Friday, May 19, 2006

Random thoughts, roughly presented

Having been gently reprimanded for my lack of output lately (call it a golf mentality where less (strokes) is more) I've taken the lazy man's out and cobbled together some of the notes I take during my morning reads. It's rough but perhaps better than nothing...then again perhaps not.

Sticky Expectations and Gold

Anyone who has bought a stock and watched it rally can attest to the temptation of mentally booking profits at the highest recent price. When markets go on a tear, the temptation is even harder to resist. For those long Gold or Gold equity, past weeks were pure joy. On almost a daily basis, speculators could calculate their profits and reset their mental benchmarks of the price $600....$650...$700...$725. Then the correction sets in.

Prices fall back from recent highs. The small door problem (far more currency than real world deals at current prices) which led to the stunning rise of Gold and Gold equities comes into play for the sellers. As an aside, I expect the small door problem to get worse in the coming years. Margin traders will have to be even more nimble than usual.

After a $75 drop in the price of Gold, those who reset their benchmarks to $725 are likely feeling a bit low. Imagine though, assuming you are a long term holder like myself, that the price of Gold had never rallied to $725 but instead had been gently rising a few dollars a week and now sat at $655, a 56% gain on the year. That's not a bad trade.

Although I've long ago conceded my inability to guess exactly when markets get ahead of themselves, I accept that such phenomenon occur. This is not to argue that I think the current price of gold represents an durable equilibrium just that, in similar fashion to the way a person who suffers a terrible shock is likely to mentally digest the news in pieces, so too do collections of people digest reality at their own pace with lots of wishful thinking as a side dish.

To the extent one believes, as I do, that American economic dominance is giving way to an ascendant China, one should not expect a graceful transition. The last transition from Britain to the US took two world wars to sort out.

Return on investment
of military spending

A few months ago, back when I couldn't golf every day and thus had more time to write silly notes the better to amuse my 3 readers, I wrote a piece which asked when investment becomes consumption. My answer was the investment becomes consumption when returns are zero or less.

With that in mind consider US military spending, which, according to this site, is about 43% of the world total (China and Russia's defense spending accounts for 6% each, who knows they might come out of this looking pretty sharp for not trying to keep up with the Jonses). Despite this disparity in spending, which has been going on for many years, the US military cannot bring rebels in Afghanistan and Iraq to submit. Moreover the carnage caused by the US military may poison the minds of those with whom US corporates will want to do business in the future. Thus far at least, the return on investment of military spending in those two endeavors is nil.

Just as a rise in the price of oil will reduce the value of a oil importing nation's capital stock, so too will military failures reduce the value of a nation's military capital stock. While it might warm the heart of a die hard militarist, being able to blow up the world 6 times over isn't much use if the prize you seek is a functioning world.

The health of the financial system

One of the dogmas of the modern economy is the preeminent need to maintain the health of the financial system. But the financial system is not the real economy, it is but a piece with a goal of facilitating trade. To the extent the financial system is not facilitating trade but is instead inhibiting it (what economists call disintermediation) then a healthy financial system will not lead to a healthy real economy.

As the Austrians would put it, the financial system directs the real sector. When the direction is poor, the results will follow suit.

Friday, May 12, 2006

Is America really the knowledge economy?

The recent nationalization of Bolivia's energy assets by the government of Evo Morales calls into question one of the main beliefs of current economic orthodoxy, i.e. the preeminence of American or more broadly western "knowledge" workers. Is America really the knowledge economy without which the rest of the world cannot prosper?

The answer to the question will determine the eventual resolution of the current conflict over resource profit flow. To the extent American or more broadly western "know how" is still required to manage resource extraction and export, the flow of funds associated with such activities will not change dramatically. However, if nations seeking to gain greater control of profits associated with resource extraction are capable of managing their assets then the future flow of funds associated with such activities are likely to shift dramatically, with the west losing out in the deal.

A century ago, western technological superiority in the field of resource extraction was evident. Whether the issue was mining in South America or pumping petroleum in the Middle East, western techniques were a quantum leap ahead. However, a century of contact including educational reform has eroded the gap in the intervening decades. Moreover, it is far easier to copy something you have seen working than to invent it yourself. People in non-western resource rich countries have been watching and learning western techniques for generations now.

Beyond the technology question there is the trade component. When the west was the biggest consumer of such exports even if a nation had the know how, they were stuck with their customers. The ascension of China, both with respect to the nation itself and the Asian nations which are commercially dominated by the Chinese, Singapore, Malaysia and Indonesia to name a few, has changed that dynamic. There's a new customer in town.

As China's growth continues to raise demand for raw materials, China, flush with dollars which the US will not accept in trade for key assets, will more and more be the swing consumer. On the trade front, the prospects for resource nationalization are robust.

This leaves the open question of western technological superiority as the swing factor. I don't know the answer to the question, but having traveled around the world quite a bit, I think the gap between the west and the rest of the world is less than a read of popular rhetoric suggests.

As was the case in the inflationary seventies, the terms of trade between the west and the rest of the world is under negotiation. The west will soon learn if the rhetoric of technological superiority is matched by the facts on the ground.

Monday, May 08, 2006

When lying becomes a habit

I'm passing along a tidbit from another blog.

Recently President Bush declared that catching a 7.5 pound perch in his lake, which, as Crawford is more than 100 miles from the Gulf, is presumably a fresh water lake, was his best moment in office.

The only problem is that the biggest freshwater perch caught on record is a 4 lb. 3 oz. perch caught in New Jersey in 1865.

So either the Prez just broke the record by a significant margin or lying is so habitual for him that he is always telling fish stories.

I'm waiting for him to start talking about the big WMD fish that go away.

Sunday, May 07, 2006

Where the rubber meets the road

It seems to me, after reading the latest from Stephen Roach, that critiques similar to mine found their way to him. He acknowledges that deciding to do a thing is not the same as doing it or as he put it; It’s one thing to have a framework that allows for shared responsibility in fixing an unbalanced world. It’s another thing altogether for individual nations to do the heavy lifting on economic policies that such responsibilities require.

Yet, I still believe Mr. Roach's sanguinity on the expected rebalancing of international accounts is premature. I am less confident than he that the current US administration will allow financial solvency arguments to trump security arguments in their deliberations.

This perspective shifts the argument from one of policy recommendation, i.e. the job of a pure economist, to one of policy execution, i.e. where the rubber meets the road. I agree with Mr. Roach's prescription, the dollar needs to fall to a more realistic level, but I don't agree that such considerations will be very influential if President Bush thinks we are fighting World War III and Vice President Cheney thinks Reagan taught us deficits don't matter. The buck, after all, stops with them.

(Blogosphere debate note: whether they actualy said such things is less important than whether they believe them, as their policy choices seem to indicate.)

While the esteem in which Central Bankers are held has risen markedly during the Greenspan era, this was, I contend, mainly a function of his easy money policies. And even Greenspan's suggestions of fiscal discipline fell on deaf ears with this administration. They are, as they have repeatedly said, on a mission to which other concerns are subordinated. As Arthur Burns related in his Anguish of Central Banking, it is easy to accomodate in a monetary sense, very difficult to restrict.

This development is not unique to the Bush administration. Each President's focus varies. Moreover, the virtues accruing to the issuer of the world's reserve currency have lent empirical credence to the view that deficits are easily sustainable much as a few decades without major hurricanes lend empirical credence to the view that hurricanes aren't a problem. Of course, issuing the world's reserve currency is not a birthright.

It will, I contend, take both a fear of losing dollar hegemony and faith that restoring trade and fiscal imbalances is the best means of achieving this goal to generate a sustained rebalancing policy. In my view, while this faith is likely generally accepted in economic policy circles, it is not shared by the current executive or legislative branches. They have chosen another path to maintain dollar supremacy.

None of the above is meant to diminish the importance of the shift in economic policy circles. I applaud the exorcism of the "new economics" demon from official economics. But I believe it will take time and a crisis or two before this faith leads to anything other than cosmetic changes.

Some might recall the 1993 meeting between President elect Clinton, Robert Rubin and Fed Chairman Greenspan on budget deficits and bond rates. It was portrayed in the press as if sound economics had imposed its will on the executive. I just don't see Fed Chairman Bernanke and John Snow or any other Bush administration member laying down the economic law for President Bush.

Not yet at any rate.

Monday, May 01, 2006

The first step is are all the others

Have you ever woken up one morning and decided you needed to go on a diet, stop drinking, stop smoking, spend less and save more, or spend more time with your children? I'm not referring to one of those momentary pangs of conscience that is quickly set aside but a real decision that eventually results in a change in lifestyle.

I have endured a few of these life changes and in my experience while the decision itself is important, it is only the beginning of an initially painful process as old mental associations are broken and new ones are formed. To paraphrase the catcher-sage Yogi Berra, the mission isn't accomplished until the mission is accomplished.

These thoughts were inspired by Stephen Roach's most recent optimistic research notes. While I agree with Mr. Roach that world leaders seem more vocal in noting not only that a problem exists but also that they need to do something about it, whether this proves to be another "South Beach" or fad policy that will only be followed until it is painful, i.e. when it begins to work, remains to be seen. In my experience, I've usually had to "make the resolution" quite a few times before it sticks.

Changing one's lifestyle, and the economic adjustments necessary to return to some degree of balance in international trade will require substantial lifestyle changes for many, tends to work best when the end goal is kept firmly in mind and the travails of getting there are admitted.

Resolving to stop drinking is easy while nursing a hangover on New Years Day. Not going to the bar after work the next Thursday when the hangover is gone is hard.

Resolving to spend less and save more is easy when you've just opened your Christmas season credit card bill. Not buying a new car when all your neighbors have recently bought new models is hard.

You get the picture.

Changing one's lifestyle means not only doing or not doing the chosen or prohibited activity that day, but every day forward, even when it is uncomfortable. To the extent the "fix" to what ails international finance includes a substantial increase in US savings, time periods of weeks, months or quarters, even in the event of a price discontinuity (a euphemism for a $ crash, for instance) are too short. It will require years. As they used to say in Econ 101 classes, change occurs on the margin.

During a recent phone conversation with a few friends in finance I likened the current period to the early 70s (or late 30s) when the realization that something needed to change in international finance was clear but just how to fix it, and how to apportion the pain was some years away. Nixon closed the Gold window in 1971, in recognition of the problem. The IMF didn't complete amending the relevant Articles of Agreement until 1978. Paul Volcker didn't adopt money supply targets as policy until 1979 and it wasn't until 1982 that Fed Funds rates came back down under 10%.

To avoid misunderstanding, I think it is better to admit there is a problem than to ignore it. I agree with Lao-tzu, a journey of a thousand miles begins with the first step. However, that first step is but one of many.

Given that most recent economic problems have been quickly "solved" by easing credit conditions, many seem to believe that this fix will be just as easy.

I don't think it will. It seems to me as if we are still in the fad economic policy phase. Barring a crisis, I expect it will be years before a true commitment to reform emerges.