Fear Itself

The first paragraph of FDR’s first inaugural address contains the famous line about fear:

“I am certain that my fellow Americans expect that on my induction into the Presidency I will address them with a candor and a decision which the present situation of our people impel. This is preeminently the time to speak the truth, the whole truth, frankly and boldly. Nor need we shrink from honestly facing conditions in our country today. This great Nation will endure as it has endured, will revive and will prosper. So, first of all, let me assert my firm belief that the only thing we have to fear is fear itself—nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance. In every dark hour of our national life a leadership of frankness and vigor has met with that understanding and support of the people themselves which is essential to victory. I am convinced that you will again give that support to leadership in these critical days.”

I read this entire speech today and another quote comes to mind:

“The more things change, the more they stay the same.”

I have no idea who first uttered that phrase but I’m almost certain it was a reference to politicians. The politicians of today would feel perfectly comfortable debating economic policy in 1933. The solutions offered for our current economic problems are not materially different than those offered by FDR in this first of many speeches as President.

Faced with an economic slowdown at a perilous time, an election year, our current day politicians feel, as FDR did, that “this nation asks for action, and action now”. And so they have enacted an economic “stimulus” package that promises, as FDR’s programs did, an economic recovery “by engaging on a national scale in a redistribution”. The current redistribution differs only in details from the plan put forth by FDR to end the Great Depression. The myth that government can redistribute resources in our economy and cause growth is apparently one that has endured for many generations.

FDR’s redistribution involved a movement of people from cities back to the farms and “definite efforts to raise the values of agricultural products and with this the power to purchase the output of our cities.” FDR sought to redirect capital – in this case human capital – to areas that produced a lower return on that capital. Today, our politicians seek to redirect capital from producers to consumers in the mistaken belief that the path to prosperity is to be found through consumption rather than investment.

The Great Depression has been blamed by many on faulty monetary policy, most notably by the current Chairman of the Federal Reserve. Monetary policy is said to have been too accommodative in the 1920s and too restrictive in the 1930s. Mr. Bernanke has endeavored to do his part to prevent a repetition of those faulty policies by cutting interest rates aggressively. However, even FDR realized that there is a faulty logic at work here:

“Faced by failure of credit they have proposed only the lending of more money.”

Our economy, much like the one of 1933 America, is at a crossroads. Years of excessively accommodative monetary policy has produced a society that believes, as Ludwig von Mises said that “more credit expansion is the only remedy against the evils inflation and credit expansion have brought about”. If the US continues down this path to a virtual debtor’s prison, there will come a time when monetary policy is no longer effective in limiting the periodic slowdowns that are a necessary part of a healthy economy. When that happens we will face a decision much like the one that faced America and FDR in 1933.

Monetary policy had a great deal to do with getting us into the economic mess that became the Great Depression. However, it was governmental interference in the normal functioning of the economy that prolonged that routine economic contraction into the Great Depression. Speaking of economic recovery FDR said: “It can be helped by preventing realistically the tragedy of the growing loss through foreclosure of our small homes and our farms. It can be helped by insistence that the Federal, State, and local governments act forthwith on the demand that their cost be drastically reduced. It can be helped by the unifying of relief activities which today are often scattered, uneconomical, and unequal. It can be helped by national planning for and supervision of all forms of transportation and of communications and other utilities which have a definitely public character. There are many ways in which it can be helped, but it can never be helped merely by talking about it. We must act and act quickly.”

It is this idea that government must act to generate economic growth that we should fear. Just as FDR did in the early phase of the Depression, our politicians want to protect citizens from the consequences of their bad economic decisions. There is real pain involved in the unwinding from the excessive debt that plagues our economy, but the blame for that pain lies not with the businesses that merely followed the economic incentives provided by the Federal Reserve. The blame for that pain should be placed squarely on the shoulders of Alan Greenspan and his successor at the Federal Reserve. Sharing the blame should be politicians who enact policies solely because they fear the retribution of voters. Neither the Fed nor the Congress is acting in our best interests. They are acting in their own best interests, consequences to the long term health of our political economy be damned.

The US economy is a resilient system that depends on innovation and the creative destruction that is inherent in capitalist systems for growth. Left alone, the US economy will recover from the current credit crunch because we are a nation of optimists who find opportunity even in times of economic distress. A Federal Reserve that confronts every economic downturn with a dose of monetary elixir merely short circuits the process. Likewise, fiscal policy aimed at anesthetizing the public to the economic cycle merely prolongs the pain.

The only thing we have to fear is fear itself. Fear of capitalism. Fear of the normal economic cycle. Fear of ending our addiction to debt. Fear of allowing investors to face the consequences of their risky actions. Fear of the competitive nature of free trade. Fear of immigrants who come to this country with a work ethic we seem to have forgotten. If, and only if, we can overcome these fears will we reform our dysfunctional monetary system and start to repair the damage done to our economy.

January Retail Sales - Good news!?!?

Retail sales in January rose more than expected, up 0.3% for the month, after declining 0.4% in December. Economists had expected a drop in sales by 0.3%. Excluding the purchase of autos, retail sales were still up 0.3%, in line with expectations.

Auto sales rose a surprising 0.6% for the month, while gas purchases rose 2.0%. If you exclude both from the calculation, retail sales remain unchanged. Clothing, food and beverage, and health and personal care stores also reported strong sales.

Every other category was in the red. Hardest hit were department stores (-1.1%), building materials (-1.7%), and electronics and appliance stores (-1.0%).

See full report.

No Laffing Matter

Arthur Laffer deconstructs the "stimulus" package on the pages of the WSJ this morning. He thinks it will do more harm than good and explains it in a way that anyone can understand. Taking money from a group that saves and invests and giving it to a group that is likely to spend it sounds good for the short term but the longer term effects are negative.

But even though the income effects net to zero, the substitution effects accumulate, and they accumulate in a most unpleasant way. This should be obvious to even a person untrained in economics. Ask yourself why not a $40,000 rebate per person, indexed for inflation of course, if a $600 rebate is so good. Heck, why don't we give rebates equal to GDP, so that everyone who doesn't work and doesn't produce receives everything, and all those who do work and do produce receive nothing?

GDP would go to zero in a New York minute if workers and producers got nothing for their work effort. And, as fate will have it, any rebate will reduce output because it reduces incentives to produce output. The larger the rebate, the greater the reduction in the incentives to work and the greater the reduction in output. It's as simple as that. This $170 billion rebate camouflaged as economic stimulus will deal a serious blow to the economic health of the country.

But there's also collateral damage. Few in Congress understand or care. They think their actions either don't matter or that they would see a positive impact from their actions if only they did more. If the economy worsens and when their political sensors become alarmed, they'll up the dose, and goodness knows just how far this vicious cycle will take us. A quick glance back at the 16 years of presidencies of Lyndon Johnson, Richard Nixon, Gerald Ford and Jimmy Carter should give you pause. Whenever you observe bipartisan cooperation, hold on to your wallet and run to the basement.

I never watched That Seventies Show because I lived through that miserable time. I don't think I'll like the sequel any better than the original.

GM Earnings

NEW YORK (CNNMoney.com) -- General Motors posted better-than-expected financial results for the latest quarter, but indicated that its efforts to shave costs are not behind it as the automaker offered lucrative buyouts to 74,000 employees - its entire U.S. hourly workforce.

The nation's largest automaker reported improved fourth-quarter results from its overseas auto operations, which helped to balance out continued losses at its North American plants. But problems at finance unit GMAC, of which it still owns 49%, coupled with large charges taken in the third quarter related to tax credits, left GM with a company record $38.7 billion net loss for 2007.

If you strip out all the charges, GM reported a profit for the quarter. Is it possible that GM has actually turned the corner? GM is desperately trying to cut costs but the union contracts make it very expensive. And the cost cutting is just a survival technique. Ultimately, GM will need to design cars that people actually want to drive - something they haven't been particularly successful at lately.

That's Too Bad

TORONTO (Reuters) - A major outage hit BlackBerry users in North America on Monday, cutting off wireless e-mail for everyone from busy executives to political campaign staff on the eve of three U.S. presidential primaries.

The problem, which BlackBerry owner Research In Motion described as a "critical severity outage" affecting users in the Americas, once again raised concerns about the stability of the e-mail service 10 months after a widespread crash last April.

I must admit to a little schadenfreude about this. How fricking important do you have to be that you can't wait to get to your computer to check your email? Maybe blackberry users will actually be able to engage in a conversation - at least for a while.

Buffet's Offer to Bond Insurers

CNBC is reporting that Berkshire Hathaway's new bond insurer is offering to reinsure municipal bonds for the existing bond insurers. There are no details available yet about the deal, but this seems a better deal for the investors in insured munis than the bond insurers. MBIA and the other bond insurers are in trouble because of CDOs they insured that are turning out to be basically worthless. Their muni bond business has always been solid. A muni bond insured by MBIA is now trading as if the insurance didn't exist (who really thinks MBIA could pay off in the case of a default?) so existing owners of those bonds would certainly benefit. How the bond insurers themselves would benefit is a little more murky. I'll post more details when they become available.

You really have to give Buffet credit on this. He's a hell of a businessman. He set up this company after the bond insurers got in trouble and if they fail, he will get all future business in the muni bond insurance business. By making this reinsurance offer he is attempting to get some of the existing business as well. Investors will push the bond insurers to accept but if I were them, I'd pass. Why give away their good business? If they accept, they will have written their own death sentence.

France's Second Largest Bank to Sell Shares At A Discount

Societe Generale, France's second largest bank, will raise $8 billion by selling stock in a rights offer, with the purpose of replenishing working capital. A rights offering involves the raising of capital by giving existing shareholders the right to purchase new shares in proportion to their holdings. In this case, shareholders can buy one share for every four held. The shares are usually priced at a discount to market price. SocGen stock is being sold at a 39% discount to the February 8th closing price, much higher than what analysts had expected.

Is SocGen in dire need? Well, after a $7.16 billion trading loss from one, lone, rogue trader, and a $3 billion write-down linked to risky US mortgage-backed securities, it just might seem that way. The bank's corporate and investment banking units reported a loss of $3.2 billion in all of 2007, compared to a gain of $3.4 billion the previous year. Net income for 2007 fell to $1.4 billion from $7.5 billion in 2006.

Pierre Flabbee, from Kepler Equities in Paris, described the rights issue "a matter of life or death" to the survival of the company. Ouch.

A Change In The Dow Jones

The Dow Jones Industrial Average, one of the most closely watched stock indices in the US, is adding two new components to reflect changes in the US economic structure. Bank of America, symbol BAC, the world's biggest bank by market cap, and Chevron Corp, symbol CVX, one of the largest oil companies in the world, will be added to the 30-member index of blue chip stocks. This is the first change in the Dow Jones Industrial since 2004.

The tobacco company Altria, symbol MO, and diversified manufacturer Honeywell International, symbol HON, were both removed from the index to make room.

Back to the Future

Larry Kudlow, not one of my favorite commentators because he's so partisan, has an article at NRO with some good thoughts on monetary and fiscal policy. He starts by bucking up Bernanke:

Bernanke has taken a lot of criticism in the last year, and I think much of it is undeserved. Wall Street claims that he’s an isolated academic, unaware of the real-world difficulties of sagging capital markets, slumping stock prices, and slowing growth. But he moved aggressively once he saw the credit problem develop last summer. And new information obtained under the Freedom of Information Act reveals how he has been meeting with leaders in business, finance, and government all along. He has talked with John Chambers, the CEO of Cisco Systems, Sam Palmisano, the head of IBM, JPMorgan’s chief Jamie Dimon, former Senate banking head Phil Gramm, and international central bankers Jean Claude Trichet and Mervyn King. The street was wrong about Bernanke. He’s been on top of the situation. He took remedial action and the economy will be the beneficiary faster than people think.

But this is the part that really caught my eye:

At some point, the entire corporate tax structure should be thrown out, along with all the murky K-Street tax-earmark loopholes that litter the IRS code. We need to broaden the tax base and lower marginal rates. This is the key to maximizing future economic growth on the supply side. Without strong tax-reform measures to expand the production of goods and services, further Fed money injections are only demand-side “solutions” that will surely inflate prices and depreciate the currency.

Back in the 1970s, policymakers in Washington were obsessed with increasing aggregate demand, but they forgot about aggregate supply. Today’s short-term-stimulus rebate package is a throwback to that era. It’s not economic stimulus; it’s political stimulus. Congressmen up for reelection are trying to “do something” in response to primary-season exit polls that say Americans are totally unhappy with the economy. But these rebates are budget busters. And how will Congress attempt to pay down $400 billion in budget deficits? Higher tax rates, of course. And then we’ll really be back in the 1970s.

Kudlow wants fiscal policy to take all the blame for a depreciating currency but surely the Fed at least shares the blame. Of course, Kudlow is right about fiscal policy. The rebates are a waste of money; they won't stimulate the economy and they will add to the deficit and debt.

Explanation for Low Jobless Claims

Randall Forsyth has an interesting article on the low level of jobless claims, something I've cited here as being inconsistent with a recession. The argument is that the self employed, such as real estate brokers and mortgage brokers, are independent contractors and therefore not eligible to file for unemployment benefits.

That's important because the self-employed have become an increasingly large portion of the U.S. economy, and not just because of the E-bay entrepreneurs that Vice President Dick Cheney is fond of citing.

During the housing bubble, the army of mortgage brokers and realtors swelled. The barriers to entry into those fields are minimal. As the former head of mortgage operations of a major New York bank once told me, a mortgage broker is a used-car salesman with a better suit. (Apologies to used-car salesmen.)

In any case, thousands of people began to earn a living by getting a slice of the housing boom. But even when they went to work for a mortgage or real-estate firm, they remained independent contractors, not employees. That meant that they weren't on firms' payrolls (and not counted in the establishment survey of the monthly employment report.)

Their independent-contractor status also precludes their receiving unemployment benefits. The legions of freelancers extend beyond the salesmen and saleswomen who raked it in during the housing boom to those did the honest work in the construction trades, from electricians to carpenters, who worked for contractors (also entrepreneurs.)

Many of this corps that swelled and prospered during the housing bubble are out of work. But they can't file for unemployment insurance.

If the economy is in recession this would seem to explain the low level of jobless claims. Anectdotal evidence would seem to support this thesis as well. We all know someone who was a mortgage broker or real estate broker that is now struggling. You can also include other self employed individuals who benefited from the housing boom as well. What about the personal trainer with real estate related clientele who now can't afford the luxury of a personal trainer?

The counter argument is that many of the people who entered the real estate business during the boom were just looking for extra income. Real estate was more of a hobby than an actual career, a way to supplement income from other sources. That isn't true in all cases of course, but it is certainly true of some portion. Maybe they'll go back to selling used cars...

Buttonwood Says....Nothing

The Buttonwood column at the Economist.com asks if the stockmarket is a presenting a buying opportunity. And answers the question with a resounding....uh....well they don't actually have an opinion. First BWood says sentiment is pretty negative...or not:

One approach is to look at sentiment. The best buying opportunities occur when investors are most gloomy. Unfortunately, sentiment is hard to measure decisively. At the end of January, bears outnumbered bulls by nearly 19 percentage points in a survey of the American Association of Individual Investors. That sounds pretty depressed. But Richard Bernstein of Merrill Lynch points out that Wall Street strategists are recommending a much higher weighting in equities than they did for much of the 1990s.

Then he says valuations are cheap...or not:

There are, broadly speaking, two schools of thought. The optimists argue that shares are not expensive relative to either trailing or prospective earnings and are very cheap relative to government bonds. The pessimists argue that corporate profits are historically inflated and could have a long way to fall as the economy subsides.

Finally, BWood says it is this uncertainty that explains why markets are so volatile. Duh.

This uncertainty helps explain why markets have been so volatile lately. It is tempting to believe the economic and credit problems are a short-term blip and that Wall Street will be rescued by the Fed as it has been so often before. But every time that view seems about to take hold, something happens to make investors fear a more sinister possibility: that years of debt-financed growth are finally unravelling and that the Anglo-Saxon economies face as bleak a decade as Japan did in the 1990s. The market may not hit bottom until that fear recedes.

There was a time when I couldn't wait to receive my latest copy of The Economist and the first thing I did when it arrived was read the Buttonwood column. Not anymore.

This Can't be Good

The WSJ has an article about credit card delinquencies that sounds fairly ominous. Apparently, folks are not paying their bills on time:

The result could be a sharp pullback in consumer spending that would further weaken the slowing U.S. economy.

Such a pullback may already be taking shape. Yesterday, the Federal Reserve reported an abrupt slowdown in consumers' credit-card borrowings. In December, Americans had $944 billion in total revolving debt, most of it on credit cards, a seasonally adjusted annualized increase of 2.7%. That was off sharply from seasonally adjusted growth rates of 13.7% in November and 11.1% in October. And it reflects the volatility in consumers' spending habits as economic growth sputters.

Oh my goodness. People aren't getting deeper into debt fast enough. Whatever will we do?

Something Sort of Positive

In my never ending quest to find anything positive about the economy, I found this blog entry by Greg Ip at the WSJ about a service sector index constructed by ISI. Their index did not show the plunge that the ISM survey did:

Not so fast, says ISI Group. The New York brokerage firm has its own service sector index that it puts together from weekly surveys it conducts of auto dealers, homebuilders, shopping guides, credit card companies, airlines, banks, restaurants, wine & spirit wholesalers, temp employment companies, trucking companies, shipping companies and commercial real-estate companies. While it has been trending down, it didn’t show the abrupt plunge in January that the ISM’s index did: the four week average has slipped to 46.5 in early February from 47.1 at the end of January and 48.5 at the end of December.

“We think the risk of recession is high, but the data in aggregate are not consistent with a US recession right now,” says economist Oscar Sloterbeck, who runs the surveys at ISI. Unemployment insurance claims aren’t high enough, the manufacturing ISM index is at 51 instead of recession levels of 41, the firm’s own diffusion index is still above recession territory and “the Company Surveys in aggregate aren’t low enough.” –Greg Ip

Okay I know it's thin gruel but at least it's not as negative as the ISM survey.

Now That's a Central Bank

After an FOMC policy meeting, the committee releases a statement which is usually less than a page in length. The public then spends the next few minutes trying to figure out exactly what the hell they really mean. By contrast, consider the European Central Bank. The President and Vice President of the ECB hold a press conference at which they read a very detailed statement - and then take questions! And what a statement. If Europe ever gets the rest of its economic house in order, they will be a force to be reckoned with. A few outtakes from the latest post meeting statement:

On the basis of our regular economic and monetary analyses, we decided at today’s meeting to leave the key ECB interest rates unchanged. This decision reflects our assessment that risks to price stability over the medium term are on the upside, in a context of very vigorous money and credit growth. The current short-term upward pressure on inflation must not spill over to the medium term. The firm anchoring of inflation expectations over the medium and long term is of the highest priority to the Governing Council, reflecting its mandate.

They are actually more concerned about inflation than a slowdown in growth. Imagine that, a central bank worried about inflation!

That said, uncertainty about the prospects for economic growth is unusually high and the risks surrounding the outlook for economic activity have been confirmed to lie on the downside. Risks relate mainly to a potentially broader than currently expected impact of financial market developments on financing conditions and economic sentiment, with negative effects on world and euro area growth. Further downside risks stem from the scope for additional oil and other commodity price rises, concerns about protectionist pressures and the possibility of disorderly developments due to global imbalances.

That part in bold is a direct jab at the US and it's reckless central bank.

Risks to this medium-term outlook for price developments are confirmed to lie on the upside. These risks include the possibility that stronger than currently expected wage growth may emerge, taking into account high capacity utilisation and tight labour market conditions. Furthermore, the pricing power of firms, notably in market segments with low competition, could be stronger than expected. At this juncture, it is therefore imperative that all parties concerned meet their responsibilities and that second-round effects on wage and price-setting stemming from current inflation rates be avoided. In the view of the Governing Council, this is of key importance in order to preserve price stability in the medium run and thereby the purchasing power of all euro area citizens. The Governing Council is monitoring wage negotiations in the euro area with particular attention. Indexation of nominal wages to the consumer price index should be avoided. Finally, further rises in oil and agricultural prices, continuing the strong upward trend observed in recent months, as well as increases in administered prices and indirect taxes beyond those foreseen thus far pose upside risks to the inflation outlook.

With respect to fiscal policies, a discretionary fiscal loosening in EU countries should be avoided. There is ample evidence that activist fiscal policies were not effective in stabilising European economies but rather led to sustained increases in the ratios of government expenditure and debt to GDP. Allowing the free operation of automatic stabilisers in countries with strong fiscal positions and safeguarding the long-term sustainability of public finances are the best contributions that fiscal policy can make to macroeconomic stability. Countries with fiscal imbalances are urged to make further progress with consolidation, in line with the requirements of the Stability and Growth Pact. There is a clear risk that some countries will fail to comply with the provisions of the preventive arm of the Pact, thereby undermining its credibility.

And that's left cross to the US politicians rushing to enact a "stimulus package". Wouldn't it be great if Bernanke had the guts to tell Congress that their stimulus package was BS and would only increase the budget deficit?

Structural reforms help economies to adjust to adverse shocks, foster productivity growth and increase employment and competition, thereby also helping to reduce inflationary pressures. In particular, enhancing competition in the services sectors and network industries, as well as applying adequate measures in the EU agricultural market, would be conducive to price stability in the euro area.

I love this last part. What he's saying is that capitalism works and the Europeans ought to try it.

And finally there's this at the end of the statement:

We are now at your disposal for questions.

Wouldn't it be great to see Bernanke on the hot seat answering questions about monetary policy?

The Great Inflation

Thorsten Polleit has a very readable article that explains the current credit crisis in Austrian Economics terms. The root of our current crisis can be found in Federal Reserve policy:

Initially, the artificial lowering of the interest rate creates an illusion of richness and affluence. The increase in the money stock via bank credit expansion erroneously suggests that the supply of savings increases. Investment picks up, and the economy expands. The illusion of plentiful resources leads to malinvestment, and sooner or later the boom turns into a bust. While the money-fueled expansion is a manifestation of the crisis, it is actually the slump — the correction of malinvestment — that people complain about.

He uses a wonderful quote from Mises that perfectly encapsulates the argument of those like Desmond Lachman who believe the Fed can cure a problem created by the Fed:

"In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils inflation and credit expansion have brought about."

As I stated in my debate with Lachman, my fear is the response of a government that can no longer create more inflation to cure the last credit inflation:

Inflation is a societal evil. It redistributes real wealth from creditors to debtors. It impairs the role of money as a means of exchange. The efficiency of the market's price mechanism is greatly reduced, encouraging bad decisions, which in turn harm peoples' economic well-being. At the end of the day, inflation is a serious threat to freedom. The majority of the people, suffering badly from inflation, would most likely blame the free market for their plight, rather than blame the central bank for the debasing of the currency.

From the Austrian viewpoint, the current credit crisis appears to be a precursor of great inflation. If a deliberate policy of great inflation is chosen in the United States, a monetary policy of debasing the currency would most likely also take hold in other currency areas of the world. The credit crisis has become a threat to the free societal order: as people become dispirited with the free market order, the door would be pushed open for anti–free market policies.

Read the entire article.

Poetic Justice

I don't agree with Warren Buffet about some things - the estate tax comes to mind - but he's got it right in this speech in Toronto:

TORONTO (Reuters) - The woes in the U.S. financial sector are "poetic justice" for bankers who designed and sold complex investments that have since gone sour, billionaire investor Warren Buffett said on Wednesday.

The head of the Berkshire Hathaway Inc (BRKa.N: Quote, Profile, Research) (BRKb.N: Quote, Profile, Research) group of companies also played down worries about a credit crunch by saying that recent interest rate cuts mean low-cost funds are readily available.

But he warned that the U.S. dollar will continue to slide unless the country can rein in its yawning trade deficit -- the "biggest factor" behind the decline. Still, he said, the U.S. economy will "do very well over time."

It never ceases to amaze me that Citigroup finds a way to get in the middle of every banking crisis that comes down the pike. From Latin American debt in the 80s to sub prime today, Citigroup and other banks, always find a way to lend money to folks who can't or won't pay it back. As Buffet put it later in the speech:

"I wouldn't quite call it a credit crunch. Funds are available," Buffett said during a question and answer session at a business event. "Money is available, and it's really quite cheap because of the lowering of rates that has taken place."

He added: "What has happened is a repricing of risk and an unavailability of what I might call 'dumb money,' of which there was plenty around a year ago."

Yep, the dumb money. Why do people keep bailing out these idiots?

Insider Buying that Homebuilders

What do homebuilding executives know that we don't? Apparently, they know when to buy and sell their own stock. The WSJ Marketbeat blog has an entry about recent insider activity at the major homebuilders:

Three major home builders, KB Home, Lennar, Standard Pacific and Hovnanian all have insider score rankings above 75 for the last month, suggesting positive sentiment among insiders at those companies in the last few months.

Two of the three (LEN and HOV) currently rank in InsiderScore’s top 100 companies in terms of positive buying interest, which means insider buying has spiked in the last month. Hovnanian is ranked highest, with notable purchases in January from Kevork Hovnanian, chairman, and Joseph Marengi, a director at the company. Notably, insider sentiment went negative in the first quarter of 2007, when CEO Ara Hovnanian sold off shares.

Apparently they know when to buy; the insiders at HOV are up about 80% on their investment in less than a month. There was a lot of insider selling in the homebuilders near the top as well so these guys are pretty good at timing their purchases and sales. Maybe we are near a bottom in the homebuilding industry.

Weak Demand for 30 Year Bonds

The government auctioned new 30 year bonds today and found weak demand. Most of the bonds were apparently bought by Wall Street dealers as bids from foreign buyers was very weak. That could be due to Asians celebrating the Lunar New Year. Or it could be because no one wants to lend the government money at less than 4.5% when the Fed is busily creating bunches of new dollars. One or the other.

Schizophrenic Market

We've had another volatile day in the stock market. Cisco's earnings outlook and some more weak economic data got us off to a slow start, but Cisco recovered and the market posted a 100 point gain this afternoon. Now we've sold off again into the close, down about 8 points right now at around 3:30. Volatility like this is wearying but pretty typical of a market at a turning point. There is a tug of war right now between those who are finding bargains and those who are afraid. Fear and greed. It's what always drives the market.

Cisco is a great example. They reported earnings last night in line with expectations and up 15% from the same quarter last year. Their revenue forecast for this quarter however was less than expected and they complained about orders during January. On the other hand the stock trades for just 14 times earnings and has $22 billion in cash. That's value investor territory for one of the great growth stocks of our time. And bargain hunters bought the stock from the traders who were betting on a good quarter and hoped to make a quick buck.

The economic data this morning was not very good. Jobless claims came in at 356,000, down from last week but still too high. Last week's numbers were a little suspect but this week confirms that jobless claims are trending higher. That is not good news for future employment reports. Pending home sales were down again dropping 1.5% from November. That of course shouldn't surprise to anyone.

It appears though that, at least for today, the market had already discounted most of the bad news. If things get worse of course the market could make another down leg, but at least for now we are holding above the lows set on 1/22. The pullback this week is fairly normal even if we are making a bottom. Markets rarely go straight back up after a break like this. It takes time to rebuild investor confidence.

Jobless Claims-Feb. 2 Week

The Labor Department reported a drop in initial jobless claims for the latest week. First-time claims fell by 22,000, to 356,000, from an upwardly revised 378,000 the prior week.

The 4-week moving average also rose, increasing 8,500 to 335,000. It's the highest since January 5th. The 4-week moving average is a less volatile and more accurate measure of the direction of jobless claims.

Continuing jobless claims, however, hit a high not seen since October 2005. The Labor Department reported an increase of 75,000 to 2.78 million.

Another Chapman Article

John Chapman had an article critical of Bernanke in October last year at The American. Chapman takes a decidedly Austrian view of the economic world that coincides with my general view of how things work.

Given the current panoply of worries—the housing crunch, rising oil prices, decreased consumer spending, depressed corporate profits, and slowing growth in Japan and Europe—most economists appear to welcome such a move. Harvard’s Martin Feldstein summed up the conventional wisdom last month when he said the federal funds rate should drop to 4.25 percent or less in order to prevent a significant economic downturn.

Not so fast. While it is true that substantial housing crises have often presaged a recession, the U.S. economy still has considerable strengths and solid growth prospects. What matters now is that monetary policy be oriented toward sustainable economic growth—which is to say, we need a policy that acknowledges the long-term linkage between sound money and solid, sustainable growth. Financial markets—and economic agents—are highly efficient at discounting the future into the present, and they will react positively if the Fed moves to defend the dollar’s value and stability.

Chapman analyzes the how we got in this current Fed induced mess:

Consider the present environment. From late 2001 to 2004—in the wake of a global recession, terrorist attacks, and war—U.S. monetary policy pursued a dramatic reduction in short-term interest rates. Indeed, for much of that period the real federal funds rate was negative. When interest rates are artificially held below their natural level, investors get false signals, particularly in interest-sensitive capital goods sectors, such as housing and construction, which experience a boom. The falsified interest rates induce a flurry of lending and investment in capital goods, and hiring and spending increase in these sectors. Conversely, financial institutions, which now have an excess of reserves to lend due to the Fed’s expansionary policy, seek out borrowers of dubious credit. For several quarters, or even years, a general economic boom occurs.

But the housing and capital goods booms—along with the loans to marginal borrowers—are not based on real savings. Rather, they are based on a spike in fiduciary credit triggered by Fed policies that inject reserves into the banking system to cut interest rates and fuel the boom. As such, some increases in spending and employment are unsustainable, and marginal projects undertaken without the backing of real demand may face insolvency.

Eventually the central monetary authority faces a dilemma, which is roughly where we are now. It can compound its errant intervention by accelerating the expansionary policy, keeping interest rates below where they would be otherwise. Or it can allow interest rates to return to their natural levels and thereby cause an economic slowdown, as marginal projects are liquidated, assets are repriced, and labor markets readjust.

As dislocations deepen, postponement usually makes the eventual correction more painful. But a bigger problem with continued monetary ease is the loss of confidence in the Fed’s commitment to protecting a strong American dollar. Given that the dollar serves as a global reserve currency, a flight from dollar-denominated assets abroad could mean a return to 1970s-style inflation and global recession.

As I have said a number of times, our problems are a result of bad monetary policy. They won't be solved by more bad monetary policy.

It would be interesting to see what Mr. Chapman's view of the economy is now. I'll see if I can contact him at AEI and invite him to participate on the blog.

Different Analysis from Chapman at AEI

John Chapman, a fellow at the American Enterprise Institute, has a letter to the editor of the Wall Street Journal Europe about a recent editorial from John Snow. The contrast with Desmond Lachman, also of the AEI, is stark.

Instead, what happened is the Greenspan Fed held U.S. interest rates too low for way too long earlier this decade. Inflationary increases in credit, channeled through the banking system into credit markets, fed the housing boom. But as this boom was not backed by an increase in real savings, it was by definition unsustainable.

Further, because the U.S. dollar is the world's de facto reserve currency, the Fed can "export" inflation for a time. But this too is unsustainable, as over time the dollar must fall, and U.S. inflation and real interest rates rise, to adjust to too-expansionary a monetary policy. More monetary easing is exactly what should not happen now. What we do need is less federal intervention, which breeds moral hazard in the U.S. financial system, and in turn the asset repricing, recapitalization and restructuring Mr. Snow applauds will quickly stabilize financial markets. Additionally, broader tax cuts and lower federal spending will help prevent a recession.

Fed Over Reaction?

This wonderful chart is courtesy of Greg Ip at the WSJ. It shows inflation expectations based on a five year forward basis. Inflation expectations have been rising since the Fed threw in the towel on the economy and decided to slash interest rates. The actions of the Fed may limit the slowdown in the economy but as this chart shows, there is no free lunch.

Mankiw's Wish

It's Greg Mankiw's birthday and he has an editorial in the NYT to celebrate the occasion titled, "My Birthday Wish: Not Burdening Our Children". Unlike the politicians on the campaign trail who invoke "the children" at every turn, Mankiw wants to make his wish come true through increased personal responsibility. He starts the column by talking a little about the current economy:

As I reach this particular milestone, it is hard not be worried about the economy. No, I am not talking about the subprime meltdown and the possible recession that looms on the horizon. I am confident that the team at the Federal Reserve can contain that problem.

Moreover, from the broad vantage point of history, the next recession, whenever it occurs, will likely be a minor blip. My guess is that it will be similar to the recession that was enveloping the economy the day I was born.

Don’t remember the recession of 1957-58? Most people don’t. It was a garden-variety slump — painful to those who lived through it, but short-lived and leaving few lasting scars. Today it is remembered only by the few experts who crunch the numbers in the study of macroeconomic history. My parents’ recession is not my problem, and our next recession will not concern our children when they reach adulthood.

Economic slowdowns, whether they morph into a recession or not, always seem like they will never end. Like Mankiw, I am not much worried about the present state of the economy - this too shall end. What Mankiw is worried about is the long run cost of Social Security and Medicare:

Long before I was born, Franklin D. Roosevelt established a compact among the generations. Families had long cared for their elderly members, but Roosevelt federalized that responsibility in the form of the Social Security system. Social Security is sometimes viewed as a pension plan, but it is mostly pay-as-you-go. The working-age population taxes itself to support its parents, in the hope and expectation that its children will do the same. On the day of my birth in 1958, the payroll tax to pay for this program, including both the employer and employee shares, was 4.5 percent.

Around the time I started grade school, Lyndon B. Johnson expanded the generational compact to include health care for the elderly. The Medicare system increased the payroll tax, but only modestly at first. Health care technology was far more primitive back then and, as a result, less expensive. By 1968, when, like my younger son today, I was in third grade, the payroll tax for both programs had risen to 8.8 percent.

Today, the payroll tax for these programs is 15.3 percent, far higher than the programs’ creators ever imagined. More worrisome is that this 15.3 percent is nowhere near enough to maintain solvency in the future. When my generation of baby boomers retires in large numbers and starts claiming benefits, spending on these programs will far outstrip revenue at the current tax rate.

Mankiw is right. If we don't do something about these programs, taxes will just keep rising and the cost to the economy will be enourmous. Mankiw makes some great points in this editorial. Read the entire thing.

My Final Response to Desmond

Dear Desmond,



I have said that I don’t expect a recession but I am the first to admit that is a position that is increasingly hard to defend. The economic statistics have deteriorated dramatically over the last two months and the credit crunch continues. Bank balance sheets have taken a big hit and I wouldn’t be surprised if there are more writeoffs to come. Housing prices are falling and it appears they will fall further with inventories at record highs. The stock market, even if the Dow and S&P 500 haven’t met the accepted definition of a bear market, have dropped dramatically. We are about to get a real world test of the wealth effect.



The long term problems we face will not be solved by monetary policy:



1. The housing market is in trouble because the Fed reduced interest rates to generational lows and held them there too long. Given a huge incentive to borrow, Americans did exactly that. Given a huge incentive to lend, banks did exactly that. Now as the credit spigot is tightened the process is working in reverse. Home prices are indeed falling and absent Fed action to reduce rates, they would no doubt go down faster. Now that the Fed has lowered rates again, ARM resets will not affect as many people as they would have absent Fed action. That will just prolong the price adjustment that is needed to bring home prices down to the long term trend (which is roughly the rate of inflation). This is not a pleasant prospect, but it is a necessary one. The US government needs to get out of the business of subsidizing the housing industry. Fannie Mae and Freddie Mac helped to create this problem by making the “originate to distribute” model so profitable that it would have been dumb for banks not to participate. More cheap money does not address the root cause of the housing problem and will only prolong the pain of the adjustment.

2. The banking system is in dire straights because of exactly the medicine being peddled once again by the Federal Reserve. The problem with the banking system is not a lack of liquidity. Funds are available; banks aren’t willing to lend them on the easy terms that got them into trouble in the first place. Nothing the Fed does will change that in the short term, but over the longer term, a yield curve artificially steepened by the Fed will get banks back to borrowing short and lending long. The last thing our economy needs is more debt. As you point out the US household debt to income ratio is at an all time high. Lower interest rates will only further exacerbate the problem by discouraging saving and encouraging further debt accumulation.

3. Oil prices and other commodity prices are high because Fed policy has fed a boom in every country with a currency pegged to the dollar (and that boom has led to a boom even in countries without a peg, such as Brazil). China is the prime example but the Middle East countries are another often overlooked example. If we have to live with the Fed it would be nice if they spent at least a little of their time defending the purchasing power of our national currency. Cutting interest rates and expanding the supply of dollars will not solve this problem. The economic slowdown (or recession if you prefer) will only bring commodity prices down temporarily unless we cure our addiction to cheap money.

4. You have written about the current account deficit as a major problem facing our economy and I agree. In 2003 you wrote in the Washington Post:

In normal times, an orderly decline in the dollar would be a welcome development. By cheapening American exports and increasing the cost of imports here, the fall of the dollar would facilitate the needed long run adjustment in the current account deficit. Moreover, by raising import prices it would play a useful role in countering the rapid pace of disinflation that is bothering Federal Reserve Chairman Alan Greenspan.

Well, the dollar is cheaper now and with oil and gold at or near all time highs, disinflation no longer seems to be an issue. Unfortunately, the current account deficit is still with us. I’m sure your response would be that the dollar has fallen against the wrong currencies and if the Chinese would only revalue the Yuan, that current account deficit would disappear. You might be right, but what would be the consequences of that revaluation? My bet would be much higher interest rates. If the Chinese know they are going to revalue the Yuan, why would they continue to fund our current account deficit when that revaluing would result in a huge loss in their sovereign wealth fund? So if the path to solving the current account deficit is higher interest rates, why should we wait for the market (or the Chinese in a sense) to force the issue. The only way to solve the current account deficit is through higher domestic savings and that will only happen with higher interest rates. I am not saying that there is no pain involved in that adjustment; just the opposite in fact. Solving our debt problems will be very painful, but it will only be more painful the longer we put off the day of reckoning.





You are right that we part company when it comes to the correct policy response. I don’t know if we will have a recession, but I do know that monetary policy has worked every time in my adult lifetime to minimize the impact of economic slowdown. It is powerful medicine. And I suspect that it will again. As I said in my last response though, just because we can minimize the pain doesn’t mean that we should. I could be wrong and in that case we will finally get the unwinding that some are looking for. If that happens, monetary policy will not be able to respond to the crisis. What worries me is the potential for bad fiscal policies in response. If the stimulus package currently being considered is an indication of the type of economic thinking we can expect from our politicians, I mourn for our future.



I believe the only way to solve our long term problems is to suffer some pain now in lieu of suffering much greater pain down the road. Policies that I think can move us in the right direction include:



1. A dramatic reduction in corporate tax rates.

2. A dramatic change in our individual tax system. I would prefer a consumption based tax, but I have problems with the Fair Tax proposal. A flat tax seems the most likely change. The change should include an elimination of capital gains taxes and the mortgage deduction.

3. A unilateral removal of all import tariffs. If we fund our government through income taxes, import tariffs are by definition punitive. And the way I see it the one being punished is us.

4. A new international currency regime based on gold or possibly a basket of commodities. A pure gold standard is probably impossible but the only way we will get any kind of currency stability is in a system that doesn’t allow governments in the system to run excessive deficits. I suspect the Chinese are planning to switch to a gold standard at some point in the future and it would be to our advantage to beat them to the punch.





Unfortunately, I don’t think any of these things (or the myriad other proposals I can think of) will be enacted. I expect us to muddle through this time and face a bigger crisis down the road. Politicians cannot think past the next election cycle and have no incentive to think long term. My fear is that when the crisis finally arrives (if it hasn’t already), the policy responses will be toward ever greater government intervention. The results of such a course are easy to predict. One need only look to Europe with double digit unemployment and a stubbornly high inflation rate.





Best regards,



Joe

Further Response from Mr. Lachman

Dear Joe,



I am in complete agreement with you that the Federal Reserve’s repeated past egregious mistakes have got us into our present predicament. However, I part company with you in diagnosing where we are now headed and what the appropriate policy response might be.



It would seem to me that most indicators are now clearly suggesting that a recession has already begun. Employment growth has stalled abruptly, consumption has been weak, housing remains in a deep downturn, the ISM indicators are now in recession territory, and GDP growth in the fourth quarter of 2007 was weak.



Worse still, looking forward the US economy is being hit by the following major shocks, which show little sign of abating:



(a) The housing market is in its worst slump in 60 years with housing starts down precipitously and with housing prices now falling by 8 percent. Housing prices are almost certain to fall in 2008 by at least 10 percent against the backdrop of record inventories, tightening lending conditions and the scheduled resetting of ARMs. Such a decline in home prices would wipe out another US$2 ½ trillion in household wealth and would complicate balance sheet problems in the banks.



(b) Equity prices have already declined by close to 20 percent, which has wiped out another US$2 trillion in household wealth. It is doing so at a time that the US household debt to income ratio is at a record 140 percent.



(c) The banking system is in the grip of its worst credit crunch in over 25 years as it grapples with losses on past bad lending, now widely estimated to be in the ballpark of at least US$500 billion. This week’s Quarterly Federal Reserve’s Senior Loan Officer’s Lending Survey could not have painted a bleaker picture of the banking system’s lending intentions going forward, which points to an abrupt decline ahead in bank lending.



(d) International oil prices remain stubbornly in the region of US$90 a barrel.







In my judgment, this unusual constellation of major negative forces will swamp any support that the US economy might be getting from a weaker US dollar or from the stimulatory measures to date that in any event will only come into play in the second half of the year. The question to me is not whether we are now in recession. Rather it is how severe will this recession be. It is also my view that simply letting this recession run its course without a policy response would be highly dangerous and irresponsible. For it would risk having the economy move into a vicious circle of a weakening economy worsening both the housing bust and the banks’ problems which in turn would deal a further body blow to the economy.



I guess only time will tell who of us is making the right diagnosis and I would be happy to revisit this question in 6 months time.



Best regards,



Desmond

I will post a final comment on this later today.

Lennar

According to a story in the WSJ today, Lennar will receive an $800 million tax refund from the loss on land sales:

Late last year, the Miami-based home builder sold a big swath of land -- about 11,000 home sites -- for $525 million to a partnership that it formed with Morgan Stanley. At first glance, the deal seemed terrible for Lennar, which had the land valued on its books at about $1.3 billion.

But the deal's structure allowed Lennar to recognize a big loss that it applied against taxes paid the previous two years. The result: Lennar is expecting a tax refund of more than $800 million, according to the company's annual results filed in late January.

As an added bonus, because of the way Lennar and Morgan Stanley structured their partnership, Lennar still effectively owns 20% of the land, according to the company. It also has a 50% voting interest in the partnership, meaning it will have a say in how the land is developed.

Okay so they get to take the loss and still maintain some control over the land. In addition, because of the tax refund, they really don't have a loss. They sold the land for $525 million and get an $800 million tax refund which is basically what they were carrying the land for on the balance sheet. That is a smart deal and one that other homebuilders will likely emulate. The current stimulus bill would allow companies to apply the loss against taxes paid over the last five years rather than the two years in the Lennar deal.

Pre Market

The market looks a little higher at the open as Disney reported better than expected earnings last night and improved the mood a bit. We get Cisco after the close today. The only economic data today was productivity (higher than expected at 1.8%) and unit labor costs (lower than expected at 2.1%). Both figures are for the 4th quarter and tell us little about the future but good numbers are welcome. Biogen had good earnings and that should help the biotech sector today. Toll Brothers had another lousy quarter but no one should be surprised that a homebuilder is struggling.

It is interesting though how the homebuilding stocks have performed lately. They were up most of the day yesterday but sold off late with the market. Housing starts are probably near their eventual lows (see yesterday's post) and I guess it makes sense to see the homebuilders start to perform better, but it does seem premature with the large inventory of homes on the market. I suspect most of the move in the homebuilders recently was short covering and it will take some time before real long term buyers come back to the group.

4th Quarter Productivity, Unit Costs

Productivity in the US non-farm business sector slowed to a 1.8% annual rate over the last three months of 2007. This number is a positive, since economists had forecast a much smaller 0.8% increase, but it is down from a revised 6.0% increase in the 3rd quarter.

Productivity, or output divided by hours worked, increases profit margins and real wages, since more is being produced with less. This, in turn, becomes a key deterrent of inflation and promotes a higher standard of living.

For the year, productivity increased 1.6%, compared with a 1.0% increase in 2006.

Unit labor costs, a key measure of inflation, came in at 2.1% annualized rate for the quarter. Economists forecasted a number closer to 3.5%. For all of 2007, unit labor costs were up 3.1%, compared to 2.9% in 2006.

Full Report.

Well That was Ugly

The Dow closed down 370 today after the ISM Non Manufacturing report fell into recession territory. Apparently some hadn't gotten the memo about the economic slowdown. The ISM report showed a similar drop after 9/11 and another similar dip in early 2003. Obviously, this is not good news. I've been through the report and to be honest, I can't find anything positive to say about it.

That does not mean that the stock market did not over react to the report. It is still just one month and does not make a trend. The move in stocks today demonstrates more than anything the nervousness in the market. Anyone lucky or smart enough to buy near the recent lows was itching to take profits. Combine traders with tenuous profits and investors afraid of recession and what you get is a day like today.

This move in the market is a healthy sign. Bottoms are not made in a day or a week. Long term bottoms take time to build; a V bottom would be a sign that the final bottom has not yet been made. I expect to see a lot of volatility over the next couple of months; there will be big up days and big down days. I don't know yet (no one does) whether the recent lows will hold, but I suspect they will. I do not believe this will be a bear market like 2001-2002. The S&P 500 traded over 30 times earnings back then and was nowhere near that high when this started. I suppose anything is possible but a 50% drop from the highs would put us at single digit P/Es, something we haven't seen since the 70s.

Which brings up an interesting point. I've heard a lot of talk about stagflation recently and with gold hitting new highs some are looking to the 70s for clues about the market. So let's do that. I think the period most people are thinking about is the period from 1973 to 1982. The S&P peaked in 1973 and had a nasty bear market similar to the one we had at the beginning of this decade. August 1982 is widely considered the beginning of the great bull market of the 80s and 90s. So here's the chart from January 1973 through August 1982:




And here's a chart of the S&P 500 so far this decade:



The charts are remarkably similar. The bear market at the beginning of each period lasted for approximately 2 years. The recovery to previous highs took about five years. The recovery was followed by another bear market, but not nearly as bad as the one that started the period. Does that mean this market will act exactly like that one? Of course not; no two markets are alike. But if we relate these charts to economic data it may give us some clues about what to expect.

Obviously, the housing market is the part of the economy that has people worried the most so let's look at housing starts:



Maybe this is why the homebuilding stocks are acting pretty good recently. If history is any guide at all we are a lot closer to the bottom than anyone expects.

And since everyone seems worried about the ISM, let's look at the Manufacturing series for which we have a longer history:



This doesn't tell us a lot except that things are a lot less volatile today than they were in the 70s. If recent history is a guide then even if we are headed for recession, the bottom is not far away.

What about employment?



If this is a mid cycle slowdown, like we had in the mid 90s, then this is about as bad as it gets. If this is a recession, we've got a ways to go yet. I'm still betting on a slowdown rather than a full blown recession, but we don't have enough information yet to make a determination.

What about the unemployment rate?



Well, so much for that comparison to the 70s. We aren't even close to the unemployment seen in the late 70s or early 80s. In fact, if the trend of lower highs holds, the unemployment rate is likely to rise only a little further.

One thing that does look a lot like the 70s is the dollar:



One thing that should be obvious from this though is that there is little corellation between the value of the dollar and recessions. We've had recessions when the dollar was rising and recessions when the dollar is falling.

What about inflation? A lot of people, me included, are worried about inflation. Here's the Personal Consumption Price Index:



Seems rather tame when compared to the bad old days, huh? Any inflation is too much for me, but things aren't so bad right now compared to what we've seen in the past.

I could continue in this vein with other statistics, but the evidence is clear. The economy is not great right now, but it is not out of the norm for the last 50 years. In fact, if anything, things are considerably better than at times in the past, particularly the 70s. Are we headed for recession? I don't think so, but even if I'm wrong, we've probably already seen most of the damage. Looking back at the past will not tell us where we are going. It does provide some perspective though and that perspective tells me that all the doom and gloom out there is probably misplaced. Investors need to remember that the goal is to buy low and sell high. The market is giving investors an opportunity to do the buying part of that equation. It just takes a little perspective to gain the confidence to act on it.

Yes, We Disagree

My response to Desmond Lachman:

Yes, we disagree on at least two points. I do believe there is a role for regulation however I think it needs to be very minimal. 1907 is actually a great example for both our cases. The panic of 1907 involved a real estate crash followed by two stock market crashes so it correlates well with today’s market conditions. It was also, in my opinion, a result of the National Bank Act (of what year? 1880 something I think?) and the Gold Standard Act of 1900 both of which were a result of lobbying by banking interests (primarily JP Morgan). So 1907 demonstrates a need for regulation but also demonstrates the need for caution. Regulations are often written to favor private entrenched interests (Morgan and Rockefeller in this case) and so one must be careful that regulation doesn’t stifle competition to the detriment of the consumer. Obviously, I have grave doubts as to whether regulations can be written that will not favor those with an interest in the outcome and the means to hire lobbyists by the dozen. I would also point out that the panic of 1907, as bad as it was, lasted less than a year and was ended by the same private interests who started it (again primarily Morgan - with an assist from Jesse Livermore).



1907 is also a good parallel to today for another reason – in both cases the cause of the crisis was monetary inflation caused by the banking system. Since the likelihood of changing our banking system, abolishing the Federal Reserve and adopting a true gold standard are exactly zero we are left to argue whether the Fed is charting the proper course given the system we have. The US economy has been marked by rising debt for a very long time and that is a direct result of a Federal Reserve that has too often opted for monetary inflation rather than suffer a temporary (and natural) slowing of growth. This will continue until debt has reached proportions that no longer allow for a further expansion of the debt bubble. Has that time come? I don’t think so. If you read my market commentaries, I have said that the Fed will be able to rescue us once again with monetary policy, but that doesn’t mean that they should. As an investment advisor, I am happy to spend my days trying to figure out where the bubble goes next, but as a citizen, I am distressed that we are merely putting off the day of reckoning.



You argue that a hands off approach by the Fed could result in a nasty and prolonged recession. I don’t think we are in a recession right now and have argued for some time that we won’t have an official recession from this housing and credit crisis. That prediction is based, at least in part, on my expectations of Fed action. However, from a long term economic perspective, maybe what we need right now is a nasty and prolonged recession. At some point we as a nation will have to pay the price for all this debt. Wouldn’t it be better to start the process now rather than wait until the debt burden is even larger than it now stands? As for the possibility of a lost decade like the Japanese or another Great Depression, I don’t believe monetary policy was the primary culprit in prolonging the pain in either case. On the other hand, I have very little faith that our politicians would act any differently than the politicians of Japan or FDR. They would take actions that would prolong the recession and do little to foster the recovery. They would interfere with the market and make things worse. The Japanese politicians spent most of that lost decade propping up failed banks and raiding the public treasury for questionable public works projects. They should have let the banks fail, de-regulated the economy (especially financial services) and cut taxes and public spending. Our politicians are already talking about extending unemployment benefits - with the unemployment rate at 4.9%. God only knows what they would propose if we had a nasty and prolonged recession. And that is, by far, the best argument for aggressive Fed action that I can muster.



Again, thanks for the response and rest assured that I will keep reading. I love a good debate….

Desmond Lachman's Response

Desmond Lachman has offered a response to my critique of his TCS article. Here is is in full:

Dear Mr. Calhoun,



Thanks for your email.



While we seem to agree on many matters, it seems that we disagree on two basic points. The first is whether or not there is a role for regulation in our market economy. The second, and perhaps more important point of disagreement, is how should the Federal Reserve be responding to today’s bursting of the housing market and credit market bubbles.



I would be the first to highlight the dangers of excessive market regulation and intervention in our economy. However, I would not go so far as you in suggesting that there is no role for regulation in our economy. My view is that there is a need for some minimal regulatory framework within which markets operate in order to prevent the abuses and excesses that would otherwise occur. In this context, it is well to recall that the Federal Reserve was set up in 1913 to prevent a recurrence of severe financial market panics like that of 1907, which were commonplace during the 19th century.



There is no question in my mind that cheap money between 2001 and 2005 was a major contributor to the housing market bubble and to the associated sub-prime lending problem. However, I also think that a major source of the problem was financial innovation outpacing the regulatory framework. In particular, it seems to me that the move to an “originate-to- distribute” model of mortgage finance, coupled with the increased incidence of securitization and the creation of highly opaque and complex credit instruments, have played an important role in today’s banking crisis. In my view, the marked loosening of credit standards could very well have occurred even if monetary policy was not as loose as it was and the Federal Reserve must be held to account for allowing imprudent bank lending to occur on the scale that it did. I would not want to minimize the impact that the estimated US$400 billion losses from mortgage lending will have on the banking systems’ willingness to lend going forward.



On the issue of how the Federal Reserve should be responding to the present situation, I think that it is important to recognize that the US economy is presently being hit by four major shocks that are inter-related to an important degree and that have the potential to throw the US economy into a nasty and prolonged recession. Those shocks include (a) the worst housing market bust since the Great Depression; (b) the most severe credit crunch in the past 25 years; (c) international oil prices at $90 a barrel; and (d) an important correction in equity prices. It would seem that these shocks have already pushed the US economy into recession judging by the latest consumption and employment numbers.



A hands-off approach by the Federal Reserve now runs the real danger of having the US economy slide into a full blown recession that would only aggravate the acute problems that the banks are already experiencing as well as worsening the housing market and credit market busts. That in turn would likely deepen the economic recession. This would seem to be the clear lesson of both the Great Depression and Japan’s lost decade in the1990s following the bursting of its asset price bubble, when the central bank was far too slow in easing monetary policy. It is for this reason that I support the Fed’s belated move last week to a decidedly easier monetary policy stance as well as its commitment to take further measures should the economy weaken further in the months ahead. I would caution, of course, though that the Federal Reserve will need to remove monetary policy ease once the present real recessionary danger has passed.



Best regards,



Desmond

Non-Manufacturing ISM Report

Non-manufacturing business activity in January contracted for the first time since March 2003, according to the Institute of Supply Management's monthly report on business. The non-manufacturing index came in at 44.6%, while the business activity/production index dropped to 41.9, from 54.4. A reading below 50 indicates contraction. Economists were expecting a reading in the range of 52.4%.

New orders were hit hard, falling to 43.5, from a 53.9 reading in December. Employment, imports, and inventories, expanding just one month ago, contracted significantly as well, well into the low 40s.

To see the full report, click here.

Blizzard?

Employment drops in a pink slip blizzard

That's the headline on a story by AP Economics Writer Jeannine Aversa about last week's employment report. Is it any wonder that a majority of the public believes the US economy is already in a recession?

WASHINGTON - In a shower of pink slips, U.S. employers cut jobs last month for the first time in more than four years, the starkest signal yet that the economy is grinding to a halt if it hasn't already toppled into recession.

A shower of pink slips? Um, the economy lost 17,000 jobs last month and when you consider that government cut 18,000, the private economy actually added 1000 jobs. Not a robust number to be sure, but "a shower of pink slips"? Hardly.

It's no secret that the economy is slowing but is it too much to ask the AP to just report the facts and leave the editorializing to the editorial page?

Market Summary

Stocks sold off a bit today after a rash of broker downgrades in the financial sector. UBS downgraded the credit card issuers to sell. Wachovia got a downgrade from Merrill and JP Morgan also took a hit. The brokers were also down with Goldman Sachs and Lehman both down over 3%.

It is not surprising after the rally last week to see some profit taking. There is not a lot of economic data this week but we will be getting a lot of earnings news. About half the S&P 500 has reported already with earnings down almost 20% from last year. Excluding financials though earnings are up about 10% so the damage so far has been limited to that area.

Sentiment only improved slightly last week:

Bullish 30.1%
Bearish 48.9%
Neutral 21.1%

For now, the major stock market averages are still in short term downtrends. The economy is slowing but the data is mixed as to whether we are in a recession. There have been some weak reports (employment) and some not so weak (ISM,Durable Goods, Factory Orders).

Are we in a recession? I don't think so but frankly I don't think it matters all that much. Even if we avoid an official recession, the market has already discounted one. If I'm wrong and the economy is in recession, most of the selling has probably already happened. If I'm right, the selling was overdone and we will recover relatively quickly. If not, the recovery will take longer.

This year has been a great lesson in the wonders of diversification. Stocks have taken a beating but REITs and bonds are up for the year. The commodity indices have also performed well; the Goldman Sachs index is flat and the DJ AIG index is up. Another lesson is that predicting the future performance of any market is impossible. Who would have predicted that REITs would be up for the year?

Factory Orders

New orders for manufactured goods in December, up six of the last seven months, increased $10.1 billion or 2.3 percent to $441.6 billion, the U.S. Census Bureau reported today.

The market is apparently taking this negatively as the report is less than expected. Orders are up over 5% compared to last year which would seem to be a rather healthy gain, but with the negative sentiment in the market, I guess all news is bad.

Reforms that Work

TCS Daily has an article by Johnny Munkhammar, "Reform Lessons for the United States" about the politics of real change. All the candidates for President are presenting themselves as agents of change but cynics like me aren't buying it. Why?

Reforming is usually seen as politically difficult. Luxemburg's then-Prime Minister Jean-Claude Juncker stated frankly that: "We all know what to do, but we don't know how to get re-elected once we have done it." Clearly, there are many opponents to reform - such as populist media, special interests and within the civil service. And reforms usually have a short-term cost, but larger long-term gains.

When your primary goal is to get re-elected and reform is seen as an impediment to this goal, well I think we all know what a politician will do.

Anyway, after reading this article, I thought it might be interesting to investigate some reforms that other countries have made that were successful and see why these reforms are being stifled in the US. My first choice for research is education. I believe in public funding of education. There are obvious benefits to society of having an educated population and while a strict libertarian would probably scoff at the idea that government needs to be involved at all, I think the benefits of public funding outweigh the costs to freedom.

I have for many years been in favor of vouchers for school funding. It seems obvious to me that the problem with our publicly run school system is a lack of competition. If monopolies are bad in the private sector why should we expect them to be any different in the public sector? And make no mistake, publicly run schools are as close to a monopoly as you can find in this country. So the obvious question is, has any other country tried a large scale voucher system? What were the results?

It turns out that there is a country that has a large scale voucher system that has been running since 1992. And the biggest surprise is that it is Sweden, a country not known for its free market approach to government. How has it worked? Apparently, pretty well.

Here are links to several articles about the Sweden experience:

Hoover Institution

Frontier Centre for Public Policy

BBC

The Fraser Institute

The Telegraph

The American Spectator

And it turns out there are other countries that use a voucher approach successfully. Denmark and the Netherlands also use a voucher approach. Why is it so hard for the US to follow a reform that has proven popular and successful in other countries? The obvious answer is the opposition by teachers unions. But is their opposition logical? I think not. In countries that have tried voucher schemes the number of schools has increased dramatically and therefore increased the options available to teachers. It seems to me that teachers would benefit as much as students if a voucher system were in place. Teachers would have more freedom to teach how and where they want. Pay would be more based on performance and competition for good teachers would likely increase pay for them while limiting the pay and advancement opportunities for poor ones.

It is time we finally addressed the poor performance of our public schools. The logical and proven method for doing that is a voucher system. Now we just need a politician with the guts to get it done.

Next I'll take a look at privatizing government pensions (such as Social Security).

Another Interpretation

Monday Greg Mankiw blogged about a new model for predicting recession:

Tim Kane of the Joint Economic Committee staff has a new paper on Employment Numbers as Recession Indicators. The abstract:

This paper investigates the value of employment data as real-time recession indicators. Among popular monthly labor measures, the unemployment rate is the most useful as an indicator of recession, whereas two top measures of employment growth–payroll jobs and civilian employment–have little value. Two other series, the labor force participation rate and the employment-population ratio, also provide little or no value in anticipating a recession. The best pre-recession employment indicator is actually weekly claims for unemployment insurance (UI). The paper reviews a new technique for predicting recessions, and develops an employment recession probability index. The index indicates a 35.5 percent chance that the U.S. economy is in recession, sharply up from 10 percent last month.

Today, Kane used the model to interpret the latest data:

In this morning's BLS Employment Situation report for Jan 2008, the unemployment rate is 4.9. Therefore the new employment-based recession probability index (RPI) is 0.060 (or 6.0%).

The RPI is a combination of the two most valuable employment indicators of a recession's early stages: weekly initial unemployment insurance (UI) claims and the unemployment rate.

The 4-week moving average of initial UI claims was reported yesterday at 325,750, which is 17,000 lower than 4 weeks ago and essentially unchanged from the October average. Alone, trends in UI claims suggest a 4 percent recession probability. The unemployment rate is 0.1 points lower than December, but 0.1 higher than three months ago, suggesting an 8 percent recession probability. Combined, this yields an overall recession probability of 6 percent.

I sure hope his model is right, but that claims report on Thursday was pretty lousy. If we get confirmation of a trend up in claims the odds of recession, even using this model, will rise significantly. I've been using claims as my primary indicator on employment for years. It always seemed logically to be the most accurate information because of how its produced. The weekly numbers come from actual unemployment insurance claims data provided by each state. It would seem to be the most up to date information available. Too bad I didn't build a model to prove it.

Hello Desmond

Last year on this blog, I spent a few entries debating with Desmond Lachman and it was quite stimulating. Mr. Lachman and I have different views of how the world works but I think we both are gentleman enough to debate in a civil manner. So, Mr. Lachman has a new article at TCS Daily that deserves a response.

The article is titled, "Bernank Also to Blame"; I certainly have no problem with that as I blame most of our problems on the Fed no matter who is in charge.

As the United States' worst housing market bust since the Great Depression raises the specter of a nasty recession, a serious reappraisal of Alan Greenspan's 17-year chairmanship of the Federal Reserve is underway. Justified as this reappraisal might be, it should not be allowed to detract from Ben Bernanke's role in today's US housing market debacle, especially since Mr. Bernanke assumed the Federal Reserve chairmanship in February 2006 a full year before the worst of the sub-prime lending excesses were to be made.

The gist of the article is that Alan Greenspan was responsible for most of our current mess by holding interest rates too low for too long. Furthermore, according to Lachman, Greenspan should have used the Fed's regulatory powers to rein in sub prime lending. As usual, Mr. Lachman prefers a regulatory approach where a free market approach would suffice. Sub prime would never have grown as large as it did if credit wasn't so easily available and the cause of that is the price fixing of the Fed.

Mr. Lachman and I agree on one thing. The Fed ignored asset prices in setting monetary policy and that was a huge mistake. Of course, if the Fed were held to some type of hard money standard this wouldn't be an issue.

Worse still, Mr. Greenspan never tired of arguing that it was not the job of the Federal Reserve to attempt to identify asset price bubbles. Nor did he believe that the Fed should pay attention to asset price inflation in setting monetary policy. He did so in total disregard of the United States' own untoward experience with the bursting of the NASDAQ bubble as well of that of the Japanese experience with the bursting of their asset price bubbles in the late 1980s. Rather, he left it to his successor Mr. Bernanke to deal with the consequences of having created outsized housing price and credit market bubbles.

Mr. Lachman then lays out why Bernanke is also responsible.

While one has to sympathize with Mr. Bernanke's present predicament, which is hardly of his own making, one has to ask why was he as passive as he was in 2006 as the worst of the sub-prime loans were made under his watch. During that year, a total of around US$600 billion in sub-prime mortgage lending, or around one half the total amount of sub-prime lending presently outstanding, was made on conditions that were materially more lax than earlier vintages of sub-prime lending. Indeed, it became commonplace for banks to extend loans up to 100 percent of the value of the underlying property and to make such loans to borrowers without incomes, without jobs, and without assets.

Mr. Bernanke also needs to be held accountable for totally misjudging how serious would be the bursting of the housing market bubble and how large would be the losses to the financial system from imprudent sub-prime lending. In April 2007, when he first identified that something was amiss with sub-prime lending, he assured Congress that the sub-prime problem would be limited in size and that any fallout would be confined to the housing sector. A few months later he was forced to concede that sub-prime mortgage lending might result in losses to the financial system of the order of US$50 billion to US$100 billion, only to have to modify these estimates again to something in the ballpark of US$150 billion. He did so even though current market estimates of sub-prime mortgage lending losses are anywhere between US$200 billion to US$400 billion.

Of course, this is the essential problem with central banking. It relies on a small group of people to set monetary policy for a very complex economy. It can't be done without mistakes being made.

Mr. Lachman also blames Bernanke for not lowering rates fast enough:

Mr. Bernanke's misjudgment of the severity of the housing bust blinded him to the need for early and decisive monetary policy action. Indeed, it was as late as the middle of August 2007 before the Federal Reserve started the current interest rate cutting cycle. This was long after it had become apparent to most market observers that large sub-prime losses and a lack of transparency in the new fangled debt instruments were leading to a seizing up of the international banking system. And even when the Fed did begin cutting interest rates, it did so gingerly and it repeatedly underestimated the downside risks to economic growth from the housing market debacle.

The Federal Reserve's dramatic 75 basis point inter-meeting cut on January 21 suggests that at last the Federal Reserve is grasping how serious is the threat to the economy emanating from a lethal combination of a major housing market bust, an acute credit crunch, and international oil prices at close to US$90 a barrel. While this latest cut is too late to prevent a recession in the first half of 2008, it does give hope that the Federal Reserve will at least not repeat the mistakes of the Great Depression or of Japan's lost decade, when monetary policy was kept too tight for too long in the face of the bursting of large asset price bubbles.

Okay, if the problem was created by a monetary policy that kept interest rates too low for too long, why is the cure to cut interest rates and repeat the cycle? I would also argue that the lesson to be learned from the Depression and Japan is that monetary policy does not work with a broken banking system and that banking sytems are broken by monetary policy that encourages banks to make bad lending decisions. Furthermore, government intervention and Keynesian pumping of aggregate demand merely prolong the pain.

Mr. Lachman wants a world of rules where things are predictable and all problems can be prevented through regulation and other types of government intervention. While that might be a wonderful world, it doesn't exist. Most of our economic problems are caused by government intervention. You can't solve problems created by excessive money creation by creating ever more. Neither can they be prevented through regulation as long as the Federal Reserve is still setting monetary policy based on nothing more than the group guessing of the FOMC.

Japan Redux?

Jim Jubak worries that the US will fall into the liquidity trap that bedeviled Japan for 15 years after their stock and property bubbles popped back in the early 90s. It's something I've worried about too, but in the end I don't think we will get the same result as Japan. Here's the lead from Jubak:

Ben Bernanke's Federal Reserve increasingly looks like it's headed toward a repeat of the errors that took Japan into a decade-long banking crisis and economic slump, beginning in the early 1990s.

Welcome to the United States of Japan, where growth slows to a crawl, the stock market goes nowhere and savings earn nothing. Just in time for the retirement of the baby-boom generation, too.

There are a lot of similarities between the current situation in the US and the Japan of the early 90s. There are also some significant differences. In Japan the banks took much longer to write off bad loans due to a cultural aversion to shame. In the US we tend to take our lumps and move along. I don't remember any bank CEOs getting canned in Japan over their problems. The bubbles in Japan, particularly in real estate, were also much bigger than ours.

The major difference though is the role of the dollar. Japan's bubble popping experience resulted in deflation. I suspect that when our economy finally succumbs to the massive amount of debt we've built up, the result will be inflation as all those dollars we've spread around the world come home to roost.

Jubak makes some good points though. The Fed may cause the credit crunch to last longer by giving the banks hope that policy will bail them out:

By giving banks the hope they can dodge rather than bite the bullet, the Federal Reserve has created the possibility that what would have been a very painful but short lesson for the banks could turn into a long-term drag on the financial markets and the economy.

If banks lend less because they're spending so much time watching their past mistakes that they shudder at the idea of adding loans to their balance sheets, if nobody trusts the prices for distressed assets, so big parts of the financial markets remain frozen in place, if consumers and corporations with decent credit can't get new loans to fix bad ones or to expand production or consumption, then the economy will run slower than its potential. And if the Japanese experience is any indication, it will run slower for a very long time.

Manufacturing ISM Survey- January

The manufacturing sector expanded in the month of January, according to the Institute of Supply Management's business survey. The purchasing manager's index (PMI) rose 2.3 percentage points, to 50.7%. A reading above 50 indicates expansion, while a reading below signals contraction.

New orders are contracting, albeit at a slower rate, coming in at 49.5. Production increased from 48.6 to 55.2, while employment contracted to 47.1. Exports are still in high demand, growing at a faster rate than the previous month, and for the 62nd consecutive month.

The overall economy continues to grow for the 75th consecutive month.

Jobs? What Jobs?

The January jobs report was pretty lousy. Down 17,000 jobs. The unemployment rate dropped to 4.9%.

Anyone who reads this blog knows I've been saying that we were not heading for recession so I will not sugarcoat this. This is a bad report. Factory payrolls were down 28000, construction was down 27000. Services added 34000 and retail added 11200. Government lost 18000.

I guess we should be encouraged that January is a notoriously weird payroll month. The Census Bureau updates population numbers and we get benchmark revisions to old employment data. For instance, December was revised up by 68000. Overall the revisions resulted in lower employment numbers for the last year.

I also wonder about the difference between this report and the ADP report yesterday. The ADP report tracks the revised numbers from the government pretty well so it may be that this number gets revised higher at some point in the future. But I don't think we can count on that.

From a market perspective, this may not matter all that much. It is not a secret that the economy is slowing and a bad number was fairly well factored in. However without the Microsoft/Yahoo news this morning, I suspect we'd be down pretty hard at the open.

At this point it is getting hard to stay in the slowdown instead of recession camp. If we keep getting lousy numbers like this, it may turn out that I've been wrong about the economy. It won't be the first time and probably not the last. One saving grace is that I don't have to be right about the economy for our investment strategy to work. We've performed much better than the stock market recently due to our exposure to commodities, bonds and even REITs. Diversification works.