Capital Flight: Will the supports hold?

The other day I was checking the US TIC data for March 2007 and was surprised to see yet another large exodus of capital from the US by US investors. Thus far this year, US investors have purchased US$78B of Foreign Long Term Securities, which equates to US$312B over the year.

That means, in order to keep the value of the US$ stable, foreigners will need to purchase enough US assets to cover not only the US Trade Deficit of, let's call it US$750B (assuming a US$62B/month Trade Deficit) but also that extrapolated US Capital Outflow of US$312B (or more if capital flight intensifies). This assumes the Net Income figures for the US remains around zero.

I wonder if the US$ supports, provided so willingly by Asian and ME Central Banks in pursuit of mercantile advantage, will be able to withstand the additional burden of capital flight from the US?

Evolution and other modernist Shibboleths

O'Reilly: Possible, but do you right now? Do you want the United States to win in Iraq?
Letterman: First of all, I don't -
O'Reilly: It's an easy question, If you don't want the United States to win -
Letterman: It's not easy for me because I'm thoughtful.
The Late Show

Although I didn't watch the recent Republican Presidential Candidates debate, I did see a few snippets on Youtube including the response to this question, "I'm curious, is there anybody on this stage who does not believe in evolution?" The question was asked with a hint of incredulity, as if to answer in the affirmative was to be a fool.

This question reminded me of Judges 12:6- the shibboleth test: Then said they unto him, Say now Shibboleth: and he said Sibboleth: for he could not frame to pronounce it right. Then they took him, and slew him at the passages of Jordan: and there fell at that time of the Ephraimites forty and two thousand.

According to Wikipedi: The term [Shibboleth] originates from the Hebrew word שבולת, which literally means "stream, torrent".[2] It derives from an account in the Hebrew Bible, in which pronunciation of this word was used to distinguish members of a group (the Ephraimites) whose dialect lacked a /"sh"/ sound (as in shoe) from members of a group (the Gileadites) whose dialect did include such a sound.

A shibboleth question in the biblical sense is a test of belonging to a tribe. Faith in evolution, then, has apparently acquired shibboleth status in somewhat similar fashion to the modern Central Bankers' necessary faith in fractional reserve banking or fiat money. It is a test to determine if one is a member of, at least in my understanding of the question, the modern world. Those who do not believe in evolution, apparently, are not part of the modern tribe.

I have no desire to wear the ring of power that is the office of the US President (nor, I imagine, would the people of my country wish me to wear it) but had I been asked the question I too would have raised my hand.

Re-read the opening exchange between Bill O'Reilly and David Letterman, if you will, as preamble to my explanation of this iconoclastic view.

I don't think it is a simple question as it depends on the content of the faith.

If the question had been framed as, "Do you, in the main, agree with Darwin's thesis in Origin of Species that the ancestors of currently living animals, including man, had evolved into their current forms from, in some cases, radically different and simpler forms, that is biologically adapted to changing environmental conditions over time?" I would have answered yes, but that is not what I think the simpler question, asked in the debate, "Do you believe in evolution?", implies. Indeed, Darwin's view as presented in Origin of Species is rarely at issue in evolutionary debates, the focus has shifted to the age old assumed conflict between spirituality and reason, religion and science.

About a year ago, I shared my two cents on the shibboleth in question in Evolution, less than meets the eye? The key passage from that argument came from J. Krisnamurti in a 1985 Q&A with the UN: Madam, I am afraid we haven't understood each other. We have lived on this earth from the historical, as well as ancient enquiry, on this earth for fifty thousand years or more or less. And during that long period of evolution psychologically, inwardly, subjectively, we have remained more or less barbarous - hating each other, killing each other. And time is not going to solve that problem, which is evolution. And is it possible, we are asking, for each human being, who is the rest of the world, whether that psychological movement can stop and see something afresh?

In my understanding of the modern aspects of evolutionism, one tenet is that the natural world is not only responsible for man's ascent to the top of the food chain but is also expected to continue improving the breeding stock. It is materialism- a faith in mother nature, sometimes described as Gaia worship. In graphical terms, if one charted man's greatness over time evolutionists hold that the line would resemble that of modern stock markets, generally rising.

Modern man does have an affinity for a positively sloping curve as the expression of our age.

Another tenet of evolutionism holds that one cannot both believe in god, religion, or spirituality (terms which have apparently become interchangeable) and evolution, or more broadly, science and progress. In the modern shibboleth test, faith in some sort of spirituality, the notion that one's sense of the world, one's awareness, is not the same as reality, and additionally, that man is driven, animated, if you will, by his spirit, or mind, which is distinct from but related to (as William James put it; to each mental state there is a corresponding brain state) the physical organ, the brain, is presumed to be an anachronism.

In these modern times, the mind/body duality expressed by, inter alios, Descartes is seen as an error- an argument laid out by Antonio Domasio in his Descartes Error.

This is, as earlier noted with reference to Central Bankers' faith in fractional reserve banking and fiat money, but one of many modern shibboleth tests. These tests are often administered by those who share Bill O'Reilly's sense of simple certainty, which recalls Bertrand Russell's quote about such a view; The whole problem with the world is that fools and fanatics are always so certain of themselves but wiser people so full of doubt.

Faith in the virtue of the battle of ideas, which was the basis of what used to be thought of as the quintessential American faith of Pragmatism, and was hoped to provide, over time, the best ideas upon which to live, has degenerated. It is as if those who are incapable of thinking for themselves became jealous of the benefits of those who could and usurped their position through propaganda. Why, these usurpers think, waste time and effort seeing the truth, a most difficult task, if one can fake it and get the same, and, in many cases, more benefits.

As Nietzsche argued; As long as a man knows very well the strength and weaknesses of his teaching, his art, his religion, its power is still slight. The pupil and apostle who, blinded by the authority of the master and by the piety he feels toward him, pays no attention to the weaknesses of a teaching, a religion, and soon usually has for that reason more power than the master. The influence of a man has never yet grown great without his blind pupils. To help a perception to achieve victory often means merely to unite it with stupidity so intimately that the weight of the latter also enforces the victory of the former.

From a broader perspective, the degeneration of the American faith in the battle of ideas into simplistic shibboleth tests might be more easily understood using a sports metaphor. Imagine if, after a few generations of pro athletes being paid massive salaries and getting all the women, of course, other, much less talented, but politically powerful, wealthy people decided to take their place. Thus instead of true genius, either at sport or at thought, battling it out, what you have is a mockery of the old game- Baudrillard would have called it a simulacrum.

Imagine going to a pro baseball or ice hockey game and instead of seeing truly qualified individuals battling it out, one had to watch Hiltons, Rockefellers and Du Ponts fumble around. Wait a second, we already, in a sense, do that - see People magazine. The Roman Emperor Commodus was one so jealous of the admiration earned by gladiators that he reportedly fought in 1000 contests.

Sadly for those who depend on the system, the battle of ideas is far more important than a pro sports match. Imagine if there actually was intelligent debate on the wisdom of invading Iraq or staying longer? Imagine if there was intelligent debate with real consequence on prolonging the credit bubble, or peak oil, or global warming? I'm not arguing one position or another here, my point is that there is no debate, just shibbeloth tests of tribal affiliation, with each side almost as willing to slay the other. Krisnamurti might have been on to something.


To square the circle, i.e. merge the mention of mind/body duality with that of shibboleth tests for modern tribalism, it is necessary to believe that one's sense of the world is still incomplete, able to be improved, in order to see the virtue in the battle of ideas. The moment we think, as Christopher Hitchens argues in his God is not Great, that we know (actually Hitch thinks only the modern tribe knows how the world works) there isn't really much use in trying to learn more- and another fanatic in Russell's' sense is born. Christopher Hitchens becomes Bill O'Reilly.

This sensibility of certainty is, as Hitch should be and used to be aware, not new, and often crops up in cultures (and people) in decline.

Too much of a good thing?

ROSALIND (as Ganymede): Why then, can one desire too much of a good thing?
Shakespeare - As you like it

The sun is shining brightly outside my humble abode today so I'll be hitting the links (actually, to be precise, I'll be hitting a little white ball while walking ON the links....ah the perils of thinking about the idioms we use) but before I head off, I'll share a thought.

While reading an article from Bloomberg, Asia to draw on $2.7Trillion of reserves to safeguard currencies, I started to laugh.

A decade ago, the Asian Tigers, as the fast growing Asian economies were called, were suffering through a bout of currency flu, due to, in their view, as one can surmise from their policy reaction, a lack of currency reserves. Is it possible to jam more clauses into a sentence?...... fear not I won't try.

How funny to think that the next bout of currency flu they suffer may well be worsened by the abundance of currency reserves.

A lack of reserves is a drag when the value of the reserves is rising, as occurred to the US$ during the Asian crisis. A surplus of reserves is a drag when the value of those reserves is falling, as looks likely to me this time round.

The reaction of Asian policy makers does remind me of one of the guiding faiths of modern culture, the belief in the curing pill, rather than a policy of health. Why not, I wonder, on a medium term view, run a balanced economy, instead of an imbalanced one that requires all sorts of magic pills and new theories.

If the USD$ falls much further I reckon I won't be the only one wonder such things.

Time to swing that club.

Modern Tribalism

As the rats, in increasing numbers, scamper off the floundering good ship Neo-con, their defensive claims that "their hands were tied" or similar arguments remind me that tribalism, loyalty to a group, is alive and well in these supposedly modern times. In the main, these rats would have us now believe that they were all victims- deserving of our pity, not our scorn.

George "Slam Dunk" Tenet, in his new book, would have us believe that his words were taken out of context- a claim I find plausible, but also laughable. Why, I ask, as do Michael Scheuer, Larry Johnson, and Pat Lang, to name a few, did he wait so long to tell us? If the invasion of Iraq had produced more positive outcomes would he have expressed such consternation at being misconstrued? or would he have continued to bask in the glow of praise as he did upon receipt of the Medal of Freedom.

In similar fashion, Richard Durbin would like us to know that the "intelligence" on Iraq, both before and after the invasion, presented to the Senate Intelligence Committee, of which group he was a member, contradicted the tall tales being constructed for public consumption. Alas, he avers, he was sworn to secrecy- an oath which has conveniently expired now that the tide has turned.

Many on the supposedly anti-war left, some of whom are running for President, would have us believe that if they knew then what they know now, they would not have voted for the invasion. I wonder what the missing bit of knowledge was which would have changed their minds- that there were no WMDs, or that the effects of the invasion would be as they have been?

Bookies and stock brokerages (perhaps I repeat myself) are rarely sympathetic to similar, informed by hindsight claims. How many people would have purchased shares of, for example, EXDS, if they had known the corporation would declare bankruptcy? How sad that the tribe of technology worshippers could not see how things would unfold.

Men, it has been well said, (by Charles Mackay among others) think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one. I would rephrase the wisdom of Mackay thusly; individuals think, the crowd prefers the fleeting safety of numbers.

As Rudyard Kipling put it in his poem If:

If you can keep your head when all about you
Are losing theirs and blaming it on you,
If you can trust yourself when all men doubt you
But make allowance for their doubting too,
If you can wait and not be tired by waiting,
Or being lied about, don't deal in lies,
Or being hated, don't give way to hating,
And yet don't look too good, nor talk too wise:

If you can dream--and not make dreams your master,
If you can think--and not make thoughts your aim;
If you can meet with Triumph and Disaster
And treat those two impostors just the same;
If you can bear to hear the truth you've spoken
Twisted by knaves to make a trap for fools,
Or watch the things you gave your life to, broken,
And stoop and build 'em up with worn-out tools:

If you can make one heap of all your winnings
And risk it all on one turn of pitch-and-toss,
And lose, and start again at your beginnings
And never breath a word about your loss;
If you can force your heart and nerve and sinew
To serve your turn long after they are gone,
And so hold on when there is nothing in you
Except the Will which says to them: "Hold on!"

If you can talk with crowds and keep your virtue,
Or walk with kings--nor lose the common touch,
If neither foes nor loving friends can hurt you;
If all men count with you, but none too much,
If you can fill the unforgiving minute
With sixty seconds' worth of distance run,
Yours is the Earth and everything that's in it,
And--which is more--you'll be a Man, my son!

A great description of malinvestment (and its cure)

.... see, I’m old enough to remember the ... depression of the ‘20s and ‘30s. That was a moment of greatness for the American people, and indeed for politicians like Roosevelt. I remember Gene McCarthy and I were talking about it once, and he said, “You know, the Depression was the only time when anything worked!” He said, “I’ve got a lawyer now who wants to be a songwriter. I’ve got somebody else who’s supposedly fixing the roof, but he wants to be a painter.” He said, “Nobody does what they should be doing in this society.” This is a guy who’d just run for president, and a very good one, too. Anti-war. And he said, “You know, this is ridiculous. I mean, in those days, you had a carpenter, and he was a real carpenter.” He said, “The post office worked. They weren’t dreaming about being rock stars; they were dreaming about getting the mail out!” And he said, “To watch all the services crumble, and everybody fantasizing about the future, because they’d seen people in the movies who fantasized about the future, and the future came true.” I thought that was wise. And ... I think the fantasies will stop when there’s no longer the leisure, and people will actually get back to work doing whatever it is they’re supposed to be doing, or even what it is they would really like to do. An awful lot of people who want to be painters rather than doing roofs—will, be a painter. Nothing’s difficult anymore; you can get the means for everything rather cheaply. With the Internet and all this kind of interchange all around the world so rapidly, you can make a reputation, I think, rather quickly, and present yourself as a writer, as a poet, as this and that. So, that, I think, the bankruptcy of the United States, which we’re looking at the edges of now, is going to be very useful to {bring} us to our senses. Gore Vidal

Open email to some fellow golfers/doom-and-gloomers

Dude (et alios)

Let me put on my “doom and gloom” hat (which I rarely remove- must be why I get “doom and gloom” hat head) and join the fray.

As I’m currently in Mark Twain-land, Missouri, I’ll begin with a quote of his, history doesn’t repeat itself, but it rhymes.

The key, in my view, to empire dominance analysis is discerning the factors that gave rise to the dominance and discovering if those factors are currently helping or hurting.

In Kevin Phillips’ American Theocracy, he argues that the US is the oil empire as Britain was the coal empire and Holland was the wind and sea empire before that. In each case, the dominance in a particular technological form left the nation carrying an obsolete infrastructure as newer technologies and energy realities manifested.

In each case, political leadership, over time, came to rest in the hands of those who owned the infrastructure. Thus, for example, Britain’s coal interests hampered their ability to transition to an oil economy because they were unwilling to write off their investments.

In other words, the earlier alignment of national interest with political leadership’s interest broke down. The political leaders ended up trying to maintain an impossible status quo, dragging the nation down with them.

On a positive note, it isn’t as if the Dutch or British vanished as world powers, they simply gave up the position as driver. Unfortunately, this transition was not a pleasant one.

The die was cast, so to write, on our (in hindsight, foolish, in my view) choice to use the military to try and maintain our oil economy infrastructure when the Reagan administration rolled back the energy conservation legislation of the previous administration.

In the late 70s we imported a third of our oil. We could have (and were then in the process of) made the transition reasonably gracefully then. Now that we import two thirds of our oil, and are predominately led, at a national level, by oil interests, the transition to a world in which oil is not cheap but expensive will be difficult.

The “illegal alien” problem, which is but a mirror image of the, far more pernicious to our way of life, in my view, US corporate wage rate arbitrage (a.k.a. “outsourcing”) is, relatively speaking, and again, in my view, far less of a problem.

Income transfer policies (welfare, et alia) including those to undocumented immigrants are a “cutting the available pie” issue. Choosing, changing and/or maintaining an infrastructure for a way of life is a “size of the pie” issue.

When the pie is growing, how we slice it is less of a concern. Now that it is not growing (or shrinking depending on perspective) we worry about slicing that pie too thinly. A focus on the slicing and lack of concern for the size of the pie is, in effect, leading us to take our eye off the ball. (And as golfers, we know what happens when we take our eye off the ball….. FORE!)

How one slices the pie is an issue of concern to me (and others) but it isn't nearly as relevant to the argument at hand- the decline of the American economy.

We, in the US, as James Kunstler argues, need to give up our dreams of life in the suburbs with an SUV in the garage of our McMansions- a terribly energy intensive way to live. A way of life that made sense in the 50s when we were an oil exporter is silly when we are a large oil importer.

We, in the US, still have tremendous advantages; a well educated (although this too is slipping) population, lots of resources, lots of fresh water (albeit more in the east than in the west where people are moving), a well-connected water transport system and a relatively easily upgradeable rail system. But we need to get to work. And we won’t as long as we think cheap oil is just over the next horizon.

The US media needs to start promoting a new version of the American Dream.

But enough doom and gloom. The weather is (finally) warming and soon we’ll be chasing that little white ball around again. I, for one, plan to do a lot of walking.

Ciao for now

Brutes playing chess and the Trojan sailors

The President of Iran shook hands with the British hostages this afternoon after announcing he was freeing them.

The sailors will leave Tehran early Thursday and arrive at London's Heathrow airport around 1200 GMT, said Robin Air, father of Royal Marine Capt. Chris Air. Families will be reunited with the crew later Thursday at a military base, he said.

Mahmoud Ahmadinejad smiled as he talked through an interpreter to several of the men held captive for 13 days in the capital Tehran. One of them was heard to say to him: "Thanks for releasing us. I wish you success.” Daily Mail

Before I was forced, by experience, to disabuse my mind of ethno-centric views I thought, like many of my fellow countrymen, I knew what smart people looked like. They were white. They didn't wear robes or other silly clothes. They were like me.

A decade of world travel, including a few years living in SE Asia brought me face to face with smart well-read people who didn't dress the way I expected, nor look the way I expected. Buddhist monks and Islamists wore robes and unlike me, didn't spend their formative years watching Fantasy Island or the Love Boat. Instead they read books. While I could easily have beaten these robe wearing people playing video games, I would likely lose to them at chess. And as much as we Americans might like to think that video game prowess is a sign of future success, world politics is more like a game of chess- and brutes don't play chess well.

I'm not arguing that we couldn't learn to play that game, or even that there aren't Americans who can think strategically- there are. Rather, my point is that the rise of the Neo-Con brutes has shuffled those people to the background in favor of the faux-cowboy bluster of "you're either with us or against us." This is not, in the main, the path by which America rose to become a major player in the world political game. The big stick was meant to be carried more and used far less.

Over the past few days I've been wondering (worrying) if the Iranian seizure of 15 British sailors would open the door to US/UK military action against Iran. The rhetoric was heating up.

But today I see that the ruling Persians are quite adept chess players, and, I believe, wonderful students of history, both ancient and recent.

On the recent history front, the Persians have avoided the trap set for Saddam. A few days prior to the US invasion of Iraq, Saddam decided to open his country to full UN inspections, but his offer, if noted at all in the US press, was considered too little, too late.

Having focused on the captive sailors, the media was primed to tell the tale of any eventuality, in this case, their release. By now, Ahmadinejad's "gift" to the British is set to be the big story in tonight's TV and tomorrow's newspapers.

Here's an example from the BBC: Families describe joy and relief

On the ancient history front, Ahmadinejad's "gift" recalls tales of the Trojan Horse, except in this case, the "city" the gift-givers intend to enter by subterfuge is the hearts and minds of the British. How much more difficult a sell will it be for Tony Blair to argue the case for war against Iran following the release of the sailors, in time for Easter no less?

Of course, the hardened heart of the Vice President is immune to such trickery: In a rare approval of an Iranian decision, President George W. Bush welcomed the promise to free the 15 sailors while Vice President Dick Cheney said it was unfortunate the sailors were taken in the first place and he hoped there would be no "quid pro quo" for their release.

"Once people start taking hostages or kidnapping folks on the high seas and then are rewarded for it by getting some kind of political concession or some other thing of value, that would be unfortunate," Cheney told ABC News Radio.

And so the Iranians demonstrate that others can play the game of divide and conquer as well as we. For a bunch of robe wearers the mullahs of Iran seem to have very ably split the Neo-Cons from both the body politic here in the US and from the Brits. Maybe there's something to reading books and playing chess after all.

Sometimes in a chess match, the appearance of having a Queen, Rook and Bishop to your opponent's few scattered pawns and isolated King is deceiving if during the attempted capture of the King you lose your Queen and Rook while your opponent converts his pawns to a Queen and Rook. Having public opinion on your side is akin, it seems to me, to having those key pieces.

Does this mean there will be no war against Iran? I wouldn't go that far, but if it does materialize, it will not engender the nationalist chest thumping that followed the decision to invade Iraq.

On the market front, the resilience of Gold and Oil to such an event suggests interesting developments below the surface. If we don't have a new war as a distraction, and reason for foreign central banks to continue buying US bonds, we just might have to begin to deal with our domestic economic problems. And that resolution might not involve lower commodity prices after all.

When the War Party ends the bills will come due.

Let's talk about risk

Let's talk about risk, baby
Let's talk about you and me
Let's talk about all the good things
And the bad things that may be
Let's talk about risk
Let's talk about risk
Let's talk about risk
Let's talk about risk
paraphrased from Salt 'n' Pepa

We can guarantee cash benefits as far out and at whatever size you like, but we cannot guarantee their purchasing power. Alan Greenspan

One of the more perplexing developments, at least to old school thinking fellows like myself, in financial market participants' perception of risk is the view that bonds, at current rates of interest, particularly those issued by the US government, are less risky than Gold. I find the view perplexing in that it has very little basis in fact. As the Greenspan quote above alludes, there are no guarantees of purchasing power for the currency in which US bonds are currently (but not originally) denominated, US$. There is also no guarantee of the purchasing power of Gold, but unlike paper money, recalling Jefferson's adage about truth, this does not need the support of government.

Risk is defined as:

1. The possibility of suffering harm or loss; danger.
2. A factor, thing, element, or course involving uncertain danger; a hazard: "the usual risks of the desert: rattlesnakes, the heat, and lack of water" (Frank Clancy).
3.
a. The danger or probability of loss to an insurer.
b. The amount that an insurance company stands to lose.
4.
a. The variability of returns from an investment.
b. The chance of nonpayment of a debt.
5. One considered with respect to the possibility of loss: a poor risk.

The only variation of the definition that might lead one to the conclusion evidently held by the financial markets is 4-a, the variability of returns, and even then only when one restricts one's data set. It is true that Gold was a poor investment, unless you were a very nimble trader, in the late
70s and early 80s compared to US bonds. Double digit interest rates and new found stability for the purchasing power of the US$ from the mid 80s through the late 90s, but since lost, made US bonds a much better investment. But that was then.

In this century Gold has been a far less risky investment than US bonds according to variation 4-a not only because Gold has more than doubled, thus erasing the interest rate gain of bonds, but also because of the loss of purchasing power of the US$.

Moving beyond that one variation in the definition of risk, however, in the current context, it doesn't even seem to me to be a contest. Over the long term, and especially in extremis, Gold is, at least according to history, by far and away less risky than US bonds. Gold does not default, nor change the terms of repayment on the fly (Nixon closing the Gold window). It is what it is- a metal almost always acceptable in trade whose value, based on the thing itself, not the fiat of governments, throughout the past few millennia has always been relatively high.

Corporate, and by that term I mean to include governmental, religious and commercial variants, bonds have, throughout history, from time to time, defaulted. Bonds have their days in the sun, but as they draw their value from the power of the issuing institution, and not the intrinsic value of the thing itself, their value can go to zero, or as was the case with US bonds after Nixon closed the Gold window, can have their value eroded to mere cents on the dollar.

This is not to argue that there are never, or will never again be, periods of time when bonds prove to be better investments than Gold. I'm eagerly awaiting the time when governments need to compete for savings again. Rather, it is to argue that all bonds carry an inherent risk of non-performance that Gold does not. Gold transcends institutions of men. Faith in insitutions is always fleeting, albeit sometimes for quite long periods of time. It is this risk of non-performance, or minimally of failure to repay in kind that I feel to be missing from current calculations of risk.

US government bond advocates hang their hat, if you will, on the period from 1980 through 1999, but expanding their data set to include the preceding decade exposes their view as far less certain. For bonds to become an attractive investment for me interest rates would need to be much higher, like double digits. But even with the current yield curve at 5% the US mortgage market is near disintermediation. The US economy will, I fear, go through some difficult periods to get interest rates high enough to make US government Bonds worth the risk.

Of course, to agree with the view put forward here you have to be able to imagine that the US government will be unable to maintain the value of the US$. Despite the history of bonds in general, disclaimers from Fed Chairmen like Greenspan, and the dismal record of the Fed in maintaining the purchasing power of the US$, the US government is apparently considered, or at least inspires sufficient fear in prominent speakers to evoke statements to that effect, to be different than all other institutions in history.

US Bonds will be less risky than Gold as an investment in the current context if and only if the US government is truly different than all other institutions and retains the ability to do what Greenspan said it couldn't, maintain the purchasing power of the US$. Although I don't usually use Greenspan's views to support my own, in this case, I agree with him.

Some might question the wisdom of fighting conventional views in this matter. To those I would argue that history is filled with the downfall of previously considered indestructible institutions. The scheme of Carlo Ponzi, which immortalized, so far at least, his name in financial infamy, comes to mind.

It is worth noting that depositors at Ponzi's Security Exchange Company had always received on withdrawal, their promised 50% return in ninety days up until his public relations man reported that Security Exchange Company had never invested one cent in the depreciated European currencies from which he claimed his returns came. So long as investors kept depositing their cash with his company he was able to keep up with withdrawal demands.

People, even the well heeled, it seems, are susceptible to believing things that are too good to be true. Ponzi's scheme could, it seems to me, have gone on for many more years until it ran out of additional depositors. That is, the theoretical absurdity inherent in his scheme would only be exposed in fact when he reached the limit of everyone already being in the pool, so to write. Fortunately, the scheme was stopped before it reached that point.

Given that Greenspan's admission didn't lead people to question their faith in the US government's ability to produce returns for US bond investors, nor has the evidence over the first 6 years of this century, I wonder what it will take to shake their faith?

Barring the discovery of US Bond loving Central Banks on another planet, the US government will eventually run out of additional depositors and then we will see what is risky and what is not.

I met a traveller from an antique land,
who said--"Two vast and trunkless legs of stone
Stand in the desart....Near them, on the sand,
Half sunk a shattered visage lies, whose frown,
And wrinkled lip, and sneer of cold command,
Tell that its sculptor well those passions read
Which yet survive, stamped on these lifeless things,
The hand that mocked them, and the heart that fed;
And on the pedestal, these words appear:
My name is Ozymandias, King of Kings,
Look on my Works, ye Mighty, and despair!
Nothing beside remains. Round the decay
Of that colossal Wreck, boundless and bare
The lone and level sands stretch far away."
Ozymandius - Percy Bysshe Shelley

Chimerica: can we "yada-yada" the imbalances?

George: Listen to this. Marcy comes up and she tells me her ex-boyfriend was over late last night, and "yada yada yada, I'm really tired today." You don't think she yada yada'd sex.

Elaine: (Raising hand) I've yada yada'd sex.

George: Really?

Elaine: Yeah. I met this lawyer, we went out to dinner, I had the lobster bisk, we went back to my place, yada yada yada, I never heard from him again.

Jerry: But you yada yada'd over the best part.

Elaine: No, I mentioned the bisk.

Seinfeld

One of the recent themes of historian Niall Ferguson's views, while not, in the limited sample I've managed to find, stated as such, is accepted economic convergence. He uses the term, Chimerica, a merger of China and America, to explain the view that international imbalances are not as troubling as they might appear, at least if we could see the world from his perspective.

From the LATimes: Yet there's another way to see these supposed imbalances: as no more worrying than the doubtless very large imbalances between, say, California and Arizona. Think of the United States and the People's Republic not as two countries but as one: Chimerica. It's quite a place: just 13% of the world's land surface but a quarter of its population and fully a third of its economic output. What's more, Chimerica has accounted for about 60% of global growth in the last five years.

The relationship isn't necessarily unbalanced; more like symbiotic. East Chimericans are savers; West Chimericans are spenders. East Chimericans do manufacturing; West Chimericans do services. East Chimericans export; West Chimericans import. East Chimericans pile up reserves; West Chimericans obligingly run deficits, producing the dollar-denominated bonds that the East Chimericans crave. As in all good marriages, the differences between the two halves are complementary.

As an upstate New Yorker I have some knowledge of these imbalances to which Mr. Ferguson refers- in my case that which exists between New York City, the main provider of state income tax funds, and Albany, New York's Capital, one of the main beneficiaries of these down state funds. To say that this imbalance is not troubling is to misread New York State political history. While dissension ebbs during periods of economic growth, its always comes to the fore when growth stalls, with the most recent significant example being the mid 70s financial problems in "The City" as we upstaters refer to the Big Apple. Intra-state tensions have been a feature of New York politics for much of the past two centuries.

Even the relationship he chose, that between California and its neighbors, is not nearly as "smooth" as he asserts. Two sources of tension spring to mind, electricity and water.

During California's electricity crisis of 2000-2001, tensions arose between electricity providers, Washington State and Oregon, and electricity users, California. A drought reduced hydro-electric power generation in the two northern states and their efforts to maintain water flow and thus power generation created domestic political problems.

Water itself is also an inter state problem out west. As Mark Twain once quipped on California's perennial problem, "Whisky's for drinking; water's for fighting over." California has for years been exceeding its Colorado River water allotment, set forth in the Colorado River Compact, which is now becoming a larger inter-state issue as populations in Arizona and New Mexico have climbed.

While I'm not arguing the states around the Colorado River are planning to call out their respective National Guardsmen and take Twain's view to heart, after all, most of the guardsmen are in Iraq, glossing over the tensions that exist, albeit below the national radar, will lead to confusion when larger mergers are envisioned.

As a student of History, Mr. Ferguson is well aware that the "religious" wars in Europe between Protestants in Northern Europe and Catholics in Southern Europe had an economic aspect, an imbalance, if you will. The schism of Western Christendom, which is in the process of attempted repair via EMU some 5 Centuries later, was caused, in part, by Rome's assumption that the merged "tribes" of Europe would stay that way while the Vatican and Southern European Bankers like the Medici kept draining the North of specie.

I may be in the minority but the current attempt to re-knit Europe into a whole via economic rather than religious means is not a done deal. Thus far, in my view, liquidity and strong global growth has papered over international differences on the continent. The true test of the union will come when credit conditions tighten and the fiscally responsible are dragged down with the fiscally irresponsible. It has only been 15 years since Italy was forced to exit the ERM due to their high debt and deficit to GDP ratio. Currently Italy's debt to GDP ratio of roughly 107% is still the highest in the Euro-zone.

Back within the United States again, the willingness to accept imbalances will be tested as Congress looks to bail out sub-prime borrowers. According to Bloomberg: Federal aid ``would come at a cost,'' said Douglas Duncan, chief economist at the Mortgage Bankers Association. ``It has to be paid for and the question is would the 34 percent of homeowners who have no mortgage be willing to pay taxes to support the bailout of people who traditionally have not managed credit well?''

If, as I imagine will prove to be the case, a bail out of this sort will be a tough sell, imagine how much more difficult it would be (is) to sell to East Chimerica, as Ferguson calls China, that they need to take a 50% "hair cut" on their reserves to help out their buddies in West Chimerica.

Bridging cultural differences and regional concerns has been the main impediment to the presumed great benefits of global cooperation. While I agree in theory that a global economic unit would be far more efficient than a number of autarkies, or self-sufficient economies, simply assuming that regional imbalances within an economic unit will not be troubling seems to fly in the face of history. Keeping those imbalances small or at least understandable, i.e. rational to the sensibilities of the time, has been the key to maintaining unity.

Sadly the great Achilles Heel of the de-regulated post Bretton Woods Economic System is the inability to correct imbalances of large economic units thus allowing them to grow unchecked. When the time comes to truly address the "Chimerican" imbalances, I'll bet that term will be about as popular as Mexifornia is to the Orange County crowd.

Fighting between the haves and have nots has been going on for a long time. "We are all Americans" speeches did not solve the class wars in the US during the late 19th and early 20th Centuries, addressing the imbalances did. As Mark Twain might have put it, we'll only be able to Tom Sawyer the East Chimericans for so long.

A focus on the "placid surface" of global financial conditions, to borrow from Paul Volcker, to the exclusion of the actual economic conditions underneath recalls Korzybski's dictum, "the map is not the territory." Just because stock markets haven't crashed or other untoward financial developments haven't materialized does not mean that the "natives" aren't restless or that they are unconcerned about imbalances. I hope the current crop of Empire dreamers have something better up their sleeve than, "but the stock market didn't crash this time, why can't we globalize?"

The Wizards of VaR and "pilot error"

The company has also been honored for the way it does business, receiving the Ethics in America award from the Passkeys Foundation and Chapman University in 2004. “Over the years, we believe we have earned the reputation with our customers and our investors for delivering results without compromising our values; this is the cornerstone of our corporate culture,” notes Bob. “To articulate that culture, in 2005 we adopted a new brand identity, ‘A New Shade of Blue Chip,’ and created a strategy to help us live up to that brand. We are proud of our results, but just as proud of how those results are achieved.” New Century Financial Company History

NYSE's move [ to delist NEW ] came as New Century disclosed in an SEC filing today that the U.S. Attorney had initiated a criminal investigation into both the company's securities trading and accounting errors involving the company's allowance for losses from the repurchase of bad loans. New Century said it had received a grand jury subpoena and would cooperate. O.C. Register

According to Wikipedia, Pilot error is a term used to describe the cause of a crash of an airworthy aircraft where the pilot is considered to be principally or partially responsible. Pilot error can be defined as a mistake, oversight, lapse in judgement, or failure to exercise due diligence by an aircraft operator during the performance of his/her duties. In other words, the plane was working fine, us humans screwed up.

Despite fears of mechanization run amok, the financial world still relies on its pilots. Despite changes in tools (abacus, computer) and methods (cash, VaR) of calculation, people still have to input the records, ensure their accuracy and plan for the future. The most hi-tech tools and sophisticated methods (pun intended) will not mitigate the simple pilot error of being unprepared for eventualities.

I wonder how many at New Century Financial asked the question, once the Fed began raising interest rates in 2004, "How are we going to deal with the eventual slowdown in mortgage lending?"

I wonder how many times that question inspired a response to the effect that it wouldn't be a problem, that things were under control, and that all eventualities had been foreseen. In the event, as is all too often the case when money, lives and fortunes are involved, the real response was lie, deny, justify. Pilot error, sure, but show me a financial company without pilots.



And thus the ever efficient financial markets give another classic "crash and burn" picture. Like Enron, they did all they could to convince the external world that all was well, and, while buying some time, the eventual effect was to make the decline more spectacular and certain. Few things guarantee defeat more certainly than denying the possible.

Those who fear the mess to come from the VaR (Value at Risk) masked derivatives monster are in a similar position to those in New Century who worried about the eventual slowdown in mortgage lending. We are worried about eventualities, in New Century's case, interest rate hike inspire slowdowns in mortgage creation and in our case, unhedgeable (or mismanaged) price changes that lead first to individual bankruptcy and then, via ever more tightly woven financial links, a more general credit market breakdown.

While the Wizards of VaR, who turn The Wizard of Oz's trick on its head, using smoke and mirrors to make the awe-inspiring and terrible appear ordinary and manageable, (pay no attention to the trillions of $ of derivatives behind the curtain) would have you believe that by the magic of risk summation, millions of individual contracts between parties can be distilled into simple, hedgeable "deltas," I'd rather focus on those two words, pilot error.

Corporations, be they governmental, religious or commercial come and go. They are run by men and men err. Pilot error is here to stay and, as noted above, one obvious form of pilot error is to deny eventualities. So take your reassurances from the Wizards of VaR that there is far less risk than there seems to be with a grain of salt. If Toto, in the form of New Century Financial, fails to tear down the curtain there will be, I fear, more to come.

*********

The brass tacks crowd is likely wondering IS THIS IT? The problem is, I don't think anybody knows. How many other financial institutions are as unprepared for a housing recession, or any other untoward shift, as New Century, and as un-forthcoming?

My best guess is that, barring drastic changes, the world of finance can continue duct-taping the markets together for the time being. The myth, or so I see it, of safety in bonds and risk of real assets like precious metals, remains firmly entrenched judging by price action in Treasuries. When Bond prices begin to follow equity indices lower, which will likely coincide with a break in the recent correlation between precious metals and equity indicies, watch out.

Hedgeability: The premise that is false

Find the trend whose premise is false and bet against it. - George Soros

Last week brought news of the death of Jean Baudrillard, or not as the case may be, whose rather esoteric works were highlighted in the film, The Matrix. While I didn't agree with his pessimism (see Bumming out with Baudrillard) I too have stared into the abyss of incoherence- the fear that there is no truth, and it left me as shaken as a character in an H.P. Lovecraft tale shouting Cthulhu at the top of his lungs. During periods of mass mania, if you are one of those stubborn souls who refuses to toe the party line, it can seem as if the truth does not matter.

But the truth does matter, or so I believe. One can swallow the party line that, for example, the economy is doing well only so long as one has enough food to eat. The old economic adage that it is a recession when your neighbor loses his job but a depression when you do still holds true.

And one needs to believe there is a truth, and that it matters, i.e. that it will force people to change behavior, if one is to make use of Soros' trading maxim above.

In response to a few comments on Too big to bail (out) today's musings will focus on how a supposedly well hedged portfolio, i.e. with minimal VaR (value-at-risk), can become a huge liability.

Back when I was an FX-Options dealer I would begin my day by getting the volatility "runs," the current volatility prices for at-the-money straddles- straddles being a equal amount of puts and calls with the same expiration and strike. I would then enter that data in our risk-analysis computer along with any overnight trades and then publish a few reports. The two key reports were with respect to time (theta) and underlying instrument price (gamma).

A typical gamma report for a portfolio long front month options might look something like:

GBP price Delta P/L
1.9500 2.2M +50.0K
1.9250 1.0M +17.5K
1.9000 0.0M 0.0
1.8750 -1.0M +17.5K
1.8500 -2.2M +50.0K

What the table means is that as spot GBP rises the portfolio becomes longer GBP and as it falls it becomes shorter. If getting longer as spot rises and shorter as spot falls seems too good to be true, it is. The catch is that good gamma, as the above is known in the trade, comes at a cost of time decay.

A typical theta, or time decay, report of the same portfolio might look something like:

Date Delta P/L
March 11, 2007 0.0M 0.0
March 12, 2007 0.0M -8.0K
March 13, 2007 0.0M -16.0K
March 14, 2007 0.0M -25.0K
March 15, 2007 0.0M -33.5K
March 18, 2007 0.0M -60.0K

That is, each day the portfolio loses about 8K and these losses will increase over time until expiration.

While there are many different strategies one can employ which might produce a similar report, thus leading to the conclusion that not all VaR neutral reports are equal, I've assumed an at-the-money straddle whose notional value might be 15M GBP per leg, i.e. a 15M GBP put and a 15M GBP call. Assuming nothing else in the portfolio (an assumption very rarely seen in the major trading house wherein one usually finds thousands of options of $100Bs of notional worth with wildly varying strikes and expirations along with spot and forward hedges) the true value-at-risk is the cost of the options.

If the portfolio had instead sold the options in question the true risk would be equivalent to a 15M GBP spot position mitigated by the receipt of the cost of the options. In that case the risk reports above would have their signs flipped- the portfolio would be getting shorter as spot rose, and vice versa (known as bad gamma) and would be earning money each day in the event spot remained the same (positive time decay.)

Let's assume, as is general practice in the industry, that the portfolio will be hedged in a sense, automatically. That is, each time, for instance, the delta reaches 1.0M GBP (one could choose a different amount), it would be "hedged" by entering a spot (or forward) trade of equal amount. In our example, the portfolio would then become a mix of both options and spot (or forward) deals.

This hedging would be done assuming that one or the other leg would be exercised which brings us to the first big risk options portfolios encounter, counter-party risk. In our initial example of a long options position, with spot rising, the portfolio would be short GBPs against the expected purchase at the strike price on exercise. If that counter-party defaults, as New Financial has apparently done, but not, I believe, in the FX options market, then the portfolio is just short GBPs sold at lower levels. That is, what seemed well hedged wasn't.

Thus you can hopefully see how LTCM's billions of $ of defaults were a major problem. Dealers who had bought options from or sold options to LTCM had hedged assuming LTCM would hold up their end of the deal. They assumed that all dealing institutions would exist in perpetuity, a rather silly assumption given the intermittent failure of financial institutions over the decades. Often though, counter-party risk is a secondary effect of a primary cause, a hedging failure.

The false premise, in my view, standing at the heart of our dilemma is the assumption of constant hedgeability. Option models, like Black-Scholes or their variants which we used to produce the hypothetical reports above, and which are used to produce reports throughout the financial universe, are based on this assumption of continuous pricing.

But what happens if markets don't exhibit continuous pricing? Let's assume we were managing the short side of the portfolio above and GBP gapped up from 1.900 to 2.000 in a few moments, say because Britain decided to join the ERM, as happened in October 1990. In that case, as they delicately put it on Wall St., you're screwed. In a few brief moments following an announced economic policy change, your nicely hedged portfolio becomes a disaster- you're now short 15M GBP from 10 cents lower (leading to a current loss of US$1.5M, far more than you collected in premium) in a rapidly rising market.

Perhaps you can now see how the Nobel Prize winning economists who founded LTCM, whose members included Myron Scholes of Black-Scholes fame, got blind-sided when emerging market debt prices became very volatile in the summer of 1998, a period which included Russia's default of sovereign debt. Markets which had seemed liquid enough to hedge suddenly became very illiquid. Prices were changing by large amounts (not exhibiting continuous pricing) and few wanted to take the other side of the trades, like buying Russian debt which was about to default, LTCM needed to make to stay hedged.

Thus the tremors of fear that emanated from financial centers around the world when China's market dropped 9% in a day and particularly when "calculation problems" caused an apparently instantaneous 200 point drop in the Dow. If you had been using the Dow Jones Index as spot price to "automatically" hedge, you didn't. (to be fair, from what I understand most equity hedging strategies used the relevant futures which were unaffected).

In other words, when markets gap up or down substantially the premise of continuous pricing upon which option pricing models are based is proved false. Moreover, as the LTCM case makes clear, even if you are well hedged and not directly involved in the volatile markets, exposure to other institutions who are involved can still get you. Thus the term, contagion.

Given that markets have, from time to time, exhibited just such discontinuous pricing (imagine a Wahhabi inspired coup in Saudi Arabia) many times in the past, basing a risk model which will serve as VaR calculator for portfolios which carry notional amounts (in our case above the notional amounts total 30M GBP) of many multiples of global GDP seems downright silly.

To be fair to Fischer Black and Myron Scholes, I'll bet that if they were told their theoretical musings would become the cornerstone of modern day portfolios they would likely have thought differently. So long as dynamic hedging flows (we referred to them above as automatic hedges) remained small relative to real trade flows, their assumptions, while not perfect, were, in a sense, workable. As these dynamic hedging and other speculative flows have grown, now swamping real trade flows, the flaws in the assumptions are laid bare.

Thus the ever increasing need for governments to engage in "market smoothing operations." Of course, market smoothing doesn't change the underlying fundamentals that gave rise to the discontinuities, they merely, if they work, foster the illusion of an "efficient market," and in so doing, lead more and more to join the party- thus begging the un-smooth-able.

Ultimately, I fear, we will regret the growth of the derivatives monster from manageable to unmanageable size. Political coups, abrupt decisions to not accept this or that currency and even economic warfare will, as they have in the past, appear. Certain financial institutions will get caught and their contagion effect will shake the whole house. We will, I fear, test whether these derivative dealing institutions have become Too Big to Bail (out).

p.s. many thanks to those who linked to this blog and brought thousands of new readers, although I hope one new reader so directed, the US Treasury's Executive Office of Asset Forfeiture, is just interested in my musings and not my house. (lol, I hope)

Too big to bail (out): a case of Humpty Dumpty Finance

The circuit is now complete. Darth Vader

I've only been alive for a shade over 4 decades but I feel as if my past life as a Wall St. trader occurred in a different era.

No, I'm not referring to the change in technology although I do remember having to share a computer at Chase Manhattan, watching Telerate pages on little green screens and the days before Reuters dealer when voice brokers were charging $10-25 per million $ on spot FX, which allowed them to keep me and my co-workers in the industry fat, drunk and happy. Ah, the memories of those Friday morning hangovers and then the calls from the brokers who financed them asking me to do 20 "switches" sometimes totaling $200Mil, or $2K in bro, thus returning the favor. Switches, for the uninitiated, are back to back deals to allow two parties who didn't have credit with each other to complete a trade with my bank as intermediary. As Chase usually had great credit we could deal with everyone.

But Chase didn't always have great credit, although it now seems that such a thing could never come to pass, and it is the conception of credit and the relation of the government to leading financial institutions to which I refer when I write of a different era.

According to Bloomberg: Moody's announced new guidelines for bank credit ratings last month that consider financial strength along with any support companies may get from government and financial institutions if they get into serious trouble. Such backing might be offered if regulators conclude the effects of a failure would be catastrophic for the nation's economy, a concept rooted in banks' financial woes in the 1980s.

Fortunately, as noted above, I remember those halcyon days of yore, the 80s, when banks could have financial woes.

What exactly caused those financial woes, you might be asking? The same thing that always caused them, too much leverage. That's not what you meant? Ah, you mean what was the catalyst that exposed the overleveraged balance sheets? Funny you should ask. It was the mortgage industry, in the form of the Savings and Loans.

You might recall that period in our history if you are around my age or older, and if so, you might remember when (February 1989, don't worry I had to look it up, I'm not that much of a geek) George Bush the Elder proclaimed the creation of a program to fix the S&L crisis with taxpayer money- a program that, with the help of Congress, became the Financial Institutions Reform, Recovery and Enforcement Act of 1989. You might also remember that up until that point, the fall out from the banking problem was considered to be mostly contained, wink, wink, nudge, nudge Hank Paulson.

You might also, if you are old enough, recall the introduction of the phrase, "too big to fail," into the financial lexicon. I don't have access to lexis-nexis but I did a search on the NYTimes archives and the first instance of the phrase in "the newspaper of record" occurred in mid-1987. The author of the article, Thomas Olson, then President of The Independent Bankers Association of America (I guess this institution doesn't have much longer to live), argued that the US did not need "superbanks." I guess his view was not echoed by others.

The notion of "too big to fail" became a serious topic of discussion during the latter half of 1990 when major US banking shares took a swan dive. To give one example, Citibank, whose share price had just surpassed its 9/87 peak in July of 90 lost more than 50% and tested the 10/87 lows by 9/90. Major US banks were considered so un-creditworthy at that time that I needed to get banks to do switches for me at Chase because our credit was "no good," particularly with the Japanese banks.

After watching Drexel Burnham Lambert go bust that year (which taught me just how nasty unwinding options portfolios can be and that was back when a US$100M position was considered "big") I guess the powers that be decided that certain financial institutions could indeed be too big to fail. By late 1991, Citibank's share price has recouped all its losses.

Meanwhile, in 1991, Salomon Brothers, 12% of whose company stock was purchased by Warren Buffett's Berkshire Hathaway in 1987, got caught submitting false bids in Treasury auctions. After raising the ire of then NY Fed Chief, Gerald Corrigan (details of which can be found here), the US Treasury announced that Salomon would no longer be able to participate in Treasury auctions. This threat from Treasury led Salomon to up the stakes, and threaten bankruptcy.

The Most Important Day: The Treasury spokesman then got Secretary of the Treasury Nicholas Brady, at that moment visiting Saratoga Springs, N.Y., for the horseraces, to call Buffett. The two men had been friendly acquaintances over the years but could hardly have imagined they would be facing off on this Sunday morning. His voice cracking with emotion and strain, Buffett made his case, telling the Secretary that Salomon could not cope with the Treasury ban and that it was bringing in bankruptcy experts to prepare for a possible filing. Buffett stressed Salomon's gargantuan size and the worldwide nature of its business. He predicted that a Salomon bankruptcy would be calamitous, having domino effects that would reach worldwide and play havoc with a financial system that subsists on the idea of prompt payments.

Doomsday scenarios are not easy to get across. Responding, Brady was friendly and empathetic but inclined to think this talk of bankruptcy and financial meltdowns was far-fetched. He could not imagine Buffett refusing to take the job or failing in its execution. Brady was also highly aware of where things stood: The announcement had gone out, and reversing it would be an enormous problem.

But to Buffett's enormous relief, Brady did not cut off the dialogue. Instead, he went off to make some calls and then kept getting back to Buffett. In one of the stranger details of the day, Buffett talked on Salomon phones that had been programmed not to ring but instead flashed a tiny green light when someone was calling. For longer than he cares to remember, Buffett stared at the telephone, waiting for the Secretary of the Treasury to create light. With each call, Buffett tried to make Brady realize the seriousness of the situation and his sense that they were rocketing along on a train that had to be stopped--but that could be, once everybody realized that this was an accident that mustn't be allowed to happen. At one point in the Brady conversations, all of Buffett's anguish and sense of futility got jammed into a single sentence: "Nick, this is the most important day of my life." Brady said, "Don't worry, Warren, we'll get through this." But that didn't mean at all that he had changed his opinions.

It took Corrigan's entrance into the telephone calls in the afternoon to make a difference. This was the man who told Buffett to prepare for "any eventuality" and defined his term by endorsing the ban. But Corrigan now listened hard and seemed to assign credence to Buffett's talk of bankruptcy and of his personal plans to leave were a filing to come. Said Corrigan to Brady and another regulator on the phone with them: "We better talk among ourselves." Buffett went back into the boardroom and waited with the other directors. Six floors below, over 100 reporters and photographers, this author among them, were gathering for the 2:30 press conference. Directly outside the boardroom, some of the managing directors that Buffett had interviewed on Saturday were milling around, summoned because one of their number was to be named operating head of Salomon.

And then, just at 2:30, Jerome Powell, an Assistant Secretary of the Treasury, called Buffett to read a statement the Treasury was ready to go with. It was effectively half a loaf, or maybe two-thirds, saying that the ban on Salomon's bidding for its own account was lifted while the ban on bidding for customers' accounts remained. "Will that do?" asked Powell. "I think it will," answered Buffett. The board then raced through electing Buffett as interim chairman of Salomon Inc. and Deryck Maughan as a director and operating head of Salomon Brothers. Buffett found Maughan and said, "You're tapped," and the two went down to the press conference, entering at 2:45.

And thus too big to fail became policy.

It is now 16 years later, the thin edge of the wedge has done its thing and the circuit is now complete. The financial industry has been, in a sense, nationalized. Credit rating agencies, as already noted, will now simply assume government support for large financial institutions. Moreover, this support has apparently been assumed sufficient to offset any balance sheet imbalances these financial institutions might encounter.

It was with this assumption in mind that the "too big to bail (out)" title came to me. There are limits to the amount of support even the mighty US taxpayers can provide, especially given the expected financing problems created by US population demographics (think baby boom) with respect to US entitlement spending over the next few decades.

My initial concern over the assumption of sufficient support was with respect to derivatives. If the derivatives inspired collapse of LTCM was a problem how much more problematic would be a similarly inspired derivatives collapse at JPMorgan given their US$62.6T in exposure. According to the Office of the Comptroller of the Currency (page 22), this US$62.6T in derivatives exposure is funded by assets of only US$1.2T. While this exposure is spread out over different asset classes and may well be perfectly hedged now, it seems to me that a discontinuous, i.e. unhedgeable, 10-20% move in key markets might be sufficient to drain JPMorgan's assets. And who will fill in the gap, US taxpayers? Are we now willing to upend social harmony, or what little that remains, by breaking promises of social security and other "entitlements" in order to keep big banks that mismanaged their investment portfolios afloat? And all this, by the way, while the upper class has been enjoying its biggest tax breaks in decades. I reckon that will be tough sell.

But, while reading today's news, I find another concern. Hank Paulson would like China to remove the restriction on foreign ownership of China's banks. Given the now enshrined in stone "too big to fail" policy will US taxpayers be expected (and able) to support our domestic banks in the event their investments in China's financial institutions, who already have substantial bad debt problems, go bad?

This seems to me to be a case of one's eyes being bigger than one's stomach. China is not Thailand or Argentina. At current growth rates the Chinese economy will surpass that of the US within a few decades. How can the US taxpayer fill a funding gap created in an economy bigger, thus leading to larger imbalances, than its own? Methinks the US is about to learn the lesson Britain learned when it was overtaken by the US- the tail cannot always wag the dog.

If US financial institutions expect to be bailed out they have to ensure their imbalances stay small enough such that the US taxpayer can, and be willing to, foot the bill. The $150B bail out of the S&Ls in the late 80s caused a recession and cost George Bush the Elder a second term. I wonder what effects a $1T or even $5T bail out would cause, particularly in the event it was engendered by problems in China's domestic economy. Short of a military dictatorship, I can't imagine a bail out of that size for that reason passing through Congress. And even if it did, who would buy Treasury bonds under those conditions?

What if the problem arises due to a collapse of some intervention scheme? Will US taxpayers be expected to bail out a covert scheme to keep the price of Gold down? or oil? More to the point, could US taxpayers bail out such schemes? Again, in the event support was needed and could be obtained under these conditions, why would anyone want to buy US bonds?

While the big banks are likely enjoying their "too big to fail" status, investors might want to consider if they have already become "too big to bail (out)." If one is searching for a conclusion, that, if generally accepted, would send the precious metals to the moon, this seems to me to be it.

A children's rhyme comes to mind.

Humpty Dumpty sat on a wall.
Humpty Dumpty had a great fall.
All the king's horses and all the king's men
Couldn't put Humpty together again.

Got Gold!

Is the militaryindustrial complex bad for the military?

In the councils of government, we must guard against the acquisition of unwarranted influence, whether sought or unsought, by the militaryindustrial complex. The potential for the disastrous rise of misplaced power exists and will persist. President Eisenhower

In the speech from which the opening quote was taken I found this sentence which seems even more true now than in 1961 when it was delivered: Our military organization today bears little relation to that known by any of my predecessors in peacetime, or indeed by the fighting men of World War II or Korea.

The men who returned from W.W.II and Korea had benefits such as the GI bill of rights which legislation, according to this website, provided funding for some 7.8 million veterans' education expenses and 2.4 million veterans' home loans. Injured veterans returning from the War on Terror have to face Walter Reed, and the prospect of lying in one's urine.

What went wrong? How is it that the United States can spend hundreds of billions of $ on "defense," more than the rest of the world combined, but cannot provide care for its own?

In my view, one causal factor is the profit motive. That is, the militaryindustrial complex of which President Eisenhower warned has taken control of the flow of "defense" funds. Funds flow to those endeavors from which handsome profits can be made, and don't flow to others.

While there are many human endeavors which are assisted by people's drive for profit, there are others which are not. Child rearing is one which comes to mind. As a father I am well aware that raising children is unprofitable in a monetary sense (wildly profitable in a human sense). My son is unlikely to repay my wife and me for the time and money we have and will sink into his care and education. And I don't expect him to. My hope is that he will treat his children at least as well as I have treated him.

Creating newer and more lethal machines to kill people, like the creation of any new machine, is an endeavor which is assisted by people seeking profit. But caring for the human element in the military apparently is not. Billions of $s in profit will be reaped by those engaged in the creation of the new nuclear weapons. But there will be relatively little if any monetary profit reaped by those caring for our injured. Of course, a great deal of human profit could be reaped by providing adequate care for those who were prepared to make the ultimate sacrifice, and came home missing a limb or their sanity.

It seems to me extremely odd that China, whose military spending is roughly 1/10th of the United States, can maintain a standing army of some 2.25 million men while we cannot adequately maintain an armed forces of some 1.4 million. While I imagine the average Chinese soldier expects far less than the average American soldier, the 10 fold gap seems to me more than sufficient to overcome this difference in expectations.

Moreover, given the abysmal results from the most recent hi-tech, and hi-expense shock and awe campaigns, and the now apparent lack of boots on the ground necessary to complete the mission, perhaps it is time to consider shifting the flow of funds a bit, even if it means less profit for the militaryindustrial complex.

I wonder if President Eisenhower ever worried that one negative effect of the growth of the profit seeking military industrial complex would be the diminution of our ability to win wars? As Rome discovered to its dismay one cannot maintain the necessary human element of any military campaign on the cheap.

Say it ain't so, Al

We are in the sixth year of a recovery; imbalances can emerge as a result. Ten-year recoveries have been part of a much broader global phenomenon. The historically normal business cycle is much shorter'' and is likely to be this time. Alan Greenspan

I guess you have to leave Financial Official-dom to divine that imbalances can occur during business expansions and that those imbalances might hamper further expansion.

Hank, The Hammer, Paulson, as he has not yet left Financial Official-dom thinks The global economy is more than sound: it's as strong as I've seen in my business lifetime. No flies (or imbalances) on you, eh Hank?

He went on to opine about problems in the mortgage market, Some of the credit issues are there, but they are largely contained. Isn't that what they said when the Titanic first started taking on water?

I'll pick a nit with Greenspan's view- the idea that imbalances CAN occur. Is he suggesting that the US economy was in balance when he left it? Or is he expecting imbalances to show up some time in the future?

One last nit to pick, I wonder to what much broader, global phenomenon is he referring- globalization, productivity or himself?

Sticky wages get stickier

When Michael Maynard's company announced it was moving overseas, the 53-year-old machine technician from Massachusetts quickly found a job at another firm. As the sole provider for his wife and two daughters, Maynard jumped at the new opportunity, even though he had to take a pay cut of nearly $8 an hour.

Then Maynard got lucky. He discovered that, unlike most Americans who lose their jobs, he qualified for a little-known federal program that pays up to $10,000 to certain workers dislocated by trade. In addition to his regular paycheck, he gets a government check for $117 a week, he said, a sum that "helps a lot."

Now, congressional leaders want to expand the program, known as wage insurance, with some arguing that it should be available to any worker who loses a job for almost any reason. The proposal is part of a broader effort to ease the anxieties of middle-class Americans who feel threatened by the globalization of business and a churning U.S. labor market that creates and destroys about 30 million jobs a year. Making up for lower pay

It looks like the labor market arbitrage of globalization just got a little more expensive, albeit tangentially as the costs will be distributed throughout the nation's tax base.

Who knows, maybe some clever soul will decide that it might actually be better to once again MAKE THINGS in America.

p.s. before I get any nasty comments from my Austrian friends, NO I'm not supporting this initiative. I'd much rather corporate heads take a voluntary interest in making the country of their residence a better place to live for all, which might take the form of not accepting pay that is 400 times their average worker's income. Income disparities such as we have in the US inevitably give rise to such reactions.

Ben Bernanke, Super-Central Banker (we hope)

When I was a youth, in addition to stamps and coins I used to collect comic books. As my collection expanded from the Marvel Comics I loved like The Fantastic Four and The X-Men to the DC Comics like Batman and Superman I learned that initially Superman couldn't fly, he jumped, as in "able to leap tall buildings in a single bound." I guess the authors figured that people wouldn't believe a man could fly. But this habit of disdain for the implausible faded and eventually Superman began to fly.

Over the weekend I learned, yet again, that this disdain for the implausible no longer exists. Look, up in the sky. It's a bird, a plane. No it's Ben Bernanke, Super-Central Banker, able to leap the impossible in a single speech.

What am I writing about? I'm referring to Ben Bernanke's recent speech on Globalization and Monetary Policy, in which he raises the concerns of other (obviously un-super) Central Bankers that the Fed's ability, given the accepted policy of globally open capital markets, to control monetary conditions in the US has been lost, or at least, seriously impaired.

But, fear not ye lesser mortals, sayeth the Super-Central Banker, the fact that the dollar is a freely floating currency whose value is continuously determined in open, competitive markets means that the Fed retains its control over monetary conditions in the US.

Why is this important? Let me cede the floor to an obviously lesser Central Banker, swervyn Mervyn King, whom I had the pleasure of meeting a few times in the late 90s:

Perhaps the key difference between the world of Bretton Woods and the world today is the size and volatility of private capital flows. Then, as now, it was recognised that no system could ensure the compatibility of:
(i) Domestic monetary autonomy;
(ii) Stable exchange rates;
(iii) Free capital mobility.

This "impossible trinity" has been at the heart of the debate on the international monetary and financial system for many years. A sustainable system must sacrifice one of these three objectives.

In that case it's good that the things a Super-Central Bankers asserts as facts, like the freely floating, continuously determined in open, competitive markets value of the US$ are so just by virtue of him saying it. For if the US$ did not float freely but was, for instance, subject to intervention by other Central Bankers attempting to maintain stable exchange rates, then the US would not have domestic monetary autonomy.

Yes, it's a good thing that the Japanese, Chinese, and oil exporting Middle Eastern nations don't intervene to maintain stable exchange rates for if they did we might come to wonder about the claims of our resident Super-Central Banker.

But wait, didn't our main man and the most recent ex-Goldman director turned Treasury Secretary recently visit the Chinese to implore them to let the Yuan, which has risen a whopping 6.5% against the US$ in the past 5 years, float more freely? Were you aware that the average price of $/JPY in the 21st Century is 115.13? Did you know that the Saudi Riyal is, in practice, fixed to the US$ at 3.75 per (in theory it is fixed to the IMF's SDR.)

Hmm, I'm starting to get confused because it seems to me that the US$ exchange rate with three of our major trading partners is pretty stable. Either the impossible trinity is no longer impossible or our Super-Central Banker is, well, er, um, WRONG! The Fed, to the extent US$ exchange rates are stable, has lost a degree of domestic monetary autonomy.

What would it mean if the Fed lost domestic monetary autonomy? Why it would mean that, for instance, bonds yields would fall when they would, with more autonomy, rise. It would mean that, instead of being able to drain liquidity from the ever growing derivatives bubble, liquidity would continue to flow and the bubble would continue to inflate. It would mean that the unregulated capital markets are OUT OF CONTROL and headed for a meeting with reality.

Fortunately, we have lost our disdain for the implausible. Superman can fly, financial professionals would never let narrow self-interest interfere with their important social functions as intermediaries, and Super-Central Bankers can do the impossible.

I feel better already (gulp!).

When "divide and conquer" fails

Divide and conquer fails when the parties one aims to divide find they have more in common with each other than with you. A. Burns

The two parties [Iran and Saudi Arabia] have agreed to stop any attempt aimed at spreading sectarian strife in the region. Prince Saud al-Faisal, Saudi foreign minister

China's (missing) FX reserves: a case of pay me later?

Brad Setser's blog, which I highly recommend, has focussed on, inter alia, China's missing FX reserves. His take, that China's reserve growth is actually higher than reported, may not be entirely correct, to the extent that the following is true.

According to Asia Times: Although the exact amount of overdue accounts receivable overseas is not known, Han Jiaping, director of the credit-management department under the research institute of the Ministry of Commerce, estimated that China has about $100 billion of accounts receivable overseas and the figure is growing by $15 billion a year.

In other words, China's missing FX reserves may not be as much a function of undercounting as under collection. What is better than paying for goods with newly printed currency or bonds? Not paying at all.

While US$100B may not be the sum is used to be, it ain't chicken feed, and as an owner of chickens I know the difference.

I wonder if we are nearing the end game of China's willingness and ability to service America's consumer needs. At some point, the lack of payment for goods received leaves the goods providers unable to continue to provide.

Further, and perhaps more interesting for those of us long the precious metals, bringing the account current would mean a substantial increase, given that there is a multiplier effect yet to be applied to the unpaid $100B, in global liquidity yet to be seen.

Seems to me like a damned if you do, damned if you don't scenario.

How big a fuse does one need to ignite the derivatives Neutron Bomb? perhaps $100B will suffice. We will see.