Wednesday, December 31, 2008

Holiday Price Trends

After a bad retail year, the holiday season failed to turn things around, and sales were the worst in decades despite aggressive Christmas price cuts. General retail saw a downward trend even compared to previous months, and online sales saw year on year reductions of 3%. So, stores on the edge hoping for a seasonal reversal probably didn't get it. Recent bailout measures have shown no signs of invigorating the general economy, not this holiday season at least. Strong deflationary trends continue.

On housing, recent S&P/Case-Shiller data show year on year declines of 18% over 20 metropolitan areas, with Phoenix, Las Vegas, and San Francisco leading the way with price drops over 30%. Case-Shiller numbers continue to fall off a cliff with no sign of flattening yet.

Otherwise, the DJIA has been hovering in the mid-8000's for weeks now, which reflects a huge year on year loss from its 14000 peak in Oct '07. Foreign currencies and gold are a mixed bag and showing relative strength due to debasement of the dollar, still the dollar has advanced slightly over the year in these areas. I anticipate the U.S. dollar index will strengthen as other countries follow suit in debasing their currency. Gold remains to be seen.

Tuesday, December 23, 2008

TARP: the first $350B

Since it was passed, the first $350B of TARP money has now been spent—as of Friday when the last of it was used to bail out GM and Chrysler.

This article has a quick summary on how the TARP money was spent: $250B was used to recapitalize banks, $40B went to AIG, $20B to insure loses from the New York Fed in its latest bailout measures against a wide range of credit like student loans and credit cards, $20B went to CitiGroup, and then another $5B as a loan loss backstop to CitiGroup, and now $13.4B to the automakers.

The second $350B of TARP money needs Congressional approval and will probably be delayed until Obama takes office.

Money given to the banks is essentially preferred stock purchases from the Treasury Dept at a fixed return of 5%. So it’s an advance of capital of indefinite term which dilutes the value of existing shares. The remaining money was dolled out as loans.

Credit, this blog proposes, is temporary money. When it is paid back or defaulted on faster than it is lent, then money supply shrinks, and deflationary pressures on prices follow. These injections of capital function as credit: they may slow down price corrections, but they do nothing to reverse the course of the credit collapse.

Friday, December 19, 2008

You Will Inflate Dammit!

Over the last couple months the dollar has been shot, stabbed, strangled, and thrown into an icy stream. Thus, quite sensibly, investors are running away from the dollar to other currencies, and much of the advances made in the US dollar index since August has been wiped away. This is still a highly volatile state of affairs.

But yeah, the U.S. dollar is a horrible store of wealth at the moment. With overnight rates now at 0%, and $850B in newly minted bills (now up from $650B) ready to be shoveled into the economy, plenty of systematic effort has been made to devalue it.

Though the U.S. dollar index (USDX) is the usual way the value of the dollar is gauged, this blog posits that a better measure still is purchasing power in its resident economy. Generally, I keep my eye on stocks, houses, commodities, and gold. The coming weeks will tell if the Feds changes in monetary policy will affect the deflationary trends in these sectors.

Tuesday, December 16, 2008


Today the Fed announced it would drop overnight interest rates by 75 to 100 basis points to the 0% - 0.25% range. This is a record low for the Federal Funds Rate, and it cannot go any lower than this.

It is hoped that lending money for free will increase credit, lending, and general economic activity. We haven't seen that with the prior interest rate drops, and we won't see it with this one either. Lending already reached its terminal limit when interest rates were in the 1-2% range in 2003-4. I anticipate credit will continue to contract faster than base money is issued and so deflationary trends will continue.

With the Fed's money printing since September, such that bank reserved have expanded seven-fold, a ZIRP has been the economic reality for over a month. This makes it official.

Monday, December 15, 2008

Lost Money

There’s been a lot of talk about people losing money. Here, “lost money” will mean something different. If you lose $500 in Las Vegas, that’s not lost—the casino has it now. If you tried to flip a $500K house in Stockton and today you are lucky if you get $200K for it, that’s lost wealth, not lost money. Here lost money refers to cash outside the economic system that’s not available for spending; it’s “lost” to the economy, even if we know where it is.

Naturally, I’ve been following closely this latest expansion of base money by the Fed. A few days ago, what had been vertical growth since September has briefly flattened at exactly $1500B. Before, it had stabilized for over a two years around $850B; the rise to that level took years, so the latest 40% increase is very sudden and concerning. Put that in to a 10% fractional reserve system and that could inflate to another $6.5 trillion.

So far though, the U.S. dollar has been maintaining its trend of strength. Against stocks, commodities, real estate, and foreign currency it is much better off than it was a year ago. Though strengthening trends have leveled over the last month, it shows no sign no of remitting back to where it was. (UPDATE 5/20/10: it did over 2009, but today has rebounded and is showing strength again.)

Mish explained nicely with a series of charts from the Fed that the money printed isn’t going in to circulation. This money is on loan to banks, for them to lend out, but banks aren’t lending it out, so it’s just sitting in reserves. The reserve expansion of banks from $100B to $700B over nearly the same time course explains where most of where this money has gone.

So that’s what I mean by “lost money.” If one takes half the currency of an economy and puts it in coffee cans and buries it in the desert, prices will adjust to what money is left; they will fall to accommodate the reduced money supply. If the money is dug up and spent, as it redistributes throughout the economy, prices rise in response to the “new” money. Factoring in "lost money" simply says that prices adjust to what money is actually available for spending.

Wednesday, December 10, 2008

The Timing of Deflationary Downtrends

Austrian economics conceptualizes asset bubbles as being the result of credit expansion in fractional reserve systems. Once the forces fueling the expansion have exhausted themselves, it anticipates asset prices will drift back to “fundamentals” where costs of investments are justified by dividends and risk. Austrian economics explains the reason economic bubbles happen and their ultimate deflationary course (excepting cases of hyperinflationary events).

This post will examine two questions: how long and how high can these credit bubbles go, and once they reach their stall point, how long can inflated prices persist before they return to fundamentals.

Prior posts proposed the “cash-inventory equivalency” where the combined prices of all goods for sale in an economic system tend to self-adjust such that the sum exactly equals the money supply, which in a fractional reserve system is the sum of printed currency and credit. If money supply increases, then prices will follow; if credit and/or printed currency contracts then there is downward pressure on prices else velocity of sales slows and inventory starts to build. “Price disequilibrium theory” anticipates that if money supply grows through an unsustainable expansion of credit, then prices which were inflated as a consequence will be pressured downward once credit collapses.

If such is the case, then peak prices would be consistent with peak credit, assuming printed currency holds constant. Though printed currency is not holding constant at the moment, this discussion will consider the theoretical situation where it does. In hyperinflation, the entire economy collapses and would be in limbo until a new money supply is established. Settings of moderate printing could still be assessed with this model where money supply is the sum of printed currency and credit. But for simplicities’ sake, it will not be.

I have argued before that in our current system banks have nearly infinite capacity to lend, so the limits of credit expansion is not with banks but with borrowers. The limit of credit growth is when borrowers do not have the ability to repay loans anymore, so they can’t borrow anymore. This stands to reason. Unfortunately, it is wrong—otherwise this would all be mathematically straightforward. In the present crisis, credit was expanded beyond and oftentimes without regard to the likelihood of loans being repaid. Banks didn't seem to care. So the question becomes, how far can that go?

The farther this trend does go, the more corrective forces will start to resist further lending. Failure to repay loans will erode the capital base of banks. The political tolerability of bailouts will eventually wear thin as these loses start to mount. As the capital base of banks heads toward zero through failures of loan repayment, the terminal limits of credit expansion would be the willingness of banks to risk their corporate viability on loans which have little chance of being repaid. For each bank, risk appetite will be slightly different, but the general erosion of the capital base of multiple banks marks the endpoint of credit expansion.


Now, for the second question of how long it takes for prices to return to fundamentals after the credit contraction begins. If the prices of investments rise above their fundamental values, and prices keep going up and up, then their worth as investments is driven by the expectation of continued capital gains. Once the credit peak is reached and begins its contraction, further capital gains ought to no longer be expected, and the investment value of an asset is only its ability to generate dividends, rents, or yields. If there is a great discrepancy between disequilibrium asset prices and their fundamental values, then once the peak is reached asset prices should descend immediately to their fundamentals. At this point no buyer should pay more than that. To do so would be “catching a falling knife.”

But the price correction won’t happen immediately; they are slow with losses and advancements, and occasional bear runs, cycling over and over around a downward trend line toward the eventual correction.

Another way to look at the question is to ask why the seller should lower their prices? Prices are a negotiation between the buyer’s desire for the good and the sellers want of money. As desire for over-inflated assets drops, and as sellers need the money—if they need the money—then prices begin to budge downward. If a seller has infinite resources an can hold out forever for a supposed turnaround, and they never need to “cash in” on a held property or investment asset, then prices could stay elevated forever, as velocity slows to a crawl.

If there is a holding cost to an investment—like interest payments on the money to purchase it, or property taxes, maintenance, and fire insurance—then pressure starts to mount on underperforming investments. If maintenance costs exceed rent for comparable properties, then the duration one can wait for the turnaround of property values is a function of economic capacitance, or duration one can weather negative cash flows through dipping in to savings or selling unneeded assets. Once economic capacitance is exhausted, the asset must be sold and the price it fetches reflects market value.

An economic system is composed of many micro-economies—of individuals, families, businesses small and large, non-profits, and government at all levels—and the economic capacitance of each will vary. In a disequilibrium contraction, prices move downward if a critical mass of asset holders are forced to sell at re-adjusted prices such that the market value is reset downward.

So, in price disequilibrium events, the upper limit of credit expansion is when the capital base of banks erodes through the non-repayment of loans. The maximum duration prices remain elevated after credit stalls is a function of the economic capacitance of those who hold the assets.

Saturday, December 6, 2008

Automaker Bailout

So, the news has been back and forth lately around the CEOs at the big 3 automakers saying at Congressional hearings they are "too big to fail," somewhat like CitiGroup did, and along with union representatives are requesting a bailout. The first round, they arrived in Washington in their private jets and asked for $25 million all told. They left empty-handed. This time, they drove there in their hybrid cars and requested $34 billion. It seems from reading about it they had a mixed and lukewarm reception, but an agreement has been reached between the White House and Congressional Democrats for $15 billion in loans.

I wrote my representative Nancy Pelosi, urging her to not use taxpayer money to support unprofitable corporations; rather, what is best for America would be to let the big 3 go under, so their production capacities could be sold to new firms that conduct their business better. I mean, at least the financial industry didn't off-shore Wall Street jobs... I don't think.

Actually, I see a plan starting to unfold: passing another bailout would be politically inexpedient at this point; so, Congress agrees to pass the unspent $350B of TARP bailout money, if the Bush adminstration agrees to give some of it to automakers.

UPDATE [12/11/08]: Though the $14B bailout proposal of the automaker passed in the House, today it was voted against in the Senate. Plan B mentioned in the above paragraph is still in play. [12/19/08] The Bush administration, citing concerns of a disorderly failure of automakers, will lend $13.4B to GM and Chrysler, coming from the first $350B of TARP bailout money. The second $350B still remains unapproved by Congress. Apparently this finishes up the first $350B of TARP funds. [12/29/08] For what it's worth, the Canadian government throws in another $4B to rescue the automakers, and the Treasury allows GMAC, which financed mortgage and auto loans, to be regarded as a bank, and adds another $6B to GMs bailout.

Thursday, December 4, 2008

World Rate Cuts

Today central banks of the world announced rate cuts in a move to offset the global liquidity crunch. Of note: The ECB cut by 75 bps to 2.25%, Bank of England cut by 100 bps to 2%; Australia by 100 bps to 4.25%; New Zealand by 150 bps to 5%, and Sweden by 175 bps to 2%. The coordinated move speaks to the widespread nature of the financial meltdown that began with the collapse of the subprime mortgage market and has extended to credit markets domestic and foreign. Today is a stepping stone that will likely conclude in a worldwide zero-interest-rate policy (ZIRP).

A half-point cut from the Fed to 0.5% is anticipated in their next meeting.

Monday, December 1, 2008

Bernanke’s State of the Economy Speech

Ben Bernanke gave a speech today before the Chamber of Commerce in Austin, Texas. It’s a bit dry but a good read. It paints a sober and sensible assessment of the financial crisis. He has given us some pretty misguided assessments in times past so this is a change.

The first section: “Federal Reserve Policies During the Crisis” is a recapitulation of major financial events since the collapse of Bear Stearns, and policy which has been formulated in reaction to them. It echoes most of the events reported on in this blog, telling things from the Fed’s perspective, and making some attempts to encapsulate the arguments pro and con to its actions. The only thing left out—that should have been included—is the recent expansion of base money supply.

The second section: “Economic Outlook” predicts the continuation of general economic downtrends at least for the short term, in housing, cars, and general retail, for example. In the long run, naturally he is optimistic about the U.S. economy. Around housing he specifically anticipates the “eventual stabilization in housing markets as the correction runs its course.” Finally, Ben has discovered the blogosphere!

The third and final section: “The Outlook for Policy” there were four points he spoke on: (1) Regarding the Federal Funds Rate that is now 1%, he admits the actual effective rate has been lower than that because Fannie Mae and Freddie Mac have been undercutting the Fed and lending their reserves overnight for less. Though he indicated the possibility they might go lower, at 1%, there isn’t much farther to go. (2) The Fed also offered the possibility to purchase GSE bonds, and Treasury Bonds to boost liquidity in the system. (3) The vast array of liquidity measures provided now can be broadened out and expanded further, he tells us—which would necessitate a expansion of the Fed’s balance sheet that would need to be contracted over time to prevent inflation. And (4) the Fed will continue to “preserve the viability” of failed financial institutions where it poses a systemic risk. He concludes by adding that foreign central banks are conducting similar extraordinary efforts. Again he leaves out the increase in base money by $650B (and counting).

Treasuries rallied on point (2) of the third section. Stocks fell sharply today.