Friday, March 30, 2007

Commerce Department Sanctions China

From the Department of Commerce:

Washington - The U.S. Department of Commerce today announced its preliminary decision to apply U.S. anti-subsidy law to imports from China. This is the first time countervailing duties will be imposed on imports from a non-market economy. The decision alters a 23-year old bipartisan policy of not applying the countervailing duty (CVD) law to non-market economy countries, and reflects China’s economic development.

Today’s preliminary decision determined that Chinese producers and exporters of coated free sheet paper received countervailable subsidies ranging from 10.90 to 20.35 percent.

"This Administration has aggressively enforced our anti-dumping laws to combat unfair Chinese trade." said Commerce Secretary Carlos M. Gutierrez. "China’s economy has developed to the point that we can add another trade remedy tool, such as the countervailing duty law. The China of today is not the China of years ago. Just as China has evolved, so has the range of our tools to make sure Americans are treated fairly. By acting on the petition filed last October, the United States today is demonstrating its continued commitment to leveling the playing field for American manufacturers, workers and farmers."

Apparently, the Commerce Department thinks it is bad when foreigners sell products here below the cost of American producers. Damn those Chinese selling things here on the cheap. Whatever will we do? Apparently the answer is to raise the price of these goods for Americans. That'll teach those foreigners.

Tuesday, March 27, 2007

Remember Me

I avoid politics on this blog except when I have to touch on it, but a friend just sent me a link to a YouTube video that I have to share. It's not really political but it does relate to the Iraq war. I don't care what your feelings are about that conflict, if you can watch this video without shedding a tear, you are a lot tougher than I. Click on the title of this entry to view the video called, Remember Me.

Thursday, March 22, 2007

Chinese Ponzi Scheme

I saw this on the WSJ Best of the Web and couldn't resist commenting. The New York Times has a story about the crisis in the pension system in China. A couple of paragraphs of the story were revealing. First, the Chinese have at least made a stab at reform, unlike our own politicians:

The new system combined elements of what had existed before — the fixed contributions of older workers in state industries — with individual retirement accounts for those working in the modern economy.

That sounds familiar doesn't it. Kind of like what has been discussed here as a possible reform.

Here's the part that was highlighted by Best of the Web:

Most troubling to financial experts, the government has used payroll taxes paid by the current generation of workers, who in theory are paying into their individual retirement accounts, to pay pensions for the previous generation.

That is most troubling isn't it? Sounds a lot like our Social Security system too. Maybe we should do something about that....

Wednesday, March 21, 2007

Fed Decision

The FOMC just released its statement:

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5-1/4 percent.

Recent indicators have been mixed and the adjustment in the housing sector is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters.

Recent readings on core inflation have been somewhat elevated. Although inflation pressures seem likely to moderate over time, the high level of resource utilization has the potential to sustain those pressures.

In these circumstances, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Cathy E. Minehan; Frederic S. Mishkin; Michael H. Moskow; William Poole; and Kevin M. Warsh.

It seems the market really likes the last sentence about "future policy adjustments" being dependent on the outlook for both inflation and economic growth. The Fed seems to be acknowledging the economic slowdown and this will raise the hopes of those calling for rate cuts. I still expect the Fed to remain on hold for quite some time.

Rules and More Rules

This week I have been conducting a running conversation with Desmond Lachman about the currency markets and the potential role of the IMF. Mr. Lachman believes that the IMF should be more involved in the market to prevent countries such as China from manipulating their currencies to gain a trade advantage. I share Mr. Lachman's desire to see a more stable currency exchange rate system. The current system has a mix of systems that are inherently incompatible. China feels free to maintain the exchange rate of the Yuan (RMB) at a level that, in the opinion of Mr. Lachman and others, gives them an unfair advantage in trade. Japan likewise is accused of manipulating its currency by maintaining an artficially low interest rate structure. Meanwhile the value of the US dollar and the Euro are left to be determined by the market. The Chinese and other Asian countries stand accused of distorting these values by maintaining their current systems.

More stable exchange rates between the various countries would certainly seem desirable. A company or individual making a cross border investment must consider the affects of the currency on that investment. Should they hedge? If so, what is the cost associated with that hedging? Will the investment still make sense after considering the currency volatility? Surely it would be easier to make investment decisions if currency values were more stable. This desire for stability was certainly a factor in the decision to implement a single currency in Europe. The imposition of stable exchange rates in Europe (through the introduction of the Euro) however seems to prove that the stability of exchange rates will not, by itself, result in better economic performance.

In his previous response, Mr. Lachman mentions the "inter-war" years and the troubles that resulted. Presumably he is talking about the 1920s and 30s which saw repeated currency devaluations in pursuit of a trade advantage. By invoking this period, he must believe that the Great Depression was caused by these competitive devaluations. In a sense he is correct; tariffs were used as a way to defeat the currency devaluations and there is little doubt that these trade restrictions were a primary cause of the economic misery of the time. The result in 1944 was the Bretton Woods system which sought to prevent this type of competitive devaluation cycle and the political impulse to retaliate through tariffs.

The aim of the Bretton Woods system was currency stability and convertibility. A system of fixed exchange rates was introduced whereby most currencies were pegged to the dollar and the dollar was pegged to gold. The IMF was created in 1947 to police this new system. The IMF charter bans competitive devaluations and established the IMF as a sort of lender of last resort for countries that had temporary balance of payments issues. The system worked fine until domestic US policies in the 1960 and 70s undermined the system. Faced with an outflow of gold after years of excessive government spending (Vietnam and the Great Society) Nixon closed the gold window and withdrew the US from the Bretton Woods system in 1971. The dollar promptly lost value and the inflation of the 70s was the result.

Since that time, we have operated essentially with no system. There have been attempts at coordination of currency values such as the Plaza Accord in 1985 between France, West Germany (that sounds odd now doesn't it?), Japan, the US and the UK. The goal of the Plaza Accord was to devalue the dollar in an attempt to remedy the trade and current account deficits of the US and particularly the trade deficit with Japan. The Plaza Accord didn't have the intended effect as the current account deficit continued to grow. Furthermore, the unintended effect was that the BOJ loosened monetary policy in an attempt to offset the drag on their economy. This loose monetary policy led to the bubble in Japanese stocks and property in the late 80s.

The dollar devaluation continued until the Louvre Accord of 1987 which sought to reverse some of the effects of the Plaza Accord. None other than Alan Greenspan undermined the Louvre Accord when during an interview with Fortune magazine he stated that the dollar was overvalued and needed to depreciate at a rate of 2% per year for some time to reach an appropriate value. In my opinion, this was a major catalyst for the stock market crash of 1987. Ultimately, these currency stablization agreements failed because the countries involved could not (or would not) coordinate domestic economic policy (interest rates, etc.).

So with all this history, let's take a closer look at what Mr. Lachman would like. In his response he states:

"My idea is certainly not to have government intervention in currency markets in the normal sense of the term. Rather, it is to have a rules-based system in much the same way as we do in every US financial market, where there are very clear rules distinguishing between permissible and non-permissible behavior...The basic rule that we would want in a freely floating international currency system is that countries are not permitted to engage in currency intervention other than for strictly “smoothing purposes”. This is the sort of rule that the International Monetary Fund is supposed to be applying in the exercise of its exchange rate surveillance functions but sadly it is not discharging its mandate in the way it is supposed to be doing."

The problem with this idea as I see it, is that there is no reference point. In the old Bretton Woods system, the dollar was pegged to gold and the other currencies were pegged to the dollar. In a free floating system as we have now, there is no reference point. If countries are not permitted to engage in currency intervention other than for smoothing purposes, what currency is the reference point? Can China intervene to smooth the exchange rate with the Euro or the US dollar? If China intervenes in the market to effect the exchange rate with the Yen, will that effect the Yen/dollar exchange rate? If it does, can they intervene again to smooth the effects on the dollar? I don't see any way that a rules based system could be implemented that would take into account all the cross currency exchange rates.

Another problem is that central banks must consider domestic concerns when adjusting monetary policy. Mr. Lachman believes that Japan manipulates its currency by maintaining an artifcially low interest rate structure. In his rules based system, will the IMF determine interest rate policy in Japan? This was the problem with the Plaza and Louvre Accords. The Louvre Accord in particular had a list of indicators that were supposed to be used as inputs in determining the needed exchange rate coordination. The Louvre Accord fell apart precisely because the Central Banks of the countries involved pursued domestic policies that were in their countries own best interests. As they should.

Mr. Lachman makes some good points in his response. He states: "It would be both in China’s long-term interest as well as that of the global economy if China were to move in the direction of allowing much greater flexibility in its exchange rate." Well that is probably true but exchange rate flexibility is as much a domestic political concern of the Chinese as anything else. For true exchange rate flexibility in China would require that the Chinese government allow its citizens to hold and invest in foreign currencies, something which they are reluctant to do as it would limit their control over their population. For sure, it would be desirable for China to implement a policy such as this, but it is politically unlikely. Furthermore, it is possible (I believe likely) that given the opportunity to invest abroad, many Chinese would do exactly that and the effect on the Yuan may not be what Mr. Lachman desires.

Mr. Lachman is also correct that "The danger to Japan and to the global economy is that the carry trade unwinds in an abrupt manner at some point, which could cause large unanticipated losses in the global financial system." We saw the effects of the unwinding of the carry trade a few weeks ago when a rise in the Yen was concurrent with a large drop in US stocks. He wants the Japanese to normalize interest rates, but what would be the effect on the Japanese economy if that happened? I contend that the problems with the Japanese economy are structural and have little to do with monetary policy. If I'm right, how would Mr. Lachman address that situation. Would the IMF punish Japan in some manner until it got its fiscal house in order?

Finally, Mr. Lachman believes that a devaluation of the dollar in the range of 20-25%, presumably in the trade weighted dollar value, would reduce the current account deficit to a more sustainable rate of about 4%. What would be the effect on US inflation if we devalue that dollar by 25%? How would that affect Fed policy? Since the devaluation of the dollar in the 80s did not have the desired effect, what makes Mr. Lachman believe it will work this time? What is different?

In conclusion, Mr. Lachman and I share a concern about the current exchange rate system. We would both like to see more stable exchange rates as this would have beneficial effects for the world economy. Mr. Lachman would have the IMF make and enforce a set of rules to coordinate exchange rate movements. I believe this effort would be doomed to failure as the Plaza and Louvre Accords were. Absent an anchor such as gold, it seems highly unlikely that a group of economists at the IMF could correctly determine the "proper" exchange rates. It is also highly unlikely that countries would allow an organization such as the IMF to have so much control over their domestic policies.

The role of the IMF has been superseded by events. It is high time to eliminate the IMF, not expand its role in the world economy. There are probably better ways to structure the exchange rate system, but longing for a world that no longer exists is not the answer. Bretton Woods failed because governments (particularly the US) would not submit to the restrictions inherent in the system. And that hasn't changed.

The Debate Continues

Desmond Lachman's latest response:

Dear Mr. Calhoun,

Thank you for your e-mail.

You raise several interesting questions, which I will try to answer in turn and which you should feel free to post if you choose:

Government Intervention: My idea is certainly not to have government intervention in currency markets in the normal sense of the term. Rather, it is to have a rules-based system in much the same way as we do in every US financial market, where there are very clear rules distinguishing between permissible and non-permissible behavior. (For instance we have an SEC that prohibits practices likel insider trading etc., to make markets work better). The basic rule that we would want in a freely floating international currency system is that countries are not permitted to engage in currency intervention other than for strictly “smoothing purposes”. This is the sort of rule that the International Monetary Fund is supposed to be applying in the exercise of its exchange rate surveillance functions but sadly it is not discharging its mandate in the way it is supposed to be doing.

China and Inflation You are certainly right in asserting that China’s maintenance of an artificially depreciated exchange rate does result in both goods price and asset price inflation that is harmful to China’s long-term prosperity. China tries to “sterilize” its foreign exchange rate intervention by mopping up liquidity through increased bond placements in its domestic market. However, China is far from successful in doing so. In the end, inflation will bring China’s real exchange rate back into line with where it should be to have a more balanced trade position. However, this process can take a very long time and it also gives China an unfair trading advantage in the interim. It would be both in China’s long-term interest as well as that of the global economy if China were to move in the direction of allowing much greater flexibility in its exchange rate. China pays lip service to this objective but in practice does not allow its currency to fluctuate very much as it feels that it must keep a very-undervalued exchange rate in order to keep its export machine humming.

Japan and interest rates Over the past few quarters, Japan’s economy has shown signs of recovery and deflation shows signs of abating. Yet the Bank of Japan, under political pressure from the government chooses not to increase interest rates from their abnormally low levels. Maintenance of low interest rates has encouraged “the carry trade”, which has led to a considerable weakening of the yen over the past year despite Japan’s very strong balance of payments position. The danger to Japan and to the global economy is that the carry trade unwinds in an abrupt manner at some point, which could cause large unanticipated losses in the global financial system. It would seem to be in Japan’s own interest to induce a gradual unwinding of the carry trade through a gradual return of interest rates to more normal levels. Clearly Japan also needs to address its pressing long run fiscal problem.

Disorderly unwinding. With the United States presently running an external current account deficit of around US$800 billion, or 6 ½ percent of GDP, I would not want to be overly sanguine about the risks of a disorderly unwinding of this imbalance. A deficit of this size has no precedent in the US over the past sixty years. I would particularly not want to be sanguine about the dollar against the backdrop of the present mess in the sub-prime mortgage market, which in my view is clearly not going to be confined to that sector of the housing market. If we do indeed have US housing prices falling at a significant pace in 2007, it is very likely that foreigners will not be as keen as they were in the past in buying US dollar denominated assets in general and mortgage backed securities and US equities in particular. If that indeed turned out to be the case, the US would have trouble financing its current account and the dollar would swoon. I would also want to keep an eye on what foreign central banks, including that of China, do with their large US dollar holding as these central banks make more noise about wanting to diversify out of the dollar.

Size of depreciation. It is true that the United States dollar would have to depreciate a lot against China if the US were to be competitive with China in high labor content goods. However, the US trades with many countries where it does not need that large a depreciation to make inroads into their markets. Most mainline econometric studies suggest that a 20-25 percent depreciation of the US dollar against a basket of currencies from its present level would be all that is needed to reduce the US current account deficit to a more sustainable level of around 4 percent of GDP. As I mentioned before, however, a devaluation of the dollar would need to be accompanied by markedly improved savings performance in the US if the dollar devaluation were to work.

Best regards,


I'll post my comments soon.

Lachman's Response

A couple of days ago, I posted a response to an article by AEI Scholar Desmond Lachman. Mr. Lachman, who I'm sure is very busy with scholarly things at AEI, was kind enough to respond. Here is his initial response and my comments:

Dear Mr. Calhoun,

Thanks for your e-mail and for sharing with me your response to my article.

I am sorry that my article was read as advocating increased currency market intervention for that was not its purpose. Its purpose was to make the case that what we need today is a more rules-based system than we have at present as well as better macro-economic policy co-ordination among the major economies. In particular, countries should not be allowed to manipulate their currency for competitive advantage through large scale foreign exchange intervention (China) or through keeping interest rates artificially low (Japan). If we are to have a floating exchange rate system, countries should simply not be allowed to engage in persistent one-way market intervention that thwarts the international adjustment process.

In my view, today’s unprecedented large global payment imbalances pose a real threat to world economic prosperity. In particular, their disorderly unwinding (as in a dollar crisis) could add to financial market instability and could trigger protectionist pressure in much the same way as occurred in the 1920s and 1930s.It is also my view that the unwinding of these imbalances would best be effected through coordinated policy action by the world’s major economies.

To be sure, probably the most important part of today’s payment imbalance problem is the paucity of savings in the US. However, if the US is to reduce its payment imbalance without inducing a domestic recession, it will need to engage in both “expenditure reduction measures” through monetary fiscal policy action to increase savings as well as in “expenditure switching policy” through having the US dollar depreciate. In the absence of a revitalization of the US traded goods sector, expenditure reducing measures alone can correct the US balance of payments problem but they would do so at a great cost to US and global economic growth.

For the US dollar to depreciate, foreign countries have to let their currencies appreciate and they have to restrain themselves from thwarting the adjustment process. At the same time, they have to engage in stimulative spending policies to create the demand necessary to replace the boost that their economies were receiving from their trade surpluses or from US profligacy.

I fear that we are living in a world in which each country follows domestic policies without consideration to the impact it might have on the countries with which it trades. We went down this road before in the inter-war years and the end results were not pretty.

I hope that this clarifies my thinking.

Best regards,


My response:

Dear Mr. Lachman,

First, let me say that I appreciate your thoughtful response. One never knows how someone will respond to criticism, especially these days.

I’m still having some trouble understanding what you propose however. You say that we need a more rules based system than we have at present, but won’t that mean, by definition, more government control? When I say government intervention, I don’t mean just direct intervention in the trading of currencies. There are many ways that government can intervene in the proper functioning of a market. In your rules based system, who gets to make the rules? Also, don’t you think that countries that attempt to manipulate their currencies will generate their own internal problems as a result? China would appear to be importing our inflationary monetary policy and the result is a property and capital spending boom that will eventually resolve itself (and probably not in a pretty way). I also wonder what would happen to the yen if the low interest rate policy were ended. My guess is that the yen would further depreciate as the Japanese economy weakened with higher rates. I have found in my years of trading that the easy answer rarely works. One would think higher interest rates would result in a stronger currency, but that is not always the case. In my opinion, Japan needs a dramatic change in fiscal policy (reduction of deficits, deregulation, tax cuts) to emerge from their deflation. Monetary pumping has had little effect and I don’t think it ever will. For sure it’s had effects outside Japan (through the carry trade and export of domestic savings), but I think that reflects the lack of good investments within Japan. That’s what they need to change; monetary policy cannot overcome the low returns on capital when capital is free to leave for greener pastures.

I agree that the current conditions cannot last forever, but I have doubts about how close we are to a “disorderly unwinding”. I also share your worries about protectionism, but it seems more likely to me that the protectionist measures could be the cause of the “disorderly unwinding” rather than the result of a dollar collapse. Why would we need protection after the dollar collapses? Politicians like Graham and Schumer would presumably be pleased with a much cheaper dollar.

I don’t believe that depreciation of the dollar will accomplish your goals in any case. How far would the dollar have to fall to make the traded goods sector in America competitive with China and other low wage countries? As long as globalization continues (and I think it is a moral imperative that it does), there is little chance that we can devalue our way to prosperity in manufacturing. If we can’t lower wages enough to compete and we can’t raise productivity enough to compete, it seems to me that our only choice is to raise the return on capital to induce more saving. Why not eliminate or drastically reduce corporate taxes? Why not eliminate capital gains taxes? Maybe if we stop punishing people for investing/saving they will do more of it.

As you may have guessed by now, I don’t have a very high opinion of governments and their ability to manipulate economies. The end of Bretton Woods was indeed ugly, but was that because we enacted domestic policies without considering the impact on our trading partners? I think it is more factual to say we enacted political programs (The Great Society programs) without considering or judging correctly the impact on our own economy.


Joe Calhoun

We are continuing the debate and I will post a followup soon. I would like to note that Mr. Lachman has been very gracious in sharing his views with us. The goal here is to learn and become better investors. I don't care how long one has been at this, there is always more to learn. It's nice to be able to debate a serious topic in a serious way. Too many in the blogosphere seem to think that if you don't agree with them you are not worthy of a thoughtful response. Mr. Lachman is a gentleman.

Housing Market

Andy Laperriere has an editorial in the WSJ this morning about the fallout from the sub prime lending mess:

Stock markets world-wide have sold off the past few weeks over concerns the collapse of the subprime mortgage industry could prolong and deepen the housing slump and threaten the health of the U.S. economy. Federal Reserve officials and most economists believe the problems in the subprime mortgage market will remain relatively contained, but there is compelling evidence that the failure of subprime loans may be the start of a painful unwinding of a housing bubble that was fueled by easy money and loose lending practices.

I don't share his doomsday outlook for housing:

The report by Credit Suisse estimates mortgage originations could drop 21% during the next year or two because of tighter credit standards. Coupled with high inventories of unsold homes and the additional supply likely from distressed sellers, this drop in demand could produce an unprecedented nationwide decline in home prices. Merrill Lynch estimates prices could drop as much as 10% this year. A price drop of this magnitude would lead to a vicious cycle in the housing market and pose a major risk to economic growth. And, of course, it would create a raging political firestorm.

But I do agree with him about the cause of the bubble:

The fact that Congress is now holding hearings on the fallout from the second major asset price bubble in the last decade should prompt some broader questions. For example, what role did the Fed's loose monetary policy from 2002-2004 play in fueling the housing bubble? Should the Federal Reserve reexamine its policy of ignoring asset bubbles?

Asset bubbles are harmful for the same reason high inflation is: Both create misleading price signals that lead to a misallocation of economic resources and sow the seeds for an inevitable bust. The unwinding of today's housing bubble is not merely an academic question; it is likely to inflict real hardship on millions of Americans. To reduce the risk of a similar outcome in the future, it is important that policy makers, economists, and policy analysts properly diagnose the root causes of the current housing bust, not just its symptoms.

The Fed cannot control monetary policy if it ignores asset inflation. And it is past time for them to answer up for past mistakes.

Monday, March 19, 2007

Good Morning, Iran

I don't know how credible this is, but it got my attention (from the TimesOnline):

IRAN is threatening to retaliate in Europe for what it claims is a daring undercover operation by western intelligence services to kidnap senior officers in its Revolutionary Guard.

According to Iranian sources, several officers have been abducted in the past three months and the United States has drawn up a list of other targets to be seized with the aim of destabilising Tehran’s military command.

I haven't commented much on the geopolitical situation on this blog. I have been reluctant since this necessarily dives into the realm of politics and folks can be rather, shall we say, passionate about these things. On the other hand, politics, unfortunately, affects our investments and is a topic I think must be considered.

The reason this report got my attention is because, if this is anywhere close to the truth, there could be a confrontation between the US and Iran at any time. And that will most definitely affect our investments. If Iran decides to retaliate by kidnapping US or British soldiers, that could change the public sentiment about how we should deal with Iran.

Sunday, March 18, 2007

A Cry for Intervention

In the article linked above, AEI scholar Desmond Lachman bemoans the lack of government control over the currency market:

Even more troubling than today's growing payment imbalances is the fact that, the IMF notwithstanding, there appear to be no rules as to what countries might do with their exchange rates. Some countries seem free to fix their exchange rates at levels that are patently undervalued, while others seem free to actively manage their floating exchange rates in a manner that maintains for them an unfair international competitive edge. In this currency free for all, currencies are simply not moving in the direction that might offer hope that today's global payment imbalances might be attenuated anytime soon.

I think what Mr. Lachman is upset about actually is that currencies don't seem to want to move in a direction that he deems proper. How exactly he would change things is somewhat of a mystery however. In one paragraph, he blasts China for manipulating its currency:

China's central bank continues to intervene heavily in the foreign exchange market to prevent the Chinese currency from appreciating. It does so despite the fact that China's current account surplus has now widened to around 9 percent of its GDP and its international reserves have now surpassed the $1 trillion mark.

In the next he is upset with Japan for not intervening:

Yet despite the Bank of Japan's hands-off foreign exchange policy, the Japanese yen has depreciated by almost 20 percent over the past two years as the Bank of Japan hews to its low interest rate strategy. This has taken the yen to its most depreciated level in almost twenty years at a time when Japan's external current account surplus has remained in the vicinity of $150 billion.

No things are not going the way Mr. Lachman thinks they should:

In an ideal world, the United States dollar would depreciate most against the countries of those countries like China and Japan, which have the world's largest current surpluses. This would allow the U.S. to reduce its payments imbalance without putting undue pressure on economic regions like the European Union, which has an appropriate balance of payments position and which is not part of the U.S. balance of payments problem.

Incredibly, he misses the IMF on the world economic stage:

It is against this background that one has to regret the conspicuous silence on these matters by the International Monetary Fund.

Because you know the IMF has been so instrumental in guiding the world economy over the years.

The thrust of the article is that all these other countries need to do something with their currencies to correct the "global payment imbalances". But even Mr. Lachman acknowledges that this wouldn't fix the problem:

The correction of today's global payment imbalance problem will require a marked reduction in the United States external deficit. It is widely recognized, however, that currency movements alone will not correct the large U.S. balance of payments deficit even were those currency movements to be in the right direction. Rather the correction of the large U.S. payment imbalance would also require a major increase in U.S. household and government savings from their presently very low levels. This would be needed to make the room for the increased production of traded goods required to reduce the external deficit.

So the problem is one of our own creation but people like Mr. Lachman want other countries to provide the solution. If a paucity of US savings is the problem, maybe we should explore why that is the case and how to fix it rather than ask other countries to fix it for us. Maybe Mr. Lachman could also explain why it would be better if capital spending is accomplished with US savings rather than foreign savings. If the investments are made, what difference does it make where the savings originate? Finally, if we are in such a bad trade position, maybe Mr. Lachman could also explain why our exports are rising so rapidly:

I agree with Mr. Lachman that the US has some serious long term economic problems. We cannot continue to import the rest of the worlds savings indefinitely. We cannot continue to run large current account deficits indefinitely. If we continue down this path the likely result is a collapse of the dollar and all the problems that would entail. However, it seems to me that these problems are ones of US policy and can be corrected internally. Other countries policies may exacerbate the situation, but until we face the facts and start correcting our internal problems, what incentive do they have to change? Who are we to tell the Chinese to revalue their currency when the source of the problem is more likely our own inflationary monetary policy? Why would it be good for American consumers if foreign goods are more expensive?

Saturday, March 17, 2007

Trade Deficit Truths

I have commented many times in the past about the trade deficit. Unlike many others, the trade deficit doesn't worry me. The last time the US ran a trade surplus, the economy was in recession. The evidence is overwhelming that free trade benefits those countries that practice it regardless of whether their trade partners are as open. Look at these charts showing imports and exports:

It seems to me that the exports are a reflection of the strength of our trading partners economies and the imports are a reflection of the strength of our economy. This article from Dan Griswold (Cato Institute) confirms that the popular view of the trade deficit is exactly wrong:

As the comparison shows, there is no evidence that an expanding current account deficit is associated with slower economic growth. In fact, data show the opposite correlation:
In those years since 1980 in which the current account deficit actually shrank as a share of GDP, real GDP growth averaged 1.9 percent.
In those years in which the deficit grew modestly, between 0.0 and 0.5 percent, GDP growth averaged 3.0 percent.
And in those years in which the current account deficit expanded by more than 0.5 percent of GDP, real GDP growth grew by an average of 4.1 percent.

Beware of politicians spouting economic drivel. Protectionism is the single greatest threat to our prosperity. Hopefully someone will inform Congress about the facts before they do something really stupid.

Friday, March 16, 2007

Diversification Doesn't Work Anymore?

I've seen a number of articles recently that bemoan the fact that diversification among varioius asset classes doesn't seem to work anymore. Typical of these articles is this one by Jim Juback at MSN Money:

I thought investing in gold, copper, zinc and other commodity stocks was supposed to diversify a portfolio and protect it from falling too far, too fast in a general stock market retreat.
Some protection. Maybe instead of calling it "diversification," they should rename it "di-worsification." Portfolio diversification, that tried-and-true tool for reducing the volatility and risk of a portfolio by making sure that some of what you own will go up even if the rest of it goes down, isn't working too well right now.

This seems to me a vast misunderstanding of the principles of diversification. I don't expect that diversification will protect our portfolios from every downturn in the market. Indeed, during corrections driven by changes in liquidity, it seems apparent that most asset classes will move together. Furthermore, Juback seems to have forgotten the one asset class that did do well during the selloff: bonds.

All of our portfolios except the most aggressive contain bonds and/or cash. Diversification worked exactly as it is supposed to during this correction. The bond portion of the portfolio gained while the risk assets declined. The percentage of the portfolio in bonds determined the degree to which your portfolio was protected. What's so unusual about that? Nothing. Juback seems to be upset that a portfolio with all risk assets declined when investors wanted to reduce risk. Duh.

Diversification works just fine when applied properly. It also tends to work better when viewed from a longer time perspective. Even a portfolio of all risky assets will do fine over a longer period of time. Expecting a diversification strategy to also protect you over a short time frame is unrealistic.

Tuesday, March 13, 2007

Second Leg of the Correction

On February 28th, after the 400 point loss on the Dow I wrote:

The market will probably try to make some kind of rebound over the next couple of weeks. I doubt it will make new highs though and a retest of the low yesterday would be routine. I will probably be looking to do some selling on the rebound and save my ammunition for the next downdraft. That's the plan anyway. Let's hope my timing is a little better this time.

Well today looks like the start of phase 2. The market did rebound and of course we did not make new highs. We'll see how things go, but my guess is that today is the start of the retest of the lows. The sub prime mortgage market gets the blame this morning as New Century Financial is defaulting all over the place. They're also now being investigated by the SEC and have receieved a subpeona from the US Attorney's Office for the Central District of California. It may be a New Century, but loaning money to folks who can't pay it back still has the same results as the in the old century. Accredited Home Lenders also seems to be under a little stress (the stock is down 52% right now) and is considering its "options". I suspect their options will be rather limited in the current environment.

The sub prime mess, which many dismissed at first, is starting to have some real effects. Many of the big Wall Street brokers bought these loans and packaged them into securities. They tried to protect themselves by including buy back provisions for loans that defaulted within a short time frame, but the loan originators don't have the cash to buy back all the mortgages that are now in default. As a result, expect some of the big boys to end up as creditors in bankruptcy court and to recover pennies on the dollar from these loans. The brokers will probably make an attempt at making their investors whole but the episode is likely to be costly.

The real question is whether the sub prime market is the canary in the coal mine. Will the defaults spread to the better loans? Will there be a credit squeeze? I am watching the economy closely and I think as long as job growth remains relatively strong, the damage should be contained to the sub prime sector. If that is the case, the long term damage to the economy will be minor. If the economy starts to roll over though, look out below because there will be a lot more defaults.

For now, we are sticking with our plan. I still expect the market to test the recent lows. While sentiment has turned sour very quickly with this correction, it still needs to get worse before I get very bullish again. I suspect another downdraft may do it, but I'll wait for confirmation before getting aggressive about buying.

Friday, March 09, 2007

China to Diversify Reserves

China is creating an investment company to make more profitable use of its $1 trillion in foreign currency reserves, the finance minister said Friday, in a move that could change the flow of billions of dollars in global markets.
Finance Minister Jin Renqing gave no details of how the Cabinet-level company might invest the reserves, which are believed to be mostly in safe but low-yielding U.S. Treasury bonds. He also did not say what portion of the reserves might be channeled through the company or when it would start to operate.

This is something we reported on just a few weeks ago (see here). This would seem to be a much more important announcement than the employment report. Will the Chinese start buying US stocks? If they do, the impact on equities could be as important as the impact they've had on the US bond market over the last few years. Expect to start hearing soon about how the Chinese are buying up America.

Employment Report

Nonfarm payroll employment continued to trend up (+97,000), and the un- employment rate (4.5 percent) was essentially unchanged in February, theBureau of Labor Statistics of the U.S. Department of Labor reported today.Employment grew in some service-providing industries but declined sharply inconstruction. Manufacturing employment continued to trend downward. Averagehourly earnings rose by 6 cents, or 0.4 percent, over the month.

The much anticipated February employment report was released to a great sigh of relief on Wall Street this morning. The 97,000 jobs added was basically in line with expectations. The losers for the month were manufacturing and construction, losing 62K and 14k jobs respectively. Winners were Profeesional and business services, Education and health services, Leisure and hospitality and government. The workweek fell by 0.1 hours and pay increased by $0.06/hour.

There is little here that should be surprising. Manufacturing has been declining for a long time and the housing slowdown is finally hitting construction jobs.

The rise in earnings is likely to keep the Fed on hold for a while longer as they continue to fret more about inflation than growth.

Stock market futures rallied immediately after the report, but it will be interesting to see if the rally can be sustained for the entire day.

Thursday, March 08, 2007

Jobs Report

The market staged a big rally Tuesday and gave back a little yesterday. The futures are pointing to a strong rally at the open this morning. So far, things have followed the script I laid out last week. The question we face now is whether to sell into this rally or put money back to work in the market. And the employment report tomorrow complicates that decision.

The employment report is important every month but has taken on added significance this month. We have had more than one weak economic report recently and many are looking to this employment report for confirmation of an economic slowdown. If the slowdown is confirmed by the report, the likely reaction in the markets will be a continuation of the correction that started last week. The yen will likely strengthen and we found out last week what that means.

Given that we have recently seen an increase in first time and continuing jobless claims, I think the greater risk here is that the report will come out weaker than expected. Therefore, I will wait until after the report to make a decision about whether any further changes are required in our portfolios.

Monday, March 05, 2007

Is that All You've Got?

The market continues its volatile trading this morning with an initial downdraft and now a tepid rally. I suspect this pattern will continue for the remainder of the week until we get the employment report on Friday. Obviously, that report now takes on more than a little significance.

The sentiment surveys released over the weekend proved once again that the market is, above all, a reflection of the emotions of its participants. Two weeks ago, bears were scarce with only 22% identifying themselves of the ursine persuasion. Bulls topped 50% of the survey participants. After one lousy week, bears are now in the majority with 39.6% and bulls clocking in at 36.6%. The rest are just confused I guess. One of the main reasons we advised doing some selling in our February 24th tactical update was the prevalence of bulls in the surveys. Now with the bears emerging from hibernation, I am looking for a bottom of some kind to also emerge.

That doesn't mean there won't be more downside action in the market. In fact, another downdraft is probably in the cards sometime this week. What I would really like to see is a day where the market opens down hard and recovers to close higher. That pattern is quite common at bottoms and is usually a good signal that it's okay to venture back in.

What usually happens after a big down day like last Tuesday? Ticker Sense has the numbers:
When a 3% decline happens during a bull market, the S&P 500 is up an average of 2.95% one month later and 9.32% three months later. The numbers are somewhat different during a bear market, but they also show gains. Let's hope that holds true again.