Fractals of Change

Nothing to Fear But Fear Mongers Themselves

Have we been talked into a recession? There's little question that's where the economy is now and it seems to be spiraling deeper by the day as we anxiously cut back on almost everything and, in the process, help make our worst economic fears come true.

Did it have to be this way?

Just a few months ago we had mainly a severe problem with mortgages that should never have been written. The people who shouldn't have had the mortgages were losing their homes (or speculative investments); the people who shouldn't have bought the mortgages, including the companies that shouldn't have written the mortgages and the companies that shouldn't have securitized the mortgages, were in a lot of trouble.

But, other than housing prices which were arguably too high anyway, the real economy seemed to be doing pretty well. This being an election year there was a healthy dose of "stimulus" from Washington. Many more dollars than were in the stimulus program were saved by drivers who went on partial strike and helped drive the prices of gasoline and oil back to less than they were a year ago. Most of these were dollars that otherwise would have left the US economy so that was pretty much all gain.

So why are we having a recession? At least partially because we were talked into it. But who would want to do that? Who would want to spread so much fear that the mighty US consumer put his or her credit card under the mattress?

• Bankers who wanted a bailout (and got it)
• An administration that needed to justify bailing out the bankers
• A Treasury Secretary with a bankerish POV
• A Fed chief whose academic specialty was the Great Depression
• The Democratic Party which wanted to show how bad things had gotten on the Republican watch
• The McCain campaign which wanted to show it wasn't four more years of W
• Those who would like to regulate everything in sight (forgetting that regulated Fannie Mae and Freddie Mac were among the worst offenders)
• Those in Congress who didn't want the blame for pushing Freddie Mac and Fannie Mae to make worse and worse mortgages
• Everybody else who wants a bailout and has seen that the threat of bankruptcy is the best way to get one
• A press which is largely economically illiterate but can tell scary and sad stories well

Turns out there was almost a perfect storm of fear mongering and we got scared. Now there is a recession. Recessions happen when money stops moving (more on that here).

The consumer price index has fallen by a record amount month over month led by fuel and housing but other stuff is getting cheaper as well. The post-Christmas sales have started before Thanksgiving this year. Consumption has gone out of style – bad timing that.

If you're in debt, it IS a good time to cut back. Cash is king and we are at least partly in a deflationary time. But, if you have some money, it's not a bad time to go shopping both because you'll get good prices and because the economy needs you not to hoard. Want to be socially responsible, buy your family a fuel efficient car, furnace, or solar something or other. Good time to hire some people to do some work around the house you've been putting off. Good time to give to your favorite charity which is probably hurting.

Scary as it is, it's a good time to invest as well. We're somewhere between the end of the last bubble and the beginning of the next one. More fortunes'll be made by investing now and waiting patiently for returns than waiting for a safe time to invest.

Some ideas on how companies should invest are here.

It's also a good time for leadership – away from fear. Here's hoping we'll get that.

The Glass Is Half Full

Many of the basic problems in the American economy are rapidly being addressed – it's the "rapidly" part that's the problem.

A year ago we had the following economic problems:

• The savings rate was too low
• Credit card usage was too high
• Energy prices were staring to soar
• We imported too much oil
• We bought and drove too many gas guzzlers too far
• Housing prices were too high
• People were getting housing loans they'd never be able to repay
• The dollar was very weak
• There were signs of inflation
• Jobs were being created overseas (and perhaps lost here)

So this week we got the good news that savings as a percentage of personal disposable income ROSE to 1.3% in September from .8% in August, a more than 50% increase! The .5 percentage point increase in savings was funded by a .2% INCREASE in personal income for the month AND a .3% DECREASE in spending. Americans took all the increase in income, matched it with a decrease in spending, and salted it away. The consequence – GDP (Gross Domestic Product) is down .3% for the latest quarter since we bought less stuff. The pain is today but there is a real promise from gain in the future from that additional savings (doesn't that help the banks, BTW?)

Credit card solicitation is down and banks are reducing some lines of credit. Those who complained about the avalanche of indiscriminate credit offers of prior years should be glad about this. Even those with good credit are using it less – just ask American Express. But less credit does mean less spending.

The price of crude oil is down 60% from its high; gasoline is down nearly 40%; home heating this winter may be cheaper than last if the weather cooperates. Hardly anything to complain about there – although it does reduce some of the pressure for fuel economy and alternative energy.

Not only is the price of the oil we import down; the actual amount imported is down as well. That's a lot of money that stays home; that's a lot of money that doesn't go to unfriendly places. Some of the leaders of unfriendly places are unhappy about that – Ahmajinadad and Chavez, for example. Too bad.

So far, despite the drop in the price of gasoline, we're still driving less and looking for more fuel efficient cars to do our driving in. That's tough on gas-guzzler makers and certainly on workers in the auto industry. It's also a fleet-replacement opportunity as well as a reason why a lot of retooling'll happen.

Housing is getting downright reasonable. Congresspeople demanded that Fannie Mae and Freddie Mac loosen credit standards because houses were too expensive for people to afford if traditional credit measures were used. Of course the unwise credit not only put people in houses they couldn't pay for and prompted leveraged housing speculation, it also helped drive the cost of housing up even further. The volume of house sales is now increasing despite belatedly tightened lending standards – the buyers are super-qualified and are getting good value; the backlog of unsold housing is just beginning to shrink. But this correction has hit the balance sheet of many Americans – especially hard hit are those that withdrew the gain in value of their houses by taking out second mortgages and spending the proceeds. The gain is gone and the debt isn't.

Funny thing happened in this financial crisis which has been labeled as "made in America" and taken as an indication of America's fall from economic power: much of the world suddenly wanted to hold dollars. The dollar has strengthened so much as a consequence that the US and other countries recently intervened AGAINST it. Much of the rush to guarantee bank deposits in the rest of the world was from fear that capital would flee to the US despite an only limited guarantee of deposits here.

A stronger dollar means less inflation. So does the economic slowdown – especially the reduction in the velocity of money (see this post). This morning the New York Times finally got around to realizing that deflation is now the economic threat of the moment.

Since a lot of what we buy comes from overseas and the US has become much more a services economy than it was, the bite of job loss when we cut back spending is also globalized. We still need plumbers and doctors (but not as many bankers); but we're not buying as much of what China makes. Those layoffs don't happen here.

So why all the happy talk from me? There certainly is plenty of pain in what's happening economically. Real people are losing real jobs. People who'd hoped to retire soon have seen their savings evaporate. Deflation brings more than a cure for inflation; it also brings the threat of depression. Huge segments of our financial industry have been partially nationalized; we'll pay for that for a long time to come.

But we need perspective. This correction from excess has been violent and in many ways harmful but it HAS cured many of the excesses; the goal shouldn't be to reestablish them. We don't want housing prices to boom out of reach again; we don't want oil prices to go up or credit to be extended promiscuously; we don't want a banking economy based on the third derivative of valueless debt. We need to be wary of those crying "crisis" because they have a solution to sell. We've already gone too far in pouring aid in at the top of the financial system hoping (to put a good light on it) that it'll trickle down.

We will need to cushion some of the pain at the bottom of the economic heap; there'll be more need for unemployment insurance before there's less. We can't afford to let starved states cut back on infrastructure projects both for the sake of the infrastructure and for the sake of the economy. But we also want the excesses that have been corrected stay corrected – at least until the next bubble.

Gush Up vs. Trickle Down

We shouldn't try a trickle-down approach to "saving" the auto industry and especially the auto finance companies; instead, if aid is needed at all, it should be shoveled in at the bottom of the economy from which it is sure to gush up (see a sample plan below).

The New York Times has done a great job of revealing that banks are using their bailout funds not to make more loans but to buy out their competitors. Now Cerberus, the private "capital management" company which owns most of Chrysler and a majority interest in GMAC is seeking federal aid for a plan to bail out its badly timed investments in the auto industry. Cerberus and GM have been fairly frank that the aid is needed to finance massive layoffs so that combination of Chrysler and General Motors can save cash. The question is why would we want to use taxpayer money to do that?

There is no promise that more money will mean more loans to car buyers. There is no promise that a taxpayer bailout will result in cars Americans want to buy even if they can get loans. There is also no recognition that "foreign" car makers are building cars in America with American labor that Americans want to buy. Do we really want to endanger the American jobs at Toyota in order to finance layoffs at GM and Chrysler?

Trickle-down aid to an economy doesn't work because 1) a trickle is too slow to aid an economy which has seized up; 2) the money tends to stay at the top – eg. be used for buyouts and/or executive salaries rather than flowing out into the broad economy where it's needed.

A Gush Up Proposal

Suppose that, instead of bailing out Cerberus and GM, we use our bailout funds to buy any and all cars and light trucks over ten years old BY THE POUND. Prices should be set so they are higher than the small amounts these cars fetch on the resale market today. All such purchased cars will be scrapped and recycled; in fact the program should be run through the junk dealers – they have much less overhead than banks. To avoid buying already scrapped vehicles, only those cars and trucks which have been registered for the last twelve months should be eligible.

The nice thing about putting money into the bottom of the economy is that it's sure to gush up. The owners of ten year old cars aren't going to stuff the money in their mattresses or finance neighborhood buyouts.

A few will be able to get by with one less car and switch to mass transit and use the money for other necessities. That's all goodness. Most will buy another not-quite-so-used car; there's a very good chance the newer car will use less fuel than the old one, especially since that's what people know they want and because cars get inefficient as they get older; also we're paying more for heavier cars so we're getting them off the road. That's a bonus.

The people who sell the not-so-used-cars to the people who scrapped their junkers will now have more money to spend on a new car. This is true whether the used cars pass through dealer lots or not. The dealers, who are in bad shape, will benefit from a firming of used car prices. Also, the more you get for a tradin, the less financing you need for your next purchase.

Money put in at the top tends to stay at the top; money put in at the bottom flows through the whole economy. The gush-up proposal will put money into the hands of the consumers most likely to spend it instead of the bankers most likely to hoard it. Gush up will also reduce the average size and age of vehicles in the American fleet and further reduce our gas consumption. Let's do something like that if we need more bailouts.

The Physics of Money

Money doesn't count unless it's in motion; that's why governments not only can but also feel that they must create great supplies of the stuff in these deflationary times. The good news is that all this new money isn't inflationary (at the moment); the bad news is that this new money so far isn't breaking the deflationary cycle because it's refusing to move.

A simplistic but not inaccurate view of inflation is that it occurs when too much money is chasing too few goods; deflation, of course, occurs when money is the scarce commodity and other goods – houses, say, or oil – are abundant. So how did we go from inflation to deflation so rapidly? Where did all the money go?

Basically, the money went into various mattresses; it stopped moving.

The definition of money is complex; it's much more than just cash. It's also the debt of governments and even private entities; it's the outstanding balance on your credit cards; it's lots of other stuff. But it only counts when it's in motion. Economists speak of the velocity of money; the number of times it changes hands (turns over) in a year. The effective money supply, the money supply which at any given moment is either too big or too small for the goods available, consists of the absolute money supply MULTIPLIED by the current velocity of money.

This is easier to think about if we pretend that money is just cash. Suppose that the 100 residents of an isolated village have a million dollars of cash in their economy. How much income, then, can each resident have? The answer depends on the velocity of that million dollars. If it turns over only once a year, then the mean income will be $10,000/resident. But, if the money turns over ten times a year, if each resident spends income almost as fast as he or she earns it, the mean income will be $100,000 since each dollar changed hands ten times and got counted as income ten times.

The faster we spend, the more money there is available in the economy. Money we put in our mattresses might as well not exist as far as the economy is concerned even though it may be very important to us. Money we put in the bank is USUALLY as good as spent economically because it gets lent to someone else who spends it. But these aren't usual times; if the bank doesn't relend the money, it might as well be in a mattress.

Banks aren't lending like they used to; we aren't spending like we used to. The velocity of our money supply has slowed to a crawl; that's how we moved from inflation to deflation; the money stopped going around.

Deflation causes (and is caused by) depressions. Governments rightly don't want depressions to happen on their watch, makes the citizens surly. So governments around the world are creating vast supplies of new money to counteract the fact that the money is moving slower. It's debatable (but not in this post) whether the money is being injected into the economies of the world at the right place to get it in motion; but there's no question that lots of new money is being deliberately created to fight deflation. Inflation isn't a concern because deflation is the problem. Governments want prices to stop falling so they're working to cheapen their currencies – backwards of what we're used to since inflation is what we usually worry about.

One danger in this deflation-fighting strategy is that it can lead to hyper-inflation. The absolute money supply is being increased; if it then goes into rapid motion, the effective money supply goes through the roof. Money will go into motion if people are afraid it's going to lose value; in that case they'd rather have goods so they start spending. Some of that is good to break the current deflationary cycle, a lot of spending with a bloated money supply ends up in a situation like Weimar Germany or Zimbabwe.

Aren't you glad you aren't running the Fed.

 

Too Big to Fail

There's an excellent article in this morning's New York Times which begins:

"The financial crisis is forcing regulators to encourage the creation of bigger, more interconnected institutions. In the short term, this may serve a useful purpose by allowing healthier, well-capitalized banks like Wells Fargo, Bank of America and JPMorgan Chase to shore up weaker ones.

"But it also presents a serious threat to the financial system by fostering financial behemoths that are, to use Federal Reserve Chairman Ben S. Bernanke's euphemism, 'systemically critical.' Policy makers need to start thinking about how to downsize institutions that are becoming 'too big to fail' before the situation comes to that."

"Systemically critical" is a good phrase even though it sounds like jargon. Those of us who have built complex interactive systems know that nodes which are significantly large compared to the network as a whole pose an outsized risk. The Internet is a triumph of decentralized relatively small nodes, none of which is "too big to fail". There are always nodes failing on the Internet; this is the normal state. A brilliantly simple architecture allows the network as a whole to remain functioning despite constant failure of nodes. Because the nodes themselves don't have to be made failure-proof (which is impossible anyway), the nodes are so cheap that redundant nodes are easily affordable.

The current crisis began with the failure of mammoth nodes – blaming it on improvident home-buyers is simply absurd. These mammoth nodes – especially Fannie Mae and Freddie Mac - accumulated risk in a way that would have been impossible in a more decentralized time. Some community banks would certainly have been imprudent even if they'd had to keep the mortgages they wrote on their own books (remember the S&L crisis); but the system could much more easily have tolerated the failure of a few of these small nodes AND their failure would have encouraged others to be more prudent.

Until the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 branch banking across state lines was forbidden in the US; that was a significant barrier to horizontal concentration. Bank holding companies were not allowed to own non-financial institutions until the passage of the Gramm-Leach-Bliley Act in 1999, a barrier to vertical concentration. Both acts were passed not only because of huge lobbying efforts by financial institutions which wanted to grow but also because there was a perceived (and quite possibly real) need to allow US banks to grow large enough to compete with less-constrained foreign entities.

With the limits gone, the monster banks grew albeit with some regulation, especially around their FDIC-insured deposits. However, this regulation did not include institutions like Merrill Lynch, Morgan Stanley or Lehman Brothers which were non-bank holding companies and could neither own banks nor offer FDIC insurance to "depositors". These institutions had the advantage of light regulation but the disadvantage that competitors like Bank of America and Citicorp could offer a full range of bank and non-bank services and had a base of insured deposits which wouldn't flee in a crisis. In recent months all of these either failed (Lehman), merged into bank holding companies (Merrill), or converted and became "banks" subject to regulation (Morgan Stanley). But we got even more concentration.

There's no question anymore that institutions which are too big to fail are also too big to leave unregulated. There is significant question whether any degree of regulation will be sufficient to prevent failure. Nodes fail for unexpected reasons – usually not the ones you're watching for. Fannie Mae and Freddie Mac were regulated; that didn't help much. The problem of adequate regulation grows even worse when government owns a stake in what it regulates and, of course, that's exactly what's happening with the banks.

Perhaps, immediately after the immediate crisis we need a form of antitrust which limits the size of financial institutions. Part of this might be accomplished by reducing the amount of federal deposit insurance on each account (this was just raised) to force investors in search of the safety of such insurance to spread their wealth among banks. Maybe the total amount of insured deposits any institution can offer should be limited; this step would eliminate the risk of having institutions big enough to bring down the FDIC itself. In a global economy, such limits will be very hard without similar steps being taken worldwide. But it's a better problem for world financial leaders to work on than weekly rounds of "coordinated" bailouts.

Nothing should be too big to fail because nothing can be made failure-safe.

Has the Financial System Disconnected?

Before finding any Internet access – and so before we had any news in English – we found an ATM. Tried Mary's card and it failed authorization; tried mine – Oh oh: same problem.

Our first thought was that the world financial system had simply disconnected at the retail level! Maybe I should'nta been so antibailout. Now there's personal panic; conserve cash at all costs. Eat only at restaurants that take Visa. But is Visa working?

Tried our Visa and it still worked for purchases. Not a complete disaster yet.

Tried another ATM machine and it took both cards fine. Panic over.

But we do depend on a lot of stuff working. Hope when the banking system is put back together (if it doesn't become a government agency) that it is much less concentrated and centralized – sort of like the Internet. Not what's happening now at all with consolidation despite the fact that "too big to fail" entities caused the current problems.

The Dow’s a Brat

We've all seen parents unwisely offer treat after treat to a sullen child to stop him or her from misbehaving in public – may have even done it ourselves. The brat grabs each gift, quiets down for a few minutes, then has a fresh and louder fit to extort another gift. No reason to stop as long as the gifts keeps coming.

Before the opening of each of the world's markets each day, the central banks offer a new bunch of gifts to investors. Sometimes the markets even go up for a few hours; but, before the close, they're back down in anticipation of the next gift.

IMHO the market won't stabilize until it has to go a few days without any new goodies. (I have no idea when it will "recover", maybe it HAS just recovered to its "correct" value). As hard as it is, the central banks have got to stop navigating by the stock tickers in the rearview mirror. BTW, if a country says it will insure ALL bank deposits during scary times, wouldn't it be reasonable to expect that people will sell stock and put the money in the bank? I did. So why would anyone assume that the stock markets would go up on this type of news?

If we have nothing to fear except fear itself, we have plenty to fear when governments are acting as if the world is ending. The Dow started to go up two days after the House first rejected the US bailout; it fell after the bailout and is still falling. Could that be because people interpret the Senate's action and the House's about face as evidence that things are worse than they appear?

From the Wall Street Journal: "The way some investors see it, if the government feels the need to intervene more drastically, the problem might be even larger than it had seemed."

Meanwhile in the real economy: crude oil has come down almost 50% (and our import volumes as well) so the trade deficit is down despite less exports. The dollar is up except against the Yen. Gas is already below $3.00 gallon in very low-tax states. It may well cost less to heat our houses this winter than last. Housing is more affordable than it's been in five years. But government keeps scaring us – and giving gifts to the screaming brat.

Deflation Winners

Are American high tech companies the big winner from the current bouts of deflation? Is the US itself a winner? Remember, deflation changes all the rules we've been used to. You've got to think upside down now that cash is king, at least temporarily.

Fred Wilson points out that companies like Microsoft, Google, and Apple have loads of cash and no net debt. He speculates that the others will emulate Microsoft and do massive stock buybacks at the their current relatively low trading prices. That would be a pretty boring use of all that cash. Remember that traditional companies in our economy – phone companies, for example – run on mountains of debt. Debt's hard to get now (how's that for an understatement?). Debt you've already got is hard to roll over. Is there an opportunity here?

Well, the high tech companies have been fretting that the phone companies will become gatekeepers on the Internet and suck value and tolls out of the exchanges between the high tech companies and their customers. Should Google just buy AT&T? Or supply it with financing? Should Intel begin making the guts of cars and Microsoft supply operating systems for them? I'm sure there are better and more exciting ideas than these but we are in a time when the nouveau cash rich can run rough shod over the debt-ridden legacy companies even though the two are not usually thought of as direct competitors.

And what about the US itself? Certainly we've got plenty to worry about in our own market meltdowns; most pundits first reaction was to say that the financial crisis was a step in the downfall of the US? If so, how come the dollar is going up against almost every currency except the Yen? We worried that foreigners might not be willing to finance the borrowing that the US is doing (wisely or unwisely) to prop up markets. Well, the foreigners voted with their money and the interest rate on US bonds keeps going down – for short term US notes the real interest rate is below zero: Uncle Sam is being paid to hold the world's money.

I have a theory about that. See, cash is king but what's cash? Most of us don't keep it in our mattresses. It's not gold because that goes down in times of deflation. It used to be money in the bank counted as cash but people have gotten so nervous about banks that even the strongest are being partially nationalized. Money funds now have a limited guarantee for old deposits in the US but not much of the rest of the world. So what's cash? Turns out for many people it's an IOU from the US – all antiAmericanism aside for the moment.

Hmmm…

Deflation Primer is a related post.

Don’t Catch Falling Knives

During the collapse of the dot.com bubble, I believed that the stock of the company I'd founded, ITXC, was grossly undervalued; so I bought some both hoping to profit and also to calm the market by showing investors that I was willing to risk my own money in the stock – when CEOs buy it's public information. I may have calmed the market for about five minutes. Buybacks by cash-rich companies have some good purposes – but they won't stop a bubble bursting, either. I also tried to convince the investment bankers who bought us public to invest in the stock of company they recommended. "We won't try to catch a falling knife," one of the bankers said rather unkindly. Ironically, the bank was Lehman, one of the few big financial knives the government didn't try to catch.

When we had a rapid deflation of the dot.com bubble and dot.com stock prices, the damage was contained because margin rules are fairly strict and people did not have loans for 100% of what the stock cost. The restriction on what percentage you can borrow of the value of a stock you want to buy (it's called "margin" if you've never indulged) was a reform enacted after the Great Depression because the stock market collapse of 1929 was intensified by lenders calling for repayment of underwater margin loans. The 1929 stock market collapse also spread more quickly and more severely to the general economy than the dot.com collapse did, arguably because so many people on Main Street had 100% margin loans.

It took until recently for the "margin requirement" on houses to go to zero, for people to be able to buy a house for nothing down. The first result of making loans for a particular kind of asset easy to get is that the price of the asset goes up because more people can obtain the cash to buy it (note that I did NOT say that more people can AFFORD it). In this case Fannie Mae and Freddie Mac with plenty of help from the real private sector and encouragement from Congress in essence created a special currency that could be used only to buy houses. Surprise, houses inflated faster than almost any other asset. The Wall Street Journal to its credit has been pointing this out for years. The New York Times ran an expose the other day – better late than never; it is well done.

For a while bubbles are self-inflating because people who get in early get rich. More real money comes into whatever asset class (stock, houses, oil, etc.) is appreciating quickly so, of course, the appreciation accelerates and attracts yet more money. But trees can't grow to the sky. Money leaks out of the asset class, too. In the case of houses there are realtor fees but that's small change. More importantly huge amounts got diverted to compensation for those who managed the flow of creative financing AND people took out home equity loans based on the inflated values of their houses and spent these loans for non-housing purposes. In the dot.com bubble, there were also high financing fees, employees exercising options and immediately selling, and founders and VCs cashing out.

Moreover, the supply of a bubble asset class is bound to increase whether the asset is houses, stock in dot.com companies, or tulip bulbs.

Once the supply increases sufficiently and the outflow of cash from the asset class exceeds the inflow, pop goes the bubble! Always happens but no one knows when.

In the early stages of a bubble bursting, almost everyone expects the assets to recover to the value they had at the top of the bubble – almost everyone waits too long to sell because they are betting on "recovery". But, since the assets were overvalued at the top, that's not what the price is recovering to; the price is moving back to what it would have been if there's never been a bubble. That's why it's premature to look for a housing recovery now. There are also always attempts to "calm the market" in the hopes that nothing is wrong other than a gust of fear. We're seeing that now with many calls to support the price of houses. But, if the asset was grossly overpriced and a bubble is bursting, money spent on calming will disappear as if it were thrown into a black hole.

The deflation of a bubble bursting gains momentum just like the original inflation. If the assets were purchased with debt – and they almost always are during a bubble because leverage increases profits, once the price falls far enough, owners of the assets have to sell in order to pay off their loans. The supply of asset for sale increases as money available to buy the asset class decreases. The price goes down through whatever it would have been had there been no bubble. Eventually, of course, that sets the stage for a recovery if not another bubble. The recovery, like the collapse, always happens later than it rationally should; and no one knows when that will be. Buy before the overshoot on the downside and you're catching a falling knife.

 

Bailout Blues

Last Week

"We'll surely fail

If you don't bail,"

Said Wall Street to the gov.

 

"The Dow'll crash,

Without your cash.

Send a trill our way."

 

The gov, it caved,

And quickly gave,

The bankers all they craved.

This Week

"We gave you cash,

But the Dow did crash,

Oh Wall Street," cried the gov.

 

"We never said,

Oh friendly Fed,

What would happen if you gave."

 

 

 

Deflation Primer

Deflation is the debtor's worst enemy just as inflation is the debtor's best friend. In inflationary times the value of the asset you borrowed money to buy goes up so quickly that you can always sell and come out ahead despite the interest you paid in the meantime. In deflationary time, the outstanding amount of the loan can easily become greater than the current value of the asset. Now you're underwater and can't sell without putting money in. If you're having trouble making the payments, you have big trouble.

Obviously we have deflation in the housing market today. But what's much scarier is that we may be going through a period of much more general deflation, perhaps triggered by housing, perhaps just overdue. Commodity prices have also come crashing down, also from lofty peaks of course. Deflation is what characterizes depressions (which I'm not predicting but deflation is serious stuff). Deflation also tempts governments into hyper-inflation as a cure; can you count to $850 billion?

Deflation of an asset is self-perpetuating. When houses could do nothing but go up, you offered more than the asking price before the realtor was through showing you the place to beat out the next guy. When house prices are going down, you think long and hard about making any offer at all. If you do offer, it's low. And you don't budge much in negotiation. When fuel prices were going up faster than the wheels could spin on gas pumps, we filled up when the tanks were half empty to avoid paying more tomorrow ; so did the guys with the huge storage tanks – and they borrowed money to do so. Now I drive to near empty because the gas I buy tomorrow'll probably be cheaper than what I'd pay today . The guys with the huge storage tanks have to sell to pay back their loans but the stuff now cost less than when they bought it (if you were concerned about hoarders, deflation is your revenge). Now the pendulum is swinging towards deflation even though neither houses nor commodities have yet gotten cheaper than they would have been had they only tracked the general rate of inflation for the past five years.

In times of inflation, any Wall Streeter'll tell you "cash is trash". In times of deflation, "cash is king". Everyone all of a sudden wants to see and feel his or her cash; banks are debtors; depositors are creditors. Deflation is the debtor's worst enemy; but deflation is only the creditor's friend if he or she can get paid back. More in the next post.

Now For the Good News…

It's tempting not to put any content into a post with this title today. Even a perpetual optimist like me finds his irrational exuberance dampened by what's happening in the world's financial markets. But there is good news and it's more fun to write about than doom and gloom.

Inflation was down last month

The consumer price index DECLINED 1% month-over-month in August as energy, housing, and food prices fell. This trend will continue at least another month based on what's been happening in September to those same three components. Obviously good news for people on a fixed income. Also good news because the Fed can concentrate better on recession-fighting when it doesn't have to also worry about inflation and the possible misery of stagflation. Needless to say, the Fed is grateful for all the help it can get.

Oil prices are down

Oil prices are below the $100/barrel price they were at last winter (although have moved up in the last few days). This means it may NOT cost significantly more to heat our homes this winter than last. I put my money where my mouth is and didn't sign a fixed price agreement for heating fuel but I'm nervous about this bet. It also means, for now, pressure has lightened on consumer wallets.

Oil consumption is down

Low prices together with low consumption mean that a lot less money is flowing out of the country to pay for oil – even less than was last winter. Bad for the bad guys that sell us oil; good for us because we need the money here at home. Note that the markets are punishing Putin more for the invasion of Georgia than Europeans dare to; When oil process are falling and you're wondering which oil producing country not to invest in, one which doesn't respect either international law or property rights (markets care a lot more about the latter than the former) is a good target. Guess where that investment'll end up if we allow offshore drilling?

The government is having an easy time borrowing money

People are flocking to the safety of federal debt lowering the cost of financing our deficit and making cash available to the feds; good thing when the feds have so many bailouts on their plate. Long term it's very bad to see money only available when it flows through the government.

Housing Prices are down

Huh? Good news? Yeah, it really is. Housing prices were inflated. Many people couldn't afford houses at those inflated prices. Even worse, people who couldn't afford houses at those inflated prices bought them anyway with the help of loans they shouldn't have gotten. Now prudent people – if they have a down payment and an income – can afford to buy houses again. Mortgage rates are still low. Mortgages based on t-bill rates will stay low as people flock to t-bills. This bubble had to burst so recovery could begin and the distortion of a tulip market in real estate could be cured. Not that the bubble-burst isn't very painful, particularly for those of us who overpaid and/or paid more than we could afford. But continued house price inflation would have been even worse than the cure because the eventual collapse would have been even worse.

Lehman wasn't bailed out

Hard for me to say because I have both friends and an account there. But the bailouts had to stop to make companies sell to stronger entities while they still can – as Merrill promptly did. I still don't think the bailout of Bear Stearns should have happened and think that Lehman might have avoided failure or sold itself earlier in that case. I'm not at all sure about the bailout of AIG or the form of the bailout of Fannie Mae and Freddie Mac – but there's a lot I don't know (and hope central bankers do).

The Fed didn't lower interest rates

Making money cheaper isn't the cure for every ill. There's a pretty good argument that Greenspan screwed up badly and helped ignite the housing bubble by lowering interest rates too far to deal with the aftermaths of the dotcom implosion and 9/11. When cash is trash, we're all likely to get trashed in a pursuit of higher returns.

That's probably all the good news you can stand in one day.

Invent, Baby, Invent

Tom Friedman says we ought to be chanting "Invent, Baby, Invent" rather than "Drill, Baby, Drill". Forget that this is a false dichotomy (or read this post), invention IS a good idea. I've spent most of my career inventing both technology and business models - successfully and unsuccessfully, have a handful of patents, better stuff I was too dumb to patent, and an interesting career and comfortable life to show for it so am all in favor of innovation. Unfortunately neither cheerleading nor government subsidies are very effective in stimulating invention.

Inventor invent because they can't help it – just like writers write even when no publishers'll publish. What matters to society is how many good inventions actually can be deployed. The deployment rate of invention has a lot to do with capital (and a lot to do with marketing – I've been lucky to have Mary to promote my inventions). Government capital, however, is usually harmful to the innovation process (some exceptions below). Let's take a look at energy which is what Tom Friedman is talking about.

Corny ethanol is the greatest achievement of the latest round of government-stoked energy innovation; it's a bipartisan boondoggle made inevitable by the position of Iowa in the primary calendar. It has succeeded in adding a great deal of ethanol to our fuel mix. It's dubious whether it's led to a significant reduction in either oil imports or CO2 emissions since so much energy is required to grow, transport, and process the corn and much of that energy comes from oil. It certainly has added to commodity inflation (I have no idea how much). The subsidies paid to ethanol producers tilt the scales AGAINST other less-favored forms of energy innovation. Private capital likes to bid with and not against government capital so bad choices made by government are followed and then encouraged by private capitalists who benefit from them. VCs who bet on corny ethanol and were rewarded with subsidies like to picture themselves as green – it's only become recently clear that this particular shade of green is the color of money.

The next round of private investment in solar and wind generating capacity is waiting breathlessly to see when and whether Congress gets around to passing some subsides and what those subsidies are for. If there weren't a prospect of subsidies, more of that private investment would have already been deployed. Moreover, without subsidies the capital gets deployed better because the return is determined by base economics and good execution, not whose lobbyists do the best job writing the rules for subsidy. Let's do a thought experiment: do you think Congress is hesitating on the next round of alternative energy subsidies because our representatives are diligently trying to understand the science and economics involved?  I didn't think so.

BTW, it's not that private investors are prescient or infallible. Most private investment in innovation is in dead ends. But, when the government isn't tipping the scales, private investment fans out across the landscape and the good stuff inevitably gets funded along with a lot of what turns out to be junk. Government as an investor concentrates on what'll pay the highest political dividend and, even worse, drags the private investment in the same direction and discourages diversity of investment.

Let's talk about cars. Both major Presidential candidates are in favor of $25 billion of subsidized loans to American car manufacturers; have you noticed that Michigan is a critical swing state? Is innovation, especially radical innovation likely to come from the major manufacturers? Of course not. Are innovators who aren't major manufacturers going to be able to raise the capital they need to bring their innovations to market; very difficult seeing that their competitors are getting these big gobs of taxpayer subsidy. The result of these loan guarantees will be to decrease the likelihood that America will turn the energy "crisis" to the energy "opportunity".

There is a role for government capital in enabling infrastructure – the power grid which creates a way for even yet-uninvented energy sources to distribute is, perhaps a good example. Keeping taxes low doesn't make inventers invent – they'll do that anyway – but it does help convince the investors the inventers need to invest. Taxing capital out of the private market and having government "invest" it is pretty much the worst way to encourage innovation.

Oil Bubble?

Yes… but.

It's an important question since the answer affects a huge swath of business, personal, and government decisions – not to mention political campaigns. Is the historically high price of oil in dollars a temporary aberration, the creation of evil market manipulators, a frothy bubble that'll look absurd after it collapses? Or are we at the very beginning of a repricing of energy and other commodities caused by developing nations developing ("developing" used to be just a euphemism like "needs improving" on a report card) and the formerly destitute becoming consumers faster than resources can be found for them to consume?

Yes.

Let's start with recent history and remember that supply and demand are never in a static balance. They affect each other and are both affected by myriad other factors. There is always change. Sometimes muted, sometime violent. This change is fractal. It is non-linear; in the short-term it may appear to follow the smooth charts of economists or other forecasters. In the long run both the direction and rate of change are unknowable and unpredictable like any other fractal phenomenon.

OK. We had a period of relative stability in energy prices. Think of the prices as a pendulum swinging back and forth: movement in one direction was about equal to movement in the other; the average was reasonably constant.

Now somebody tilts the structure which contains the pendulum – the tilting force in this case was new demand coming online faster than new supply but it didn't have to be something so significant or straightforward. The "average" has now shifted; the pendulum swings through a wider arc. Will it stop when it gets to the new "equilibrium" point? Of course not, it'll overshoot; then it'll overshoot in the other direction. Volatility is a symptom of rapid change.

The wildly swinging pendulum, however, moves the structure from which the weight hangs. It too careens in one direction and then the other. The movements of the structure, in turn, affect the pendulum. Now add in a bunch of people who are trying to stabilize (or upset) either the structure or the pendulum itself. In physics this is called the n-body problem. To quote from wikipedia:

"For n ≥ 3 very little is known about the n-body problem…

"The three-body problem is much more complicated; its solution can be chaotic. A major study of the Earth-Moon-Sun system was undertaken by Charles-Eugène Delaunay, who published two volumes on the topic, each of 900 pages in length, in 1860 and 1867. Among many other accomplishments, the work already hints at chaos, and clearly demonstrates the problem of so-called "small denominators" in perturbation theory."

Net: You can't believe anyone who says he or she knows where energy prices are going to be tomorrow let alone next week or next year. They could even crash below historic lows in the case of a worldwide recession, an epidemic, or certain wars – or technical breakthroughs. They could move much higher than they are now.

I'm sure people are making money in oil speculation. I'm just as sure some speculators are losing their shirts – just as I'm sure there are winners and losers in Las Vegas. I'm sure the chaos creates cover for illegal and immoral acts. My guess is that the speculation sometimes dampens the price swings and sometimes exacerbates them and can lead to bubbles – certainly – but can't create long term trends.

I'm also reasonably sure – barring a number of both foreseeable and unforeseeable catastrophes (black swans) – that demand for energy is currently growing faster than supply if price were a constant (which, of course, it isn't). I'm not at all sure that high-priced oil won't lead to a breakthrough in either supply or demand technology – or both – that'll lead to a decline in the price of energy if not oil itself. Through human history, energy costs have gone down and not up.

Is all this unknowability a cause for inaction? Of course not. Times of rapid change are times of great opportunity and great danger. We have to guess at short term trends; we have to duck when the pendulum swings towards us. We are sentient bodies in this n-body problem. The future is being built on the rubble of the past but the past is not necessarily prologue to the future.

The only certainty is change and change is a fractal.

 

The Pigs Ate the Sausage

That's what happened to Bear Stearns according to Andy Kessler speaking at Telecosm. Andy's a former hedge fund manager so he knows this kind of stuff and a writer so he says what he knows in an entertaining way. Bear Stearns died because the pigs ate the sausage.

His talk was titled "Who killed Bear Stearns?" Andy went back to the founding of the NYSE under the famous buttonwood tree in lower Manhattan. For most of the time since then its members have enjoyed a lucrative monopoly in trading US stocks. A license to trade there and even on other exchanges like the NASDAQ was a license to make money.

At first and for most of Exchange history, commissions were set by cartel. Plenty of profit there. Whoops – competition came to rates. That hurt but there was still plenty of margin left between the bid and ask price to make an indecent living. Whoops – people who used to have to rely on the newspaper for a daily look at prices could now see prices online in real time; spreads shrank.

Then we went from trading in fractions to trading in pennies; the spread was gone. But it was still an exclusive club with plenty of ways to make money.

Whoops – the rise of almost direct trading by day traders. How's a guy or gal to make a living?

Well, there was handling IPOs. Commissions on those somehow managed to be uncompetitive all the way through the Internet bubble. Pop – no more bubble.

Technology and transparency and competition killed the trading spread. The ingenious solution was to invent something too complex to be transparent – collateralized mortgage obligations and derivatives based on tranches of pools of mortgages were exactly that. Who knew what the damned things were worth; at the moment they were worth whatever the market would pay. So the investment banks – all of them – made a lot of money selling this stuff to the customers.

At this point Andy showed a slide of sausage being made – something, as you know, that you don't want to see. The sausage is all the mortgage-backed securities.

Everything might have been fine for the investment banks if some of them hadn't started believing their own marketing pitch that this sausage was good for you. Why should we just serve this fine sausage to our customers? they asked and began to gorge themselves on it.

Chief among the gorgers was Bear Stearns. Along came the day when the stuff that couldn't be valued began to get a little rancid and had to be marked to market and couldn't be disgorged. Bear Stearns got a fatal tummy ache. Other banks would have also succumbed to mortgage poisoning had the Fed not stepped in. JP Morgan had not been nearly as tempted to eat the sausage – they sold plenty of it, though – so they were in shape to mop up Bear Stearns.

Now, thanks to Andy Kessler, you know what happened to Bear Stearns.

Seize the Moment!

High food prices create a great opportunity to cut agricultural subsidies around the world. High food prices create a perfect opportunity to end the agricultural protectionism – especially in Europe – which has left developing countries unable to sell the crops they grow.

These prices aren’t going to go down any time soon any more than the price of energy is. There are simply more people who can afford to get enough to eat than their used to be – and that makes food even more unaffordable for those still stuck in poverty. The price of energy is obviously also part of the cost of growing food. Ethanol production is a relatively minor contributor although it certainly does somewhat reduce the land for food crops.

Speaking of ethanol production, this is a perfect time to end subsidies for that as well. The original (and seemingly enshrined) direct subsidy is $.50/gallon in the US. That was set when gasoline was about $1.50/gallon cheaper. So obviously this subsidy is no longer needed.

No subsidies are justified for oil or natural gas production with prices as high as they are. Some subsidies are protected by existing contracts but obviously should be allowed to expire as quickly as possible and should not be replaced nor should new subsidies be granted. There is certainly a good economic and strategic case for stepping up domestic production of petroleum but it’s restrictions on where production can take place rather than any problem selling the stuff at a good price which discourage production in the US.

All of these subsidies are a double whammy to taxpayers who pay the high prices and then pay subsidies to the producers who have high profits. Economically, all subsidies impede the ability of markets to adapt. Some may be justified to jumpstart important things but, once granted, subsidies and trade protections are hard to revoke. Now’s a perfect time to get rid of some of them which have long outlived any usefulness they might have had.

Positions on this are a good test for political candidates.

Are We Sure We Don’t Like Free Trade?

Detroit Sets Bold Goal: Exporting U.S. Cars is the headline of a Wall Street Journal article about how a change in relative labor costs added to a weak dollar has made the US competitive again as a car EXPORTER. Most of the article is about planning but some of the shift has already happened:

“Chrysler had been using a contract manufacturer to assemble minivans for sale in Europe, but it chose not to extend the deal beyond 2007 and this year started exporting the Dodge Caravan minivan…made in a plant near St. Louis to Europe…It is also exporting increasing numbers of compact Dodge and Jeep models made in Belvidere, Ill., to several European countries. So far this year, more than 15,000 have been exported, up about 40% from the year-earlier period.”

And

“Spurred by the dollar, foreign auto makers are also devoting more attention to the U.S. BMW AG is pumping $750 million into its South Carolina plant to significantly expand U.S. output, much of which is earmarked for Europe [emphasis added]. Volkswagen AG is looking to build a new plant in North America, and many observers expect it to be in the U.S. Italy's Fiat SpA last week confirmed it is beginning discussions to find a partner that can assemble Alfa Romeo cars built in the U.S.”

The New York Times often decries the loss of American jobs caused by cheap imports. That doesn’t stop the times from finding bad news in imports becoming less cheap. Asian Inflation Begins to Sting U.S. Shoppers the headline says. “The free ride for American consumers is ending,” says the story. “Workers in the developing world facing higher prices have been increasingly vocal in demanding higher wages, with protests erupting in recent days in Vietnam, Cambodia and Egypt.” The Times could have added, but didn’t, that increasingly prosperous workers in China and India are in a position to demand higher wages and a better standard of living by job-shopping – so they do. The Times could have added, but didn’t, that Americans increasingly buy domestic goods when foreign prices go up AND foreigners buy our goods as well.

OK. Attention those of you campaigning in Pennsylvania: are you sure you hate NAFTA and other trade agreements now that the US in INCREASING exports? I know you checked with your pollsters but they measure yesterday’s attitudes towards the day before yesterday’s news.

Here’s a couple of factoids from the WSJ article to chew on between sound bites:

Re the rustbelt: “The company [GM] also has told UAW officials it is seriously considering building a future small car in Lordstown, Ohio, that would be exported to markets outside North America, people familiar with the matter said. It would be one of five new vehicles being produced there near the turn of the decade, one of these people said. The 42-year-old Lordstown assembly plant had been considered a candidate for closure due to high UAW labor costs.”

Re NAFTA: “The U.S. last year exported $50.66 billion worth of cars and light trucks…. Roughly half of its exports are to neighboring Mexico and Canada.”

And re the future: “The trend isn't limited to the big players. Tesla Motors, a Northern California start-up developing an electric car, recently decided to scrap plans to build its $20,000-plus batteries in Thailand. Instead, it will assemble the components in the U.S. because of currency values. Tesla has also pushed ahead its plan to sell cars in Europe by one year in hopes of banking big profits by selling cars to buyers paying in euros.”

Hope trade restrictions don’t stop us from a chance to lead the world in electric cars.