be smacked down in short order by his European counterpart Jean-Claude Trichet, and some piling on s by some of Trichet’s deputies. The sequence of events last week went like this:

1. In the face of an accelerating rise in oil and other commodity prices, the Fed and the Treasury made comments on Thursday that implied that they stood ready to support the USD’s value from falling further. Oil and commodity prices, which are priced globally in USDs,  pulled back noticeably on the news.
2. Trichet, without blinking, called and raised Bernanke one day later, saying that the ECB stood ready to raise its lending rate by another 25 basis points if necessary. The clear implication was that the ECB is not going to submit to the Fed’s Humphrey-Hawkins mandate to support both the domestic economy and USD price stability.The ECB’s only mandate is to ensure price stability, i.e., a stable value for the Euro. The dollar fell anew on Trichet’s comments, while oil and commodity markets surged even higher.
3. There was some market chatter on Friday that hawkish comments about Iran by Israeli Transport Minister Shaul Mofaz were behind the surge in oil prices. Another explanation being bandied about exchange floors yesterday was that a popular ‘convergence trade’ between interest rates in the U.S. and Europe involved mimicking a long USD position by shorting oil futures; when the ECB took the wind out of the USD’s sails, these trades were quickly reversed, causing a pop in the oil price. While either one of these explanations might have been at work on Friday, much of the rise in the price of oil since 2003 has been fundamentally driven in our view.
4. A weaker-than-expected U.S. employment report also appeared to have an effect, as rising unemployment raises expectations for easier Fed monetary policy, and relative to circumstances in the rest of the world–high growth rates especially in emerging economies, and a very hawkish ECB–that can only lead to higher USD inflation globally. It’s our opinion that the parabolic movement in oil and other prices since 2007 is driven in large part by rising inflation expectations due to (a) overly easy monetary policy by the U.S. Federal Reserve and (b) a dearth of sound domestic economic policy in Washington.

As we continue to point out, the correct policy mix for this situation is tighter money in combination with more competitive taxes and regulations, and expanded trade.  Unfortunately, the American ship of state does not currently appear to be headed in that direction. That means that the current pain being felt in parts of the U.S. economy will not recede entirely for some time yet, and that much of the world will continue to struggle with global inflationary pressures and social and political unrest. Not all will suffer however. For example, one interesting piece of news we came across was that the explosion in agricultural prices appears to be easing the conversion of poppy farms to food crops in Afghanistan. This of course will make life marginally more difficult for many heroin addicts, which shows yet again that economics is all about tradeoffs.

Of course, however much we might curse them, times like these bestow blessing as well. Savvy investors have a better chance of finding compellingly priced assets in difficult market environments, where fear rules the day (or the month, or the quarter, or the year(s)). If you have any doubts, the performance of Warren Buffet’s Berkshire Hathaway in the 1970s provides a fine example: