Wednesday, December 15, 2010

Treasuries? More Like Trashuries!

I mentioned a couple months ago that I might want to talk about the bond bubble at some point.  Well we recently started to see some news that the bond market could be collapsing so I decided to finally dive in.  I've gotta admit, the whole process is a little tricky to understand and I'm not going to pretend to be an expert.  Every time I do some research on the subject, it just leaves me with more questions than I started with, but I'll do my best anyway. 

When the federal government runs a budget deficit, that budget has to get funded somehow.  Well, since it's a budget deficit, that means the treasury doesn't have enough money from taxes to fund the budget.  So what they do is sell "treasury securities" (also called "treasuries" or "securities".  I'll use those terms interchangeably).  An investor (bank, individual, foreign government, etc.) buys those treasuries, the treasury gets extra money and the budget gets funded.  The securities are then paid back to the investor after a period of time, with interest of course.

These securities come in 3 forms.  The first type of treasury securities are called T-bills.  They are short term securities that generally mature in a year or less.  Another type is called T-notes and they mature in 2-5 years.  The last type of security is called T-bonds.  They are the longest term and mature in up to 30 years.

Ok, that's basically all you need to know.  At least it better be, because that's basically all I know.

As I mentioned before, the treasury department will sell these securities to fund budget deficits.  Sometimes, the federal reserve (the fed) will announce that they want to buy some of these securities in order to increase the money supply.  That is called quantitative easing and it's how the fed gets money into the system in order to stimulate it.  But the fed cannot buy directly from the treasury.  I think it's actually a law.  So what the fed does is it tells certain banks that it deals with that they are going to buy up some securities.  The banks wheel and deal and make bids to the fed and whoever has the lowest bid gets to sell the securities to the fed.  Long story short, the banks buy treasuries from the treasury and then sells them to the fed, at a higher price of course.

Banks give cash to the treasury, the treasury can fund the debt, and then the federal reserve pays the banks.  That's where it gets interesting.  When the fed buys the securities from the bank, it does so with new money.  Money that never existed before.  Money that has nothing tangible backing it up.  Fiat money.  Money that's not worth the paper it's printed on.  Actually, they don't even really print the money.  They just add a few zeros to the bank's balance sheet.  The money is all digitized, created out of thin air and added to a computer as 1's and 0's.  I guess you could say it's money that isn't worth the paper that it's not printed on.  Anyway, that's where all the inflation fear comes from.  More money starts to chase the same number of goods and inflation is the result.

I mentioned that the different types of securities all have different rates of maturity.  A lot of the debt that has been funded in the past year or so has been with the short term T-bills because the interest rate is so low.  When those T-bills mature, then the treasury has to pay back the principle and interest.  But remember, that money was used for funding the government.  When those T-bills come back, the treasury will still have to sell many of those same bills again, plus a lot more to service the new debt on the new budget deficit that congress passed in the meantime.  It's as if you max out your credit card but can't afford to pay it off at the end of the month and your solution is to get 2 more credit cards.  One to pay off your first card and another one to buy more stuff you can't afford.  Actually, you are doing that because it's your money that they're spending.  Neat, huh?

When the global financial crisis hit, a lot of people rushed to buy treasury securities.  The conventional wisdom is that when everything else is doing poorly, the safest place to have your money is in American guaranteed dollars. I guess old habits die hard.  With so many people wanting to buy bonds and bills and notes from the treasury, the treasury didn't have to offer a whole lot of interest to the buyer.  The interest rate on the 30 year bond went down to about 3.5%.  That's extremely low.  It also means that it's extremely cheep for the treasury to service the federal debt.  That means that congress is more likely to have budget deficits and issue more debt.  That cycle continues, and it can only exist with plenty of people willing to buy treasuries and low interest rates.

But what happens if people start to get the mindset that the only thing worse than owning the dollar today is to own a promise to be paid in dollars 30 years from now?  People, banks and foreign governments can sell those bonds on the open market.  If you're worried about inflation, you would probably want to sell your $100 treasury bond for $80.  That way you get today's dollars and not an inflated, worthless dollar in 30 years.  Then it becomes more difficult for the treasury to sell new bonds unless they raise the interest rate.  Would you buy a $100 bond from the treasury when you can get it from someone else for $80?  Not unless the treasury was going to offer a much higher interest rate on the new bond.

But as I said before, all of these budget deficits were only possible because the treasury could find buyers of their securities and the interest rates were so low.  When interest rates rise, then the treasury goes into more debt and does so faster because it's paying more interest to service that debt.  And without new money coming in, either in the form of a budget surplus (feel free to laugh at that) or new bond buyers, it becomes impossible to fund government.  Unless of course congress stops funding government services beyond what it can afford (feel free to laugh at that) or the fed comes to the rescue and buys up those securities in exchange for a few extra digits on a bank's balance sheet punched into a computer that represents money.  And it seems extremely likely that the fed will do just that.  If you're expecting this new congress to cut spending in any significant way, well, let's just say I wouldn't hold my breath.

Why would the fed do this if it will cause high inflation?  First, they claim that injecting new money into the system will cause job creation.  Second, it's possible that the treasury is having a tough time finding buyers for their treasuries.  That would mean that the treasury has to pay much higher interest on our debt.  We currently pay about a half a trillion dollars on interest alone.  If rates rise even moderately, we could easily be paying over a trillion dollars a year on interest, not to mention the principle.

Why would congress continue to issue more debt?  Because the alternative is to take government services away from people.  Trust me, if they started to do that, there would be a lot of angry people.  Once the government starts to provide a service to people, the people become dependent on that service and feel like it is essential to their lives.  Then it's nearly impossible to make cuts to those services without political backlash.  Hell, even the tea party people are against cuts to medicare and social security, which are by far two of the largest contributors to the deficit.

Without any other buyers of treasury securities, and without major spending cuts, the only thing we can do to keep the gravy train rolling, at least for a while, is to have the fed buy treasury securities and wait for the inflation to steal any wealth we may have.


One main reason we can have such low interest rates is because Moody's gives us a AAA rating.  They recently said that could change if budget deficits continue to increase.

There are some early signs that investors are selling off their treasury securities.  Last week saw the largest 2 day sell off since the collapse of Lehman Brothers in 2008.

The interest rate on the 10 year treasury note recently reached a 6 month high, and most economists expect the trend to continue.

Last November gave us a budget deficit of $150.4 billion.  That's the largest November budget deficit in history.

It's not just the new tax deal without spending cuts that has the world spooked about our economy.  The truth is that the world reacted very negatively when the fed announced a new round of quantitative easing back in November. 

The American public is also losing faith in the effectiveness of the fed.

Investors all around the world are starting to realize that there is no way American can ever pay back its debt.  David Bloom, currency chief at HCBS, recently said "If yields are rising because people think America's fiscal situation is unsustainable, then its Armaggedon."  There is also growing concern among investors that the federal reserve simply doesn't care about the dangers of inflation.  This is making owners of treasuries very nervous.  Stephen Lewis of Monument Securities also said "There is a feeling that the fed doesn't care about inflation, in fact wants more of it, and that is certainly not in the interest of bondholders"

Over the next 12 months, the U.S. government is going to be rolling over trillions of dollars in debt (the treasury securities will be maturing) along with all of the new borrowing that it is going to be doing. In fact, the U.S. government is somehow going to have to find a way to finance debt that is 27.8% of GDP in 2011.

For decades our leaders have told us that "deficits don't matter".  What we're all going to find out is - spoiler alert - our politicians have been lying to us.  The sad part is that most people still don't understand the magnitude of our debt problems.  As the federal government's total debt approaches 14 trillion dollars, that only represents a small fraction of the real problem.  The government has reached a "fiscal gap" of 202 trillion dollars.  That "real debt" includes our current federal debt plus all the other unfunded liabilities that the government has made commitments to pay but has no actual plan or ability to pay.  Just to put it in perspective, if the government taxed 100% of everyone's money in the country, it would have to do so for nearly 13.5 years to pay off that "real debt".  Does anyone actually think we'll ever pay that money back?

Let me try to recap the federal government's actions into a very simple statement.  Our national debt needs a continual source of new treasuries buyers in order to pay off the old buyers of treasuries once they mature.  Without a new supply of buyers, we can't pay the people we promised money to.

What I just described there is the textbook definition of a Ponzi scheme.  They are exactly the same.  Tweak a few words and those two sentences could also read like this: Bernie Madoff needed a continual source of new investors in order to pay off the old investors once they retired.  Without a new supply of investors, he couldn't pay the people he promised money to.... and anyone who was financially invested in him lost everything they had.

As a citizen and a taxpayer, we're all financially invested in the federal government.  And thanks to our government, the entire economy is one gigantic Ponzi scheme.

Wednesday, November 17, 2010

Obama is the perfect president, so don't let him do much.

My reach is global
My tower secure
My cause is noble
My power is pure
I can hand out a million vaccinations
Or let them all die from exasperation
Have them all healed from their lacerations
Or have them all killed by assassination

I try to avoid discussing President Obama for a few reasons, mostly because the conversation usually misses the point.  On TV you'll see lunatics on the right who claim that he's purposefully trying to destroy the country so he and the lefties can rebuild it in their image.  You'll also see lunatics on the left claim that he's the smartest and greatest person to ever hold elected office and we need to let him do whatever he can to fix the terrible mess he inherited.  He understands the issues better than anyone and, given that, he should have carte blanche to do whatever is necessary to fix the problems.  This post will mostly address the people who support Obama and his policies, and I'll attempt to explain why even his strongest supporters shouldn't support many of his decisions, even if they're the right ones.

For the sake of argument, I'm going to have to make a few assumptions, many of which aren't even too far off from how I really feel about the guy.  Since I'm addressing the Obama supporters, I'll have the assumptions cater to their arguments and views, and take them to the extreme to make my point.  Let's assume that he is the smartest person in any room he enters.  Let's assume that he has a greater understanding of the issues than anyone else and he is 100% right on everything.  Let's assume that he has the country's best interest in mind and will not ever be corrupted in any way.  And let's even go so far as to assume that every decision that he makes is perfect in every way and ushers in a new, unprecedented era of prosperity for not only the country but every single individual.  Everything he does and every law he passes is perfect, great and pure in every way.  The Health Care Law is the perfect law to fix the problems in the industry.  The war in Afghanistan is being waged in the perfect way, killing only those people we want to kill without harming innocent civilians or disrupting their society in any negative way.  The trillions spent on stimulus and bailouts work exactly the way they should and we see economic growth like we've never seen before, leaving nobody behind and benefiting all.  Essentially he is a perfect, magnanimous, benevolent and wise leader, like Bill Pullman in Independence Day, only better.  Let's start from there.

So what should we do, given the assumptions that I laid out above?  The easy answer would be to step back and let him work his magic.  Let him make the tough decisions and give him whatever he needs in order to follow through with them.  Whatever changes he wants to make to health care, we should support him.  Any amount of money he wants to spend to improve the economy, we should support him.  After all, any decision he makes is going to have amazing results and we won't have to give up any freedoms to accomplish them.  What would be the result of this course of action?  Well, given the assumptions that I made, we would certainly find ourselves living in a Utopian society in a very short period of time, and supporting Obama in all of his endeavors would certainly lead to great and amazing results.  

There's only one problem with doing that though.  At some point President Obama will leave office.  Even if he is so wonderful that we let him be our president for life and an entire generation grows up in a perfect society with a perfect leader, at some point he will die.*  And when he is no longer the president, we will have to elect a new one.  That new president will suddenly have all the power and authority that we gave to Obama, and the chances are pretty good that the new president won't be able to manage all that power in such a great way.

You see, the power of the Presidency sticks around much longer than any one president, so when we give any power to an elected official, we're also giving that power to everyone else who holds the office in the future.  This is something we all know, but tend to forget when it's "our guy" in charge.  When we gave President Bush the power to wire tap our phones to keep us safe, we also gave that power to future presidents who might not use the power so sparingly.  When we gave President Obama the power to overhaul the health care industry to keep us healthy, we also gave that power to future presidents, some of whom might not have our best health in mind.  When we gave Obama the power to spend trillions of our dollars to stimulate the economy and bailout corporations, even if it was the perfect solution to a terrible problem and everything works out wonderfully, we gave that same power to everyone else that comes after him.  And there's a chance that the next guy won't use that power and spend that money in such a perfect way. 

If you're reading this and trying to either defend or indict his policies that I meantioned, then you're missing the point.  This has nothing to do with Obama or his policies.  It has everything to do with the power he has.  Even if his policies are the perfect policies, we still shouldn't support him if those policies allow the president to have any power over the individual citizens.  If you love the man and think his policies are great, that's awesome and I'm glad you got the perfect president.  Just remember that the next guy probably won't be as perfect and you might wish the president didn't have so much power.  If you don't agree with what he's done and want to "take back Washington", remember this.  Because eventually your guy will get into office and he'll probably use the power to shuffle trillions of dollars, but in the way he wants to, and fight wars without approval from congress, but the ones that he wants to fight.  And it'll all be done because at some point we gave someone else the power to do that because we liked the way he used the power.

Just because someone is using their power in a way that you agree with doesn't mean the person should have that power.  In fact, it's even more important to deny a president more power when we approve of his policies because it's very likely that we won't object to a whole lot and we'll allow him a lot more power.  Hopefully all the people who support Obama think of this when discussing how good of a job he did at overhauling the health care industry, or stimulating the economy, or fighting pseudo-wars, or fixing the car industry, or stabilizing the housing market, or anything else that he did or does.  We shouldn't be asking if these policies are going to deliver good or bad results, we should be asking if we want to give so much power to a small number of people.  Because even if everything works out and the country is better because of these policies, it's still dangerous to give the president enough power to overhaul huge industries, distribute trillions of borrowed dollars however he sees fit, wage war without approval from congress and influence the price of homes.  Once we give that power away, it's nearly impossible to get it back and one day we might wake up and realize that we gave too much power to too few people.

I used the word "power" about 13,000 times and I just wanted to make the point that when someone has the ability to enact sweeping policy changes that are good, they also have the ability to enact sweeping policy changes that are bad.  And the best defense against this catch 22 is to not give our leaders that ability in the first place.  Keep the government as small as possible and leave the power with the millions of individual citizens, not whoever gets elected to office.  If we don't follow that one simple rule, one day we might have a president with so much power that he resembles Old Spice Odor Blocker Body Wash.  Then again, maybe that wouldn't be so bad either.

*I better clarify for the CIA, FBI, Secret Service and/or Fargo Police that might end up reading this.  I only mean to imply that he is a mortal human and because of that he will die at some point.  In no way should this line of reasoning be interpreted as a threat against President Obama or a suggestion to a lunatic.**

**Are there any lawyers out there who can let me know if I'm covering my bases here?  I don't want to go to jail over this.  And yes, I'm putting a footnote in a footnote.  Why would I do such a thing?  Because I can! I've gone mad with power!

Monday, October 25, 2010

How We Measure Inflation

I've been talking a lot about inflation lately.  But if you look at the traditional way we measure inflation, the Consumer Price Index (CPI), we are seeing inflation of 1.1% which isn't very much at all.  But like every number and statistic that you hear, you'll learn far more by looking at the methodology that was used to get that number or statistic.

Ostensibly, the CPI is a measure of consumer prices.  That is, an imaginary shopping cart full of goods from many different sectors of the economy (food, houses, cars, clothing, energy, etc.) is brought to the checkout and the price of all those goods is added up.  Then, one month later, the same imaginary shopping cart full of the same goods is brought to the checkout and the price is added again.  By doing some simple math you can figure out what the rate of inflation or deflation is by comparing the change in the price of your shopping cart's contents.  That seems like a very accurate and reasonable way to measure inflation, right?  I think it does.  And that's how the CPI is currently measured.  That's how the CPI was measured before the 1980's.  You see, modern economists and politicians have found some neat new ways to measure the price of those good in the shopping cart.  Let's take a look, shall we?

Alan Greenspan and Michael Boskin argued that changes to the CPI needed to be made for certain items when they became too expensive.  For instance, if the price of steak rose too high they should quit using steak in the CPI measurements and use hamburger instead.  They reasoned that once steak got to a certain price, the consumer would simply eat hamburger instead.  BAM!  Now inflation isn't as high.  Of course, this only shows the rate of inflation measured in terms of maintaining a lower standard of living.  Inflation stayed low on paper but in real life inflation was higher and living standards decreased.

Some years later there was another change that took place.  In addition to substituting cheaper goods for more expensive goods, the CPI started to use geometric weighting.  This means that when the month-to-month (or year-to-year) prices are calculated, more weight is given to prices that are falling, and less weight is given to prices that are rising.  If the price of bread has gone up 10% in the past month, but the price of milk has gone down 10%, then the official CPI measurement will give more weight to milk prices than bread prices, making the rate of inflation appear to be lower than it otherwise would.

More recently, the politicians and economists in charge have come up with a truly amazing new way to measure the CPI.  It's called hedonics, and it shows that these guys will stop at nothing to make inflation appear to be lower than it actually is.  Hedonics adjusts the price of goods for the increased pleasure the consumer derives from them.  That 20% increase in the price of your washing machine?  Well, that isn't going to be included in the CPI because of all the pleasure you get from pushing the fancy electronic buttons instead of turning the loud clicking wheel thing.  When the price of gas goes up due to federally mandated additives, it doesn't raise the inflation rate because the consumer got so much thrill from breathing the fresh air.

I've read that the real inflation rate (measuring CPI with the methods that were in place before all these changes) could be up to 7 or 8% higher than what the official measurements are.  And the Federal Reserve is making decisions based on a 1.1% inflation rate that they want to raise to about 2%.  But because they use such innovative ways to measure inflation, the real inflation rate will have to go up a lot more than 1% in order to get the official number to go up 1%.  I probably sound like a broken record but to me these are all signs that we're heading for an extremely high(er) rate of inflation.

If you're reading this you have access to the internet.  If you're curious about any of this just use the internet to watch the dollar index and commodity prices to see what inflation is doing.  The value of the dollar has been going down for some time and the price of sugar, cotton, corn, etc. has been going up.  When commodity prices (food) go up, and the value of the dollar goes down, you're seeing inflation.  The changes that I've been seeing in these two areas in recent months are significant.

The other day I was talking with someone about what I've been writing and I was told that I'm painting a really bleak picture.  I couldn't argue with that, but I had to clarify that what I'm describing is still the worst case scenario.  But with every passing day, and with every decision the Fed makes, the worst case scenario is looking more and more like the most likely scenario.

Pssst, that's not good.

Monday, October 11, 2010

WWIII: The Currency War

Believe it or not, we're in the midst of a war right now.  It's not Iraq or Afghanistan.  It's a war waged by the major governments of the world to destroy their own currency.  All across the world countries are enacting policies that devalue their own money.  It's a race to the bottom.  Last week, Brazilian Finance Minister Guido Mantega made headlines when he mentioned that a worldwide currency war was brewing, and the winner would be the nation with the weakest currency.

In a normal war countries try to kill the enemy.  In a currency war the countries point their guns at their own citizens and kill them with a currency that loses its purchasing power.  The country that can make its money worth the least is the country that wins the war.  The bad news is that the winner of this war will experience a Pyrrhic victory. The worse news is that America is poised to win this war.

Why on Earth would a country want to devalue its own currency?  That is such an easy question to ask because the premise makes absolutely no sense.  But the answer is actually quite complicated.  That's because modern economists have figured out a way to make it seem like a weaker currency is advantageous to a nation.  Of course, this is complete nonsense.  A weak currency is the result of bad policies that politicians love.  And if an economist can make it seem as though the terrible results of bad policies are actually desirable, well, that economist will probably get a job in the White House on the President's economic staff.  An economist who states otherwise (and speaks in terms of truth and common sense) isn't allowed in that elite club.

There are two reasons why a weaker currency would be desirable.  First, it helps the nation export more goods.  When your money isn't worth very much, it makes the goods you produce considerably cheaper to purchase.  When the price of goods is low, the amount of exports goes up.  Second, and this is related to the first point in a way, a weak currency leads to more jobs.  When the dollars that you pay workers in is worth less, it's more affordable to hire workers and the economy can create more jobs.  Politicians love this.  Debase the currency, raise exports, create jobs, get elected again.  On paper, everything works out perfectly.

Now, you might be thinking that this is what we need right now.  If a weaker dollar will create jobs then a weaker dollar we need.  But let me ask you something.  What's so great about a job?  There are very few people who work because they love labor so much.  Everyone in Soviet Russia had a job.  Every slave in early America had a job.  Seriously, the unemployment rate for black people in America during slavery was basically 0%.  There is nothing great about having a job.  The reason jobs are desirable is because having a job is a means to an end.  You earn money at your job and can use that money to buy stuff you want or need.  But by making that money worth less, which is what happens in a currency war, the people with jobs lose the ability to buy stuff with the money they earn.  Selling goods and having jobs become a means unto themselves and little attention is given to the fact that there are obvious negative effects of currency devaluation: diminished purchasing power and lower living standards.  Individuals see jobs as a means to an end.  Governments see jobs as an end in and of itself, and a devalued currency is the means to that end.

Way back in the 19th century, before economic models developed their current levels of sophistication, the goal of a government's economic policy was to bring prosperity to its citizens.  In other words, they tried to raise the general level of material comfort, while at the same time reducing the amount of toil and work needed to reach that end.  Unfortunately, due to the blather spouted by modern economists, success is no longer measured in those terms.  A country's currency used to be viewed much like a company's stock price.  The reliability, competitiveness, and growth of a national economy usually translated into a strong currency. This system made sense and it worked.

Countries that offered the most fertile soil for investment capital, or that made products other countries wanted, would attract funds from abroad. Demand for the currency of these “blue chip” countries (which was needed to invest or buy locally) would inevitably push up the value of the currency. And so, much as shareholders of successful companies are rewarded by higher stock prices, citizens of successful countries were rewarded with stronger currencies, with which they could buy more goods and services both domestically and internationally, raising their living standards.

But all that has changed in recent years. With a strategy that seems to be taken from the playbook of Sam Walton, governments now look to gain a competitive edge by lowering the cost of their exports. To do this, they have adopted a beggar thyself (as opposed to beggar thy neighbor) policy of habitual currency debasement. Although such a move may benefit those who buy the products, it is a burden to the country’s own workers who, like Wal-Mart employees, have to get by on lower wages. While the markets like a low-cost provider, this is not a niche that everyone can, or should, fill. Some will compete only on price, but more successful ventures will compete on quality and innovation. For every Kia there is a Mercedes Benz.  Nearly every country on Earth is attempting to compete by lowering the price of their goods and no thought is given to producing higher quality goods or developing innovative production techniques.

When a government debases its currency in order to gain sales overseas, the nation earns less for the goods that it exports. As a result, its comparative advantage is ruined, and its citizens consume less as a result. In other words, as a nation’s currency declines, its citizens are forced to work harder for less.

If a department store decided to have a sale in which all of its merchandise were marked down 50%, it will surely sell a lot more stuff.  However, it would earn a lot less than if it had been able to sell its goods without marking them down.  This is how currency debasement works.  Similarly, one way for the unemployed to get work is to accept lower wages.  Workers will sell a lot more of their labor if they accept 50% pay cuts.  But are they better off as a result? Relative to being unemployed, the answer is yes, but they would be much better off being employed at full pay.

As I pointed out earlier, the fact that America holds the world's reserve currency makes it easier for us to have a 50% off sale.  It also makes it easier for politicians to print money and inflate the currency at ridiculous levels.  Politicians love easy solutions so I'm convinced that extremely high inflation is on our horizon.  America is going to win the race to the bottom.  And eventually we're all going to be casualties of war.

Wednesday, October 6, 2010

Kittens, Bar Rafaeli and football. Oh yeah, the dollar collapse that will destroy our economy too, I guess...

Since I started writing this blog thing I've gotten some positive response from people who tell me how much they enjoy it.  So I want to take the time and say thanks to both of you that read my ramblings.  The other people who have brought it up to me have expressed concerns, most notably that politics/economics is much too complicated and boring to waste their time reading about, especially during football season.  Well, I want everyone to know that I've heard your criticism and I am going to take some steps to make these posts more enjoyable to a larger audience.  I'm not a good enough writer to make these topics interesting and fun, but I do know how to link to pictures and other websites.  So as you're reading this just know that there will be some extremely uncomplicated and entertaining links scattered about.

I know reading that paragraph was probably difficult, so here, take some time to enjoy this picture of Israeli supermodel Bar Rafaeli

Now, onto the topic at hand.

I wrote last time about how the trade deficit coupled with the fact that our dollar is the reserve currency of the world has lead to a huge number of dollars that we printed, sent overseas and because they're not coming back we see no inflation.  I'm going to try to expand on this inflation idea but focus more on our domestic policy this time.  I think that this is the most important issue facing our country right now and it's not going to be very long before we start seeing a currency in shambles.  I'll try to explain why I feel this is a very real possibility.

Right after I show you this clever Calvin & Hobbes cartoon strip!

 Since the recession started, the Fed has increased the money supply by $2 trillion and lowered the interest rates to 0%, which is what they call "Quantitative Easing".  The Fed recently hinted that they were going to do another round of Quantitative Easing.  In an effort to prop up an economy that is trying to crumble, the Fed is printing money and giving it to banks at historically low interest rates.  This is being done in an attempt to give banks incentives to lend to businesses and consumers.  The reason we're not seeing the inflation that should come with an extra $2 trillion is that the banks aren't lending the vast majority of that money.  The dollars are just sitting in the banks, and since they're not reaching the economy we don't see the inflation.

WOW!  Have you guys seen the 2010 Lamborghini?!

Now these dollars aren't going to sit in the banks forever.  At some point we'll start to inflate another bubble and it'll send false signals through the economy and banks will feel like it's safe to lend again.  Or maybe the Fed will take interest rates from the current 0% into negative territory to further incentivise banks to get the money into the economy.  Once enough of those dollars enters the economy, we'll start to see real signs of inflation.  This is where the Fed will have to time their actions almost perfectly in order to keep inflation from getting out of hand.  What can they do to keep inflation under control?  Well, they have to suck back those dollars that they pumped into the economy.  This is done by raising interest rates.  Banks don't lend as much when rates are high, the money starts flowing back to the Fed and they remove the money from the economy.  The tricky part is that the Fed has to time this out perfectly.  Raise rates too soon and you lose any positive effect of pumping those dollars to banks.  Raise rates too late and you'll be chasing inflation and it'll get out of control.

This is essentially what we did in the 1970's.  Back then we had inflation at about 12% and a weak economy.  In order to fix the mess, the Fed had to raise interest rates to 20% for an extended period of time to get inflation under control.  That was a difficult move because it kept people from borrowing money which in turn stalled economic activity.  But back then we were the world's largest creditor nation.  Today we're the worlds largest debtor nation.  This brings with it a whole host of problems, the most notable one is the damage that is done once interest rates start to rise.

Remember this hilarious scene from the hit movie Armageddon?  HAHA, that Affleck is so lovable and goofy.

Ok, so let's say for the sake of argument that the banks start lending and the dollars start to hit the economy and inflation starts to go up more than the Fed is comfortable with.  Fed chairman Ben Bernanke said that he would combat the inflation with higher interest rates, as is historically done.  The problem with that is that we have a lot of debt.  And a lot of that debt is financed with short term treasury bills because the interest rate is so low.  When the Fed raises interest rates, and those loans are reset, the government's payments on the interest of those loans is going to go through the roof.  We just did the same thing when people bought homes with adjustable rate mortgages.  When the rates went up, people suddenly couldn't afford their house.  Right now we pay about $200 billion every year on interest alone.  That's because the interest we pay is at 0.3%  If we see interest rates go up to even a modest 4 or 5%, we're going to be paying an astronomical amount of money just on interest, not to mention the principle.  What if the Fed has to raise interest rates to 10 or 15% to combat inflation?  Remember, with all the Quantitative Easing that the Fed did, they DOUBLED our money supply.  In the 1970's they added less than 15% to the money supply and got 12% inflation and 20% interest rates.  If you passed 3rd grade math you can see what a mess this is.

Hey, have you seen this adorable clip of cats running in a wheel?  How cute!

The bottom line is that there are really only 2 options for the government to take when it comes to the debt we owe to foreign nations.  We can either default on the loans and not pay them back, or we can inflate our way out of it.  Let's take a look at each option, shall we?

...After this awesome picture of fireworks.

Let's say our fearless leaders (whoever they are when this mess unfolds) default on the debt.  They tell China and Japan "Sorry guys, we're not paying this.  We cannot afford it at all and we're gonna screw you over".  Now this would actually be the better long term option.  It's extremely difficult to do in a political sense though.  First, nobody likes to tell their lenders that they aren't paying back their loans.  Second, it makes the nation look week and good luck trying to get those countries to cooperate with us on anything.  Third, and most importantly for America, it means we lose our premium credit rating and are forced to pay MUCH higher interest on any money we borrow.  Since we're planning on running deficits measured in trillions of dollars for at least the next decade, and since so many Americans love the perks of deficit spending, it would be political suicide to default on the loans and be forced to balance the budget overnight.  That's the worst part about this course of action (from a political standpoint anyway), it happens very quickly and whoever makes that tough decision will not be able to pass the blame on to someone else.

So the easier course of action is to inflate the currency, because it happens relatively slow and allows politicians to pass the blame.  It's also, of course, the worst option since it essentially brings us to the same destination in a far more destructive way.  Instead of raising interest rates to sufficient levels in order to keep inflation under control, we'll simply keep them low to protect our debts and let the value of the money decline.  This also helps us pay our debts because we can borrow $1 trillion now, then make that money not worth as much, and when we pay it back we're paying far less than we borrowed in terms of what those 1 trillion dollars are actually worth.

The problem is that, with inflation, the price of everything we buy goes up.  Pretty soon we're paying more for the necessities like food and clothing and spending less on the products that are keeping our economy viable (I'm using that word very loosely).  70% of our economy is based on consumer spending.  Once we stop consuming because of inflation, the government will try to prop up the consumer with stimulus packages and business bailouts and more deficit spending (printing and borrowing money) all in an attempt to keep us spending money on stuff.  It's exactly what the previous administration did and what the current one is still doing.  Obama likes to remind us that it was the failed policies of Bush that got us into this mess.  He's absolutely right.  The problem is that he's repeating those mistakes and at a much higher level.  Keep Americans buying for as long as possible.  Keep the country drunk on credit and debt and convince us that this phony economy pipe dream is real.  Assure us that we can have it all forever and we can borrow our way to prosperity.  Oh, and pray that when the system eventually crumbles you're out of office and the next guy gets all the blame.  Bush nearly made it.  I don't think Obama will get that close, especially if he picks up a second term.

I'm sorry, I went a long time there without taking a much needed fun break.  I bet that was painful.  Hopefully not as painful as this though

But anyway, once our lenders see our currency depreciate, there is no way they'll want to lend to us anymore without higher interest on the loans.  It will become increasingly difficult to finance our debt.  But again, instead of doing the wise and prudent thing (stop running huge budget deficits because credit dried up) that would lead to political backlash (voters complaining about their government checks/programs going away), our fearless leaders at the time, whoever they might be, will decide to finance our debt by simply printing the money.  You want your social security check?  Sure, we'll just print the dollars.  The retired federal employee wants his nice pension and benefits package?  Sure, we'll just print the dollars.  You're out of work and want the unemployment benefits for another year?  Sure, we'll just print the dollars.

Eventually this set of policies can lead to an extremely high rate of inflation that becomes harder and harder to fix.  But fear not America, because we'll have fearless politicians to fix (make worse) the problem (that they created). When prices start to rise our fearless leaders will find someone else to blame, probably the greedy business owners who are only raising prices to pad their huge bank accounts.  So we'll get price controls on things like food and clothing, but that will only lead to shortages of food and clothing.  We'll get wage controls, but that will only lead to higher unemployment.  Every solution to a problem will create another problem that cowardly politicians will combat with a terrible solution that creates more problems.

This kitty does the YMCA.  Isn't that precious?

And all the while, the countries over in Asia will be going through a transformation of their own.  They currently think that they need America to consume their products.  That's why they keep lending to America long after it became obvious that they wouldn't ever be paid back.  But after Americans stop consuming their goods, they could let the value of their currency gain in value.  Suddenly the people who worked hard to make those goods can afford to consume those goods.  Their standard of living will go up as the standard of living in America goes down.  The world will realize that humans have an unlimited amount of demand for products that make their life better.  Americans don't have a monopoly on that.  When our ability to monetize that demand goes away, there will certainly be humans on this planet who will fill that void.

One more of Bar Rafaeli.  Because seriously, that woman is simply gorgeous.

Tuesday, September 28, 2010

Why Manufacturing Jobs Are Leaving, And How It Could Destroy Our Currency

Ask anyone this question: "Why has America lost over 3 million manufacturing jobs in the last 15 years?" and I'll bet you good money that the most common answer you'll get is "free trade", or maybe "NAFTA".  It makes sense, right?  American companies can send jobs overseas, get the products built with cheap labor in countries with low regulations and nearly nonexistent labor laws, and then ship the products back to America for next to nothing.  Sure beats meeting the laws and regulations associated with hiring workers in America.  I mean, this is just common knowledge. Duh.

Well, this is a very solid argument.  But there's just one small caveat to it... it's completely and utterly wrong.  Free trade may have been a factor in speeding up the outsourcing, but not really.  If done right, free trade is a good thing and doesn't automatically lead to the deployment of manufacturing jobs to developing nations.  It only worked that way because it's a symptom of a much larger disease.  I'll try to explain this in a clear way, but I should warn you that it gets rather complicated.

For all intents and purposes, the United States is the only country that uses the American dollar.  Every dollar that leaves America must come back at some point.  That is, when America imports goods, we send dollars to the countries that we get the goods from.  Since those dollars cannot be spent in the foreign countries, they must eventually come back to America. Foreigners could buy up manufacturing plants in America, but if they move those plants overseas, any profit they make in the United States would have to be spent in the United States.

I'll put it another way.  Suppose an American exporter sells his goods to a Japanese importer and is paid in Japanese Yen.  The American cannot use the Yen to pay his workers, buy clothing and food for his family, or buy theater tickets.  If he wants to do any of those things he needs American dollars.  Therefor his Japanese Yen are of no use to him unless he uses them himself to buy Japanese goods or sells them to some other American importer for dollars.  The buyer of the Yen will use that currency to buy Japanese goods.  So every Yen that leaves Japan has to eventually get back to Japan in exchange for something that Japan produces, because Japan is the only country that uses the Yen as currency.  It works the same way with America.  Every dollar that we send overseas for goods has to eventually make it back to America.

You see, there really shouldn’t ever be a trade deficit of any major significance. This may seem strange, but it shouldn’t. Exports pay for imports, so they must eventually balance out. Think of a bartering society.  I can trade you 5 chickens for your goat.  My 5 chickens are my exports, and the goat is my import.  Your goat is your export and the 5 chickens are your import.  Because we both agree that 5 chickens is worth 1 goat (maybe I have too many chickens and you have too many goats.  Supply and demand dictates the value of the chickens/goat), neither one of us has run a trade deficit.  It's no different if we were countries instead of individuals.  Say my country has a lot of pens, but no pencils.  Your country has pencils but no pens.  So, we trade.  I give you pens and you give me pencils.  For both of our countries, our exports paid for our imports and we have no deficit.  When money gets involved, the situation is essentially the same.  I'll sell you pens for money that you earned by producing pencils and then use that money to buy your pencils.  That's how economies work regardless of whether there are 2 goods involved or 2,000.  My excess production/resources are traded to you for your excess production/resources, and there is no trade deficit.  It works the same way for nations as it does for individuals.  At least that's how it's supposed to work.

"But Chris, the U.S. does have trade deficits and we just racked a whopping one of 568 billion dollars in 2008!"  Well, two points need to be made here.  The first one is general while the second one is specific to the United States.

In general, it’s obvious currencies don’t leave and come back instantaneously. There will be up and down cycles. It’s also hard to account for every economic transaction taking place between individuals, companies and governments in one country or another. This is especially true, given there are often large black markets in even the freest economies. And finally, well, governments just lie sometimes. Shocking, I know. All of this becomes obvious when you look at the CIA Factbook for 2009, which says the world as a whole ran about a $133 billion dollar trade surplus. This is, of course, impossible.

Accounting errors can only account for small discrepancies though.  The United States is a very peculiar case.  We just so happen to hold the world's reserve currency.  To explain what this is and how it came about, we have to go back to the end of World War II. After the war, the Allied governments wanted to set up a system that would facilitate international trade and prevent the hyper-nationalistic protectionism of the 1930′s, which helped spur the Second World War. John Maynard Keynes and Harry Dexter White designed a system known as Bretton Woods, in which every country in the American sphere of influence tied their currency to the U.S. dollar at a fixed exchange rate and the dollar was in turn tied to gold at $35 per ounce.  Basically the dollar was valued at $35 per ounce of gold and every other currency in the world was valued at some fixed exchange rate with the US dollar.  All these currencies throughout the world could be exchanged for a certain number of American dollars, and those dollars could in turn be exchanged for gold at $35/ounce. Sounds like a good idea, right?

In reality, the system was doomed from the beginning.  The problem was simple: it relied on wise fiscal policy by U.S. politicians.  In 1971, after a decade of paying for "guns and butter" (the Vietnam War and the Great Society) by inflating the dollar, the U.S. government could no longer justify the $35/ounce exchange rate.  When foreign investors started requesting their gold in exchange for dollars, president Nixon responded by removing the gold standard.  From that point on the only thing that gave our dollar any value was the trust and confidence of the dollar.  It's called fiat money, and without the trust and confidence of its value you may as well have monopoly money or a dirty bar napkin with "IOU" written on it in sharpie.

The fixed exchange rate system was eventually replaced with floating exchange rates that had no gold backing. This allowed investors to set currency values by bidding on them in relation to each other. Now, this system works in principal, but unfortunately it opens up countries to currency attacks. If a government enacts poor policies, investors can leave that currency en masse. Or, as many leftists claim, powerful countries can simply de-fund weaker countries if they don’t like their policies; although whether this has ever actually happened is disputed. Regardless, it leaves countries vulnerable as illustrated by the most famous example of such currency implosions, the Asian Financial Crisis of 1997.

To avoid these crises (and store a “risk free” currency in case of other problems), governments started stockpiling dollars to act as a safety net in case their own currency was attacked. While the dollar was the reserve currency under Bretton Woods, as well as in the ’70′s and ’80′s, government stockpiles really accelerated in the 1990′s and 2000′s when China started taking off and the fall of communism brought with it a whole host of new countries, who, lacking Soviet support, needed to start stockpiling dollars.  America, as the world's economic leader, was seen as having the strongest currency and countries began to gather up dollars in their reserves.  If their currency was "attacked" at least they had dollars that were worth something.  But, as I said before, the dollar is only worth something because people think it's worth something.  Since leaving the gold standard, there is nothing of value that these little green pieces of paper represent.

So what does all of this have to do with disappearing manufacturing jobs and trade deficits?  As I pointed out earlier, we don't really have a trade deficit per se.  What we have is countries selling us goods for dollars.  But instead of those countries exchanging the dollars for our goods as would be normal, they're stockpiling them in their central banks because the dollar is the reserve currency and owning dollars is supposed to protect their money against any currency attacks.  Essentially, we have no trade deficit because the figures don't include our number one export: little green pieces of paper about the size of a dollar bill that are easy and cheap to print.  But remember, the dollar doesn't have anything of value behind it ever since we left the gold standard. Hopefully you can see where all of this is leading.

The dollars are no longer returning to the United States, or at least, a sizable portion of them are not. We buy toys from China and oil from Saudi Arabia and cars from Japan and electronics from Taiwan and cocaine from Mexico and they turn around and stuff those dollars into their central banks. This does two things: first, companies no longer have to buy anything from the United States with the dollars they receive (because foreign countries will buy the dollars to put in their reserves); they can simply outsource their factories and then sell the dollars they collect to the host country’s central bank, or other investors.  If these countries did not want to buy and stockpile the American dollars, those dollars would have to be spent in America on goods produced in America.  But the dollars are being funneled elsewhere and the result is that our manufacturing sector is hollowed out because foreign countries would rather hoard American dollars than spend them on American goods. Second, it gives the U.S. government a license to print an almost infinite amount of money without producing inflation. Or in other words, we pay for our imports with nothing more than thin, green pieces of paper that we can print for nothing.  And as long as those little pieces of paper don't come back to America, we don't see any inflation because there is no velocity.  We get a great standard of living, the rest of the world gets jobs, and all we have to do to keep the system working is to print paper (dirty bar napkins with "IOU" written on them in sharpie).

This is a great system, right?  Now we get to have Guns And Butter Part Duex and not see any inflation as a result.  How wonderful!  But as Herb Stein once said, "things that can't go on forever don't".  The dollar currently makes up about 64% of foreign reserves, with the Euro at a distant 2nd with about 26%.  This creates an extremely precarious situation.  While the dollar isn't sinking like a rock (yet), many foreign countries are worried about our bailouts, stimulus packages and gigantic deficits.  Foreign central banks are becoming so nervous they have started diversifying into the euro and other currencies. If we’re not careful, they will pull the plug and all those dollars will come rushing back to the United States. If this happens, the dollar will hyperinflate overnight.  And all it'll take is for one country to start sending dollars back to America or stop buying American debt.  That would start a domino effect where everyone starts trying to sell their dollars but nobody wants to buy them, the price of the dollar will fall through the floor and the whole house of cards --er, dollars-- will come crashing down.  Think of the housing crisis, except instead of houses it's dollar bills.

I'm actually surprised that the rest of the world hasn't realized that the dollars they're holding are worthless and they would be better off spending their money on themselves instead of financing our debt and consumption.  I guess the short term pain of dumping U.S. dollars currently outweighs the long term positive effects of having a stronger currency and being able to consume the goods that they work so hard to make.  It seems that politicians, no matter what country they're in, don't have the guts to make short term sacrifices for long term gains.  But eventually this will all happen.  Some event will take place and it will trigger a little bit of worry around the globe and within a very short period of time those dollars will all come back to America, the world will stop financing our debt and consumption, and we'll all be millionaires buying $10,000 loafs of bread. Or, you know, we could continue to run trillion dollar deficits forever, nobody will want to be paid back and everything will work out perfectly.  We'll probably find out in a few years.

Thursday, September 2, 2010

Mosque - 1, Ground - 0

OK media, you win.  The ground zero mosque is, somehow, a topic worthy of a national debate.  I suppose I'll throw my hat in the ring as well, even though it's utterly pointless and stupid.

First of all, I take issue with the term "ground zero mosque".  It is neither on ground zero, nor is it a mosque.  It's a few blocks away from ground zero and it's a Muslim community center.  (It's at this point that half of everyone reading this will tune out and lose any sliver of open-mindedness that might have existed.  But I guess I'll continue anyway.) It'll have a basketball court, swimming pool, auditorium, culinary school, and *gasp* a place for Muslim prayer.  If the "place for Muslim prayer" part makes it a mosque, then the pentagon is technically a mosque.  This is little more than a YMCA with a prayer room.

The media pundits have gotten very good at misleading phrases just like this.  Death panels, blood for oil, welfare queens, vast right-wing conspiracy, yes we can, ad nauseum...   These phrases might sound vaguely correct, but they're horribly misleading.  "Ground zero mosque" is just another one to add to the list.  Is everything around ground zero a "Ground zero [something]"?  Ground zero starbucks.  Ground zero McDonalds.  Ground zero jiffy lube.  Ground zero homeless bum begging for change and vodka next to the ground zero transvestite prostitute.  Just how far away does something have to be before it stops being in the "ground zero" halo area?  Would it be OK if they built this building 5 blocks away?  10?  20?  Where do you draw the line with this?

There are really only a couple things to consider here.  Is the land privately owned?  Why yes, yes it is.  Can people do whatever they want with the land they buy (for the most part)?  Why yes, yes they can.  But there I go, trying to use logic and reason in an issue as emotionally ripe as this one.  So instead of trying to give you my opinions, I'll take some time to address a few of the arguments I've heard.  And give you my opinions in the process, I guess.

"THEY'RE BUILDING A MOSQUE AT GROUND ZERO!!!!!!!!!!!!!!!" - Shut up, they're building a Muslim cultural center a few blocks away from ground zero.

"BUT MUSLIMS BLEW UP THE TOWERS!!!!!!!!!!!!!!!!!!!!!!" - Shut up.  The 'terrists' were Muslim extremists.  Stop grouping a whole religion into the most radical elements of that religion.  It's not as if all Christians rub little boys, blow up abortion clinics and protest war veterans' funerals with "God hates fags" signs.  Muslim does not equal Terrorist.  It's a very simple concept.

"BUT THEY COULD BE TRAINING NEW TERRORISTS THERE!!!!!!!!!!!!" - Seriously, I heard someone argue that.  I don't even know where to start with this one.  But I'm gonna go out on a limb here and say that if you actually believe this, then there is nothing I can say to make you come to your senses.  It's like arguing with someone who thinks Bush was behind 9/11.  Or, better yet, it's like trying to convince a complete moron who thinks they're really smart that they are, in fact, a complete moron.

"WHAT IF SOMEONE BUILT A JAPANESE CULTURAL CENTER DOWN THE ROAD FROM PEARL HARBOR??!!??!!!!???!!!????!!!??!???!!" - First of all, if some Jap bought the land, he should be able to do whatever he wants with it.  And yes, that includes building a Japanese cultural center.  Second, shut up and click here.

"BUT THE PEOPLE ON THE LEFT ARE CONSTANTLY ATTACKING CHRISTIANS!!!!! - Shut up.  When someone tries to keep you from doing your Christian thing it pisses you off.  So your response is to keep Muslims from doing their Muslim thing?  How childish is this?  Seriously, it's the same response you get when you ask a 5 year old why he did something wrong.  "BUT MOM, HE DID IT TO ME FIRST!!!!!!!!!"  Turn the other cheek and stop whining.

"NYC ALREADY HAS A LOT OF MOSQUES!!!!!!!!!!! THEY DON'T NEED ANOTHER ONE!!!!!!!!!!!!!!!!!!!!! - Shut up.  If you substitute "Wal Mart" for "mosque" you would be pissed at anyone making that same argument, and rightly so.  If there are too many mosques, then nobody will go there and it'll eventually shut down.  Let the free market decide how many mosques should be built in an area.  Yeah, you can't pick and choose when you want to invoke the free market argument.

"BUT THE TERRORISTS WILL VIEW THIS AS A VICTORY AND USE IT AS A RECRUITING TOOL!!!!!!!!!!!!!!!!!!!!!!!!" - Shut up.  I'm so sorry that I don't allow the opinions of religious extremists to dictate my actions.  Forgive me.

BUT IT'S INSENSITIVE!!!!!!!!!!!!!!!!!!!!!!!!!!" - OK, this one I can actually understand.  I think it's a knee jerk emotional response with no real merit, but I can at least understand the response.  9/11 was an extremely tragic event, and it changed us all in some way.  In many ways, it defined this generation.  But we all need to take a deep breath and think things through before we start letting our emotions control our logic.  And by "we all" I mean "men".  Women, there's no hope for you using logic in emotional situations.  And what is the only logical argument here?  Let them build the mosque if they want.

Maybe the people behind it have ulterior motives.  Maybe it's insensitive.  Maybe it's an asshole thing to do.  I might actually agree with some of that, but so what?  This is fucking America.  You know what we get to do in fucking America?  We get to be insensitive fucking assholes as long as we're not hurting someone else or stopping someone else from being an insensitive fucking asshole.  Once we start to prevent someone from pissing us off, then we start to lose the right to piss other people off.  And just because something pisses someone else off doesn't mean they shouldn't get to do it.  Maybe the mosque pisses you off.  I can appreciate that.  But that doesn't mean they shouldn't build it.  Eating meat pisses some people off, but that doesn't mean we should quit eating it.  Driving an SUV pisses some people off, but that doesn't mean we should quit driving it.  "In God We Trust" on our money pisses some people off, but that doesn't mean we should quit using it.  Saying "Merry Christmas" pisses some people off, but that doesn't mean we should quit saying it.

You see, almost everything that someone does will piss off someone else.  Maybe the greatest quality of America is that we don't get caught up with the emotion of being pissed off.  We have been pissing each other off throughout our history.  You know what we do about it?  Nothing.  Sure, we argue and protest and scream and yell.  But ultimately, we let people go about their business even if it offends others.  Christians, Jews, Atheists, etc. have all been offending their fellow Americans for as long as America has existed.  And now the Muslims want to join the party.  I say let them in.  After all, we've been building ground zeros next to their mosques for years now.  And if you want to buy the land next to their mosque and build a 1,000 foot tall statue of Muhammad, I'll defend your right to do it.  Even if it does make you an insensitive fucking asshole.

Tuesday, August 31, 2010

The Economy: what happened, what's happening, and what will happen (Part 3)

I've been pretty vocal in my belief that the economy is going to double dip into another recession.  Or, to be more precise, continue the recession that hasn't really ended.  To me it seems not only obvious, but inevitable.  But most people don't agree.  Most economists today say that this recovery looks like it will slow down (is slowing down), but they feel that the chances of a double dip are slim.  I'll just take some time here to explain why I think the worst is still to come.

As I touched on in the previous two posts, the main thing that happened during the last decade or so is that people lived beyond their means.  Because credit was so cheap it was far too easy for people to go up to their eyeballs in debt.  It's just that they didn't care as long as the value of their house kept rising.  Or until they lost their job and couldn't make payments.  Once that bubble popped and things came crashing down, people's debt bit them in the ass.

Now, a few things needed to happen after the bubble popped.  First, housing prices needed to go down.  Obviously they did, that was the popped bubble after all.  But they didn't go down enough.  After a couple decades of a bubble housing market, there were a shitload of houses scattered across the country.  A lot of people owned investment property.  A lot of people has 2nd and 3rd houses, vacation houses, etc.  When they started defaulting on their mortgages the banks snatched them up.  A lot of people who were barely able to make payments lost their job and the bank snatched up their house.  Think about it, there were a lot of fucking houses out there and very few buyers.  Why so few buyers?  Because 70% of America already owned a home, or at least had a mortgage.  Once they started to get evicted and once their houses were repossessed, there weren't enough people with money to pay a considerable sum for the house.  There is a huge supply and very little demand.  They would have to be sold for pennies or torn down to build something else.  But the government didn't let that happen.  Bailing out the banks, mortgage companies, etc as well as paying people $8,000 to buy a house and guaranteeing the mortgages with government money caused prices to remain artificially high.  They weren't allowed to bottom out, but they will have to happen eventually.  I'll get to that in a second.

After the housing/financial bubble, a lot of companies found themselves in hard times.  Some were doomed to fail, others needed to get rid of jobs to stay solvent.  But again, the government intervened and didn't let it happen the way it needed to.  Don't get me wrong, if the government did nothing, then things would have been really bad.  Maybe 20+% unemployment.  Maybe 5,000 DOW.  We were drunk on credit for a long time, and the hangover was going to suck.  But if the government was able to let things play out and not get too involved, the companies and the economy in general would have emerged much stronger because of it.  GM would have been sold and/or a real restructuring would have taken place.  Banks would want 30% down payment and reasonable interest rates to protect their ass because they would have learned their lesson.  Housing prices would have gone low enough for the average person to save for a 20-30% down payment.  People would have paid down their debt and lowered their consumption to do so.  Again, things would have been really bad for a couple years, but it would be a good thing in the long run.

But because the government bailed out the banks and car companies, they didn't allow the systemic changes to happen that needed to happen.  The Fed is still keeping interest rates at 0%, encouraging people to take on more debt so they can continue to consume based on the promise of future earnings.  But what happens if those future earnings aren't there? Didn't our last President tell us to go shopping and buy shit after 9/11?  We did and it bit us in the ass because we lived beyond our means for far too long.  With the Fed issuing free money to people, they're essentially telling us to do the same thing.  People are trying to save and trying to pay down debt.  The savings rate has risen and debt has dropped.  But again, not enough.  And not as much as they would have if the government had not intervened.  With the Fed keeping interest rates low, it makes no sense for someone to put their money in the bank and lose the value of it to inflation when they could use that cash to pay down a loan for something and keep the purchasing power of their money.  This is the same terrible policy that led to the housing/financial collapse.

Speaking of housing, the main problem I see happening is that the problems with Fannie Mae and Freddie Mac have not been addressed, which is ridiculous because they were a major part of the problem.  The government has essentially guaranteed the mortgages and securities that these companies own, thereby forcing the taxpayer to assume all the risks of these high-risk loans.  It makes no sense that someone can be responsible with their money, and be forced to pay for someone who was irresponsible and defaulted on their mortgage.  Having the government guarantee the mortgage also keeps housing prices artificially high and lending standards too relaxed.  Fannie and Freddie already received a trillion dollar bailout.  They might need up to 5 trillion more before it's all over.  We have the worst of capitalism and the worst of socialism at the same time.  The taxpayer assumes all the risk and pays for all the losses while the few people who head these businesses get to keep whatever profit they make.  You couldn't design a more fucked up situation if you actually sat down and attempted to do so.

A year or so ago, the government bought a lot of troubled assets (securities, mortgages, treasury bonds, etc.) from Fannie and Freddie.  At the time, the discussion was over what the exit strategy would be for the Fed to offload these assets and shrink the balance sheets.  The thing is, the underlying problems with the housing market were not addressed, and the truth of the matter is that the Fed had no plan whatsoever in clearing their sheets.  Once they start to sell these assets back, it'll expose the fundamental problems again, collapse the financial firms that they bailed out, and take away the artificial legs that are propping up the housing market.  And now, just a couple weeks ago, the Fed officially admitted that they were going to maintain it's balance sheet, precisely for these reasons.

The truth is that the recession never really ended like some people want to suggest.  The recession was only interrupted by stimulus and bailouts.  All we did was postpone it while we accumulated a lot more debt in the process, so now we're facing a bigger problem than the one we had before.  And I'm not sure that the Fed is simply going to maintain their balance sheets.  Once the weak economic data starts to filter through, and once unemployment continues to rise and more people start to default on their mortgages because they lose their income, the Fed is going to increase their balance sheet and buy up more debt because that's all they know.  Printing money is the only weapon they have to try to fight this, so that's what they'll do. It's not like they can slash interest rates anymore because they're already at 0%.

Also, we recently saw the largest trade deficit ever, at something like $50 billion a month.  And that's during a weak economy.  Imagine what would have happened if the stimulus has worked and Americans were spending money.  That number might have been twice as high.  What we really need is to create more stuff.  But we can't use any of the stimulus money to invest in production, all we can do is buy stuff the Chinese or the Japanese make and increase the trade deficit.  And since the trade deficit takes away from the GDP it's only going to create a weaker economy and we will be seeing negative growth again in the near future.  Probably the 2nd quarter of next year at the very latest.  By that time we'll be seeing unemployment head above 10% and maybe even reach 11+% sometime in the year.  That will probably mean more stimulus from the government and low interest rates for a longer period of time which is all extremely bad for the economy in general and the dollar specifically.  And if all of this happens, we'll probably be seeing the value of the dollar start to fall faster than Tiger Woods' golf score has ever since he got busted banging every girl he met.  At some point down the road the value of the dollar has got to decline.  We can't just keep printing money indefinitely, keep interest at historically low rates, and borrowing money from overseas without eroding the value of the dollar.

We have become dependent on cheap credit and low interest rates.  The banking sector certainly is.  They borrow from the Fed nearly for free and they loan to the treasury and make the spread on interest.  That's about the only way banks can make money right now.  They're certainly not investing in business.  The housing market is being held up by the lowest mortgage rates ever, the artificial lending and the support of Fannie and Freddie.  Our national debt is only able to grow because it can be financed short term with low rates.  If rates go up then this whole house of cards comes crashing down and the Fed knows this.  At some point this is going to happen, interest rates cannot remain this low forever, and we'll all be saying goodbye to the value of our dollars.  If you think the latest housing/stock market bubble was bad, just wait until the bond bubble explodes and we stop finding people/countries that are willing to finance our debt and consumption.

Finally we are going to have a lot of tax increases next year.  Ever since this became apparent, it has been really interesting to watch all these companies report higher earning, which in turn has led to a boost in the value of their stocks.  But they know that they have lower tax rates this year than they will next year.  So what are they doing?  They're acting rationally and artificially boosting their earnings report this year, earnings that they would have otherwise claimed next year, so they pay taxes on it now.  Next year when those higher taxes hit they'll have less earnings to report, the stock prices will fall and another round of layoffs will start.  They could possibly even start laying off employees en masse at the end of 2010 because they know how 2011 will go.  Another round of layoffs means less people earning money, more people becoming unable to pay their bills, less consumer spending, and more government stimulus. It could be 2008 all over again, only much worse.

Simply put, the government is doing everything in its power to revive a broken and dead economy.  Instead of allowing it to turn to shit, getting out of the way, and allowing it to restructure into a much more viable economy (one where we actually produce, save and invest), we're trying to rebuild a phony economy that shouldn't have existed in the first place.  This will only serve to make the crash much more painful and devastating.  The recession that we have been trying to avoid for the past year or so is going to eventually catch up to us.  I just hope we don't have to find a new name for The Great Depression when it's all said and done.

I know this post is all over the map but I'm too lazy to change anything.  Maybe I'll go into more detail on some of the finer points later on, mostly the bond bubble that we're in.  Just keep this in mind for the next few years: A house chimney can easily be converted into a gun turret.

Monday, August 23, 2010

The Economy: what happened, what's happening, and what will happen (Part 2)

Imagine you owned a hotel.  You typically kept the place 70% full and were making a pretty good living in the process.  Then, one day you suddenly got an unexpectedly large number of people that wanted rooms.  The next day, the same thing happened.  Now you are suddenly forced to turn people away because you are renting out all the rooms.  When this happened again on the third day you decided to take out a loan and build another hotel so you could double your capacity and not be forced to turn away customers.  All the extra money you were making would easily pay for your loan.  For the next 3 or 4 days you were filling up both hotels, hired a lot of extra employees, and business was really doing good.  But then the next day things went back to normal and you were only filling up 70% of the first hotel while the other one stayed empty.  It turns out that the circus was in town for a week and all the extra people in the area were renting out your rooms.  You misinterpreted all the sudden demand for hotel rooms as something other than a temporary bubble.  Once the circus moved on and the bubble popped, you suddenly found yourself with a loan you couldn't afford and employees you had to fire.

When it comes to a boom and bust cycle, it's a common misconception that the boom is the good part and the bust is the bad part.  That way of looking at things is simply wrong.  When the economy is booming, particularly in an inflated bubble economy, many things are actually being done wrong.  Business owners typically expect the boom to continue indefinitely and manage their business accordingly.  Good businesses will do this in a smart way and not get swept up in the hype, keeping their eye on the long-term instead of the short-term.  Bad businesses will try to cash in on the boom as quickly and as much as they can, paying no attention to the long-term consequences of their actions or planning for not-so-rosy days.  In the economic boom, far too many businesses get short sighted and begin to become mismanaged.  It's not until the bubble bursts that these bad business practices are exposed.  But, on the bright side, the bust creates a good and necessary opportunity for much needed changes to take place within poorly managed businesses.  That's why the bust is actually a good thing.  Businesses that were poorly managed fail and get swallowed up by businesses with smart management, thereby making the overall economy stronger and more sound in the long run.  At least, that's how it's supposed to work.

After the tech bubble burst at the end of the Clinton administration, it exposed a lot of poorly run businesses, and a lot of poor decisions made by individuals.  The recession that followed should have been a lot worse than it actually was.  What happened was the Bush administration, along with Fed chairman Alan Greenspan, made some extremely poor decisions in an attempt to prop up the economy.  Bush didn't want to be a one term president, and he knew he probably would be if the economy didn't recover.  So, in an effort to kick the can down the road, he told Americans to spend.  And Americans did spend, but they had to go into debt to do it.  In a typical recession, people spend less, save more and pay off their debt.  This time Alan Greenspan lowered interest rates and printed money which made getting credit far too easy and cheap, so we had a recession where people went into debt instead of paying it off.  And the federal government started spending money at an insane rate as well.  The national debt skyrocketed, as well as personal debt.  But the economy was recovering, housing prices were soaring, and wall street was booming.  The only bad thing was that it wasn't real.  It was all occurring on a pile of debt.  And far too many businesses continued to be poorly managed.  Effectively, we only made a down payment on the next bubble.

Then it happened again, only much worse.  Had the economy been allowed to tank the way it should have in 2000, the recovery would have been relatively quick and painless.  And, as a result, we would have emerged stronger and with a better foundation.  Instead, we just took on a lot of debt and artificially spent our way out of it.  Then in 2008 a similar economic collapse occurred, but this time it was far worse because we accumulated a lot of debt in the process and business practices weren't forced to change.  The housing and financial bubble I talked about last time only made the whole thing much much worse.

And then the federal government reacted in pretty much the same way as it did nearly a decade earlier.  Interest rates dropped to zero and the federal budget deficit went through the roof.  This time around, however, individuals and families decided to spend less and save more.  This was a good thing, but it cost a lot of people their jobs in the process.  But Americans were at least making some effort to build a sturdier financial foundation for themselves.  The problem is that the federal government negated what individuals were doing by spending their money for them.  A lot of cash was injected into the system thereby artificially propping it up and not allowing the systemic changes to occur that needed to occur while also putting the country deeper and deeper into debt.  The Bush budget deficits were terrible.  The Obama budget deficits are catastrophic.  They are a short-term solution that only makes the long term problem that much worse.  Government once again kicked the can down the road, leaving a bigger mess for some other day.

It's like if you have a heroin addiction.  When you first start to mess up your life, kicking the habit would suck but it is necessary for your long term survival.  But instead of sobering up and throwing away the needle, you just do more of the drug.  Sure, it feels good right away and you're not putting yourself through the pain of cleansing your system, but you're only guaranteeing that when you do kick the habit it'll be far worse.  It's the same with our economy.  There are fundamental flaws.  Most notably, we borrow too much, spend too much, and produce too little.  What we need, and what a recession would provide for us if we allowed it to happen, is to actually produce more goods, save more of our money, and consume less.  But the federal government continues to entice us to spend, consume and borrow.  We're shooting up with the same drug that's causing our problems and the only thing we'll accomplish is to guarantee that the crash will be far worse when it strikes again.

This "recovery" we're experiencing is not a real recovery at all.  It's all occurring on borrowed money.  Nobody is hiring workers, business is stagnant, and the consumer isn't spending (relatively speaking anyway).  This is actually supposed to be happening, and should be happening, but in a far more devastating way.  It's a hard pill to swallow, but we need the catastrophic to happen in order to purge out the toxins and rebuild a much more sturdy economy.  The sooner we allow it to happen, the less severe it'll be.  By trying to fight it, all we're doing is guaranteeing that it happens even worse the next time around.  All of this government spending is designed to keep the economy from doing what it needs to do (cut jobs, reduce consumption, etc).  If we had a stronger foundation, then the spending and stimulus of the past 2 years would have had better short-term results.  The fact that the economy is not seeing the results that Obama is striving for, despite unprecedented spending, should tell you something about how fundamentally bad the economy is.

Far too many economists feel that Americans need to simply consume more.  After all, 70% of our economy is based on consumption.  That's the idea behind the government programs that give people money to buy a house or to buy a car.  That's why we're spending so much money to keep jobs.  It's not the jobs that they're trying to save, it's the money that the employee gets to spend after earning a paycheck that we're trying to save.  Do whatever it takes to keep people buying shit.  What they don't realize is that it's not a good thing to have 70% of an economy to be based on consumption.  We need to actually produce things.  Consuming goods is the reward someone gets for producing something and earning a paycheck.  Instead, we're having the Chinese workers produce all our good so we can consume them.  And on top of that, we have to borrow the money the Chinese make from those goods in order for us to consume those goods.

Imagine 6 people, 5 Chinese and 1 American, are stuck on an island.  They immediately start to divide up the jobs so they can survive.  One Chinese fishes, one hunts, one farms, one gathers firewood, and one cooks.  The American, meanwhile, hangs out on the beach all day and consumes everything the Chinese people have created.  He eats as much as he can and leaves just enough left over for the Chinese to stay healthy enough to gather his food again the next day.  Most modern economists would say that the American is the key to the whole system.  Were it not for his consumption, the 5 Chinese people would have nothing to do.  Well that is patently absurd.  Were it not for the American getting fat off the work of the Chinese, the Chinese would be able to consume what they create.  They could even spend less time gathering food and more time enjoying the fruits of their labor or perusing other interests.

But politicians don't like to tell their potential voters that they have been living beyond their means.  And voters don't like to hear that from their politicians.  Nobody is going to vote for the guy who says "We're fucked.  We could spend a ton of money and it might help us for a little bit, but eventually we just need to let the economy tank.  We've consumed too much, produced too little and gotten into a pile of debt in the process.  It's time for Americans to live within their means, and right now that means a lower standard of living.  It sucks but we need to take the medicine, no matter how hard it is to swallow."  I'd actually like that to be part of the next Presidential Inaugural Address, whoever it might be.  But it won't happen, because we don't want to hear it even if it's the truth.  Instead, we'll get "Here, take this money and buy yourself something shiny!  Everything is fine, just fine!"  Perhaps we're just getting what we deserve.

Friday, August 20, 2010

The Economy: what happened, what's happening, and what will happen (Part 1)

I was going to comment on some current economic trends and make some predictions, but I ended up writing a whole lot of shit so I decided to break it down into a few parts and maybe make it more organized in the process.  Before I get into the current shit that's happening, I'll give my take on what happened in order to get to this point.  I can't take credit for much of the information here since I read it (basically stole it) from other sources.  But I think it gives a pretty good rundown on the 4 main events that led to the housing boom and bust.

EVENT 1: In 1977, Congress passed the Community Reinvestment Act (CRA).  This was passed because Congress didn't think banks were giving enough loans to poor people and minorities.  The act stated that banks have "an affirmative obligation" to meet the credit needs of the communities in which they are chartered.  That turned out to be too vague or something, and Congress wasn't seeing loans go to people that they wanted loans to go to (they assumed that was up to them for some reason), so in 1989 congress amended the Home Mortgage Disclosure Act.  The amendment required banks to collect racial data on mortgage applications.  Turns out that minorities were denied home loans at a higher rate than whites.  Was this because banks love white people and hate brown people?  No, minorities were turned down at a higher rate because they had weaker finances on average.  But a Boston Federal Reserve study alleged that there was systemic discrimination.  A University of Texas economics professor looked at the study and found it to be tremendously flawed.  He showed that the data it used contained thousands of egregious typos, like loans with negative interest rates, and he found no evidence of discrimination on any basis other than creditworthiness.  Think about it, if these banks are run by the greedy corporate type who is only interested in making a buck, then wouldn't they want to give out loans to people who pose a reasonable risk, regardless of race, in order to make money off the interest?  If they're only interested in making money, that means denying loans to high risk people, and giving loans to low risk people.  The relationship between race and loan approval was a blatantly spurious one while the relationship between risk and loan approval was real*.  It just so happens that minoriteis tend to be higher risk.  They were discriminating based on risk, not skin color.  It turns out that banks don't "hate brown people and love white people", banks "love making low risk loans and hate making high risk loans" (At least they used to.  More on that below).  But that Boston Federal Reserve study became the standard on which government policy was based.

In 1995 the Clinton administration issued regulations that tracked loans by neighborhoods, income groups and race in order to rate the performance of banks.  Regulators used the ratings to determine whether the government would approve bank mergers, acquisitions and new branches.  The regulations also encouraged community groups like ACORN and the Neighborhood Assistance Corporations of America to file petitions with regulators, or threaten to file petitions with regulators, that would slow or even prevent banks from conducting their business by challenging how banks were making loans.  This created a huge leverage over the banks and some groups were able to effectively extort banks to make huge piles of money available to the groups.  Money these groups, along with the banks, used to make loans.  Banks and community groups issued loans to low-income people who often had bad credit or insufficient income.  These loans, which became known as "subprime" loans, made available 100% financing, didn't always require the use of credit scores, and were even made without documenting income.  But damnit, minorities and low-income folks were getting extra money for some reason!  The government insisted that banks, particularly those that wanted to expand, quit using their traditional loan-approval standards (Low risk people get loans, high risk people don't). CRA-elligible loans have been valued at $4.5 trillion

EVENT 2: In 1992 the Department of Housing and Urban Development pressured two government-charted corporations, known as Fannie Mae and Freddie Mac, to purchase (or "securitize") large bundles of these loans for the conflicting purposes of diversifying the risk and making even more money available to banks to make further risky loans (risky loans to some, fair and equal loans for everyone -- regardless of merit -- to others).  Congress, in their divine wisdom, also passed the Federal Housing Enterprises Financial Safety and Soundness Act.  This act mandated that these companies buy 45% of all loans from people of low and moderate incomes.  What did this do?  First, it created more incentives for banks to make risky loans since Fannie and Freddie would buy them.  Second, it created a secondary market for these loans where they could be bought and sold.  And then in 1995 the Treasury Department established the Community Development Financial Institutions Fund, which provided banks with tax dollars to encourage even more risky loans.

EVENT 3:  All of this government intervention and social engineering created a financial instrument by-product known as the "derivative", which turned the subprime mortgage market into a ticking time bomb that would magnify the housing bust by orders of magnitude.  A derivative is a contract where one party sells the risk associated with the mortgage to another party in exchange for payments to that company based on the value of the mortgage.  They pretty much let people gamble on whether the mortgages would default or not.  In many cases, investors who did not even make loans would bet on whether the loans would be subject to default.  Although it's not the best example, derivatives can be understood as a form of insurance against risky loans.  Derivatives allowed commercial and investment banks, individual companies, and private investors to further spread, and ultimately multiply, the risk associated with their mortgages.  Some financial institutions like AIG invested heavily in derivatives.

EVENT 4:  The Fed's role in the housing boom and bust cannot be overstated.  The Fed slashed interest rates repeatedly starting in 2001 from 6.5% to 1.0% in 2004.  Naturally, this started to create too much inflation for comfort so Greenspan and Bernanke began to steadily raise interest rates back up to 5.25% in 2006.  This flluctuation in interest rates artificially and inappropriately manipulated the housing market by interfering with normal market conditions and contributed to a destabillization of an economy that was already in a very precarious position.

In 2008 and 2009 the federal government spent tax dollars at an astronomical rate in order to rescue the financial markets from their own mismanagement.  TARP money neared $1 trillion and was originally set up so the government could buy risky or nonperforming loans from financial institutions.  Just weeks later the government began using the money to buy equity positions in financial institutions, probably so they could inject cash directly into these entities. Oh, and $350 billion of the TARP funds cannot be accounted for.

On top of the TARP money, The Federal Reserve also gave $30 billion to Bear Stearns, $150 billion to AIG, $200 billion to Fannie and Freddie, $20 billion to Citigroup, $245 billion to the commercial paper market, and $540 billion for the money markets.  The Bush administration also spent $152 billion on the 2008 stimulus and the Obama administration spent $787 billion on the 2009 stimulus.  Billions were also spent on Cash for Clunkers, the Home Buyer Tax Credit, and a host of other government programs.

And this all started in large part because Congress and the federal government decided to tell banks who they should loan money to.  Numerous laws, regulations, entities and funds were created in order for the government to dictate to banks who should get loans and how they should be managed.  To say that this problem occurred in a bubble of capitalism without regulation and interference from government is utterly ridiculous.**  It's not difficult to see that the problem occurred because of government intervention in the free market, not because they were mysteriously absent.  In fact, the only place government was absent was in controlling the terrible conditions that they created, and that's the unregulated part that got everybody upset.  ""Government didn't regulate derivatives!"  "There wasn't enough oversight!"  That's true, but the fact of the matter is that government created derivatives and then failed to regulate them and government failed to oversee the shitty results of their own shitty policies.  The banks and financial institutions did what they always do, they tried to make money in whatever condition they were place in.  And politicians did what they always do, they (with good intentions) tried to get private businesses to do what they wanted them to do, created a shitty mess in the process, failed to properly deal with the shitty mess they created, and blamed the shitty mess on private businesses who only did what government told them to do.  It's the new circle of life.

I mentioned earlier how much money was thrown at the problem.  In the next post I'll explain why this was a bad idea, why it will not work in the long run, what actually should have been done and what the ultimate results will be.  Yes folks, another random person on the internet knows how to handle the nation's economy!

*A classic example of a spurious relationship is deaths by drowning and ice cream sales.  As ice cream sales go up, so does the number of people who drown to death.  As ice cream sales go down, so does the number of people who drown to death.  Does that mean that ice cream causes people to drown?  Of course not.  And minorities weren't routinely and systematically denied loans simply based on skin color.  In both examples there is a third factor that needs to be considered.  In the ice cream-drowning relationship, the missing factor is, of course, heat.  As it gets warmer, ice cream sales as well as drowning deaths go up for obvious reasons.  In the home loan example, the missing factor is creditworthiness.  As creditworthiness goes up, so does loan approval.  Minorities, on average, were less creditworthy so their loans were denied at a higher rate.

** In 2006 the official compilation of rules issued by the federal government contained 74,737 pages of regulations.  I don't think a couple more was going to solve much.