Flawed Economics On ABC

Diane Sawyer's appearance last night on Bill O'Reilly's Fox News Factor program demonstrated that economic fallacies remain widespread and embraced by media personnel who are in a position to influence masses of Americans.

I'm speaking of Sawyer's/ABC's 'buy American' push, in the mistaken belief that it is the best way to further its explicit aim of trying to find jobs for unemployed Americans.

Sawyer was on O'Reilly's program ostensibly to answer questions regarding ABC's liberal bias in the 2008 presidential election, and its putative continued bias in the 2012 election cycle. I won't bother with Sawyer's platitudes on that topic.

Instead, of interest was her turning the conversation to some feature on its news hour where the network apparently tries to compete with The Ladders or Monster.com, connecting unemployed Americans with jobs.

Sawyer went on to challenge O'Reilly to conduct an audit of his home to discern how many items were not 'made in America.' Then compounded her idiocy by wondering aloud which was 'more American,' a GM vehicle or a Toyota vehicle, both of which were assembed in the US?

David Ricardo must be spinning in his grave. Haven't Sawyer and O'Reilly heard of Ricardo's Law of Comparative Advantage?

So now, along with O'Reilly's misinformed belief that high oil prices are always the result of immoral speculation and manipulation, we can add his apparent tacit approval of beggar-thy-neighbor trade practices and outdated economic thinking.

As for Sawyer and ABC, can't someone like John Taylor, Alan Reynolds or Nouriel Roubini take her to task and end the domestic preference nonsense on that network?

Perhaps counsel them to dump the amateur-hour job placement charade and use their media pulpit to argue for lower tax rates and less government intrusion into the private sector, thus providing more money and less uncertainty, which would facilitate private investment, GDP and, with it, job growth?

Will Services Truly Go Global?

Mr. Joseph Sternberg edits the Wall Street Journal Asia's Business Asia column and recently wrote an editorial entitled Now Comes the Global Revolution in Services.

Of course this has been a feared development by many in the US economy, since our services sector is so large. The first such globally competitive service which probably comes to mind is call centers.

Sternberg wrote,

"Asia has been a big winner from the development of global manufacturing supply chains. Japan and the four tigers—Hong Kong, Singapore, South Korea and Taiwan—showed how cheaper shipping could create opportunities for factories far from the intended market. As supply chains have grown more complex, the benefits have spread. Components now travel from Thailand, the Philippines, Malaysia and Taiwan to a factory in China, where they're assembled before hitting the shelves of an Apple store in New York as a finished iPhone.


Even as the manufacturing supply chains continue their evolution, a new question confronts Asia: How to profit from increasingly sophisticated supply chains in services? Despite all the political hype in the West about the ills of outsourcing and the perceived ubiquity of overseas customer-service call centers, services supply chains are still in their infancy."

It's thought-provoking to realize how the economics of various manufactured and assembled parts of goods such as an iPhone make it affordable to ship the incomplete item around so much of the world simply to take advantage of lower labor costs. Sternberg then contends,

"We're heading for a day when a Malaysian architect will sketch out a new office tower for London, a Philippine architect will prepare detailed renderings, and a Chinese engineer will assess the structural soundness of the designs. Or a specialist firm in Bangalore will administer health benefits for a Kansas company. Indeed, such things already are happening on a modest scale.

That's particularly apparent on the infrastructure front. Ask experts what a government needs to do to develop a services- outsourcing industry, and the first answer is usually "provide more reliable electricity" or "lay fiber-optic cable." True, but more important will be the human intangibles. Educating a sufficiently skilled work force—no small task in itself—is only the start."

Sternberg's example sounds simple enough. But will it really occur? Are language barriers really so easy to overcome that complex building design will be piece-parted out as he describes?

He concluded with this passage,

"Manufacturing supply chains applied modern transportation technologies to a millennia-old principle that if someone in a neighboring village can make a good more efficiently than you can, you should buy it from him. Service supply chains derive a new principle—that you no longer need to be geographically near the person providing you a business service—from modern communications technologies. Now countries need to figure out how they fit into this trend, and how to profit from it."

Personally, I believe Sternberg is far too optimistic about the globalization of high value-added services. Especially services involving high levels of complexity.

Why?

Well, for one, globalization of product manufacture and assembly has a simple test. Does the resulting product function at a competitive price? The proof is easy to see.

Services aren't so simple. The success of a globally-designed building or other complex system using services provided in so many countries and languages might not be apparent for years. And they tend to be one-off projects, rather than, like products, things of which millions are sold and used.

Even the lowly call center has seen a reversal of outsourcing overseas from the US. Too many problems with language and basic service quality levels has resulted in some firms regaining an edge by relocating their call centers back in the US.

Then there's the recent comments of Boeing CEO Jim McNerney on CNBC. In answer to questions concerning the Dreamliner's continuing delays, McNerney confessed that the firm had overreached with its design outsourcing. He said that they won't be doing that again, focusing instead on more onshore engineering and design.

If one of the most sophisticated engineered systems we have, a modern jetliner, has failed to be reliably designed and produced globally on time, what are the prospects for equally-sophisticated systems? At least the Dreamliner results in a testable product on which quality control may be performed before it actually goes live in its initial commercial flights. And Boeing has been building such systems for decades.

I think it says a lot that they got the mix and management of global design of the various parts and subsystems of their newest jet fouled up, and are planning to move back to more centrally-sourced services in the future.

Thus, it's my guess that Sternberg's concerns and visions are very premature. And a big chunk of US exports in the service-based sector remains somewhat safe for a while.

Trade Wars & Economic Statistics

Tuesday's Wall Street Journal's lead staff editorial revealed some very troubling information regarding international trade data.

Labeling the current flap over China's currency "a distraction the economy can't afford," the editorial continues,

"How much of a distraction is suggested by a paper out last month from the Asian Development Bank Institute. Economists Yuqing Xing and Neal Detert examined the supply chain of the iPhone to reach a surprising conclusion: Technically, the iPhone contributes to America's trade deficit with China.

The basic explanation is that data on bilateral trade are calculated assuming that the entire value of a traded good is created in the exporting country. If that ever made sense, it certainly doesn't in a global economy marked by increasingly complex supply chains.
In the case of the iPhone, Messrs. Xing and Detert note that the device was invented in America by an American company, Apple. The components are manufactured, either inside or out of China, by companies based in several other countries. The only part of the process that is unambiguously "Chinese" is the final assembly—a process that, in the estimation of Messrs. Xing and Detert, adds only $6.50 to the $178.96 wholesale value of an iPhone.
Yet that entire $178.96 value ends up attributed to China in official trade statistics. As a consequence, the iPhone contributed nearly $1 billion to China's bilateral trade surplus with America in 2008, and nearly $2 billion in 2009, the authors conclude. If the trade data had been based solely on the $6.50 cost of assembling each unit, the iPhone would have added only $34 million and $73 million in those years to China's surplus.

The ADBI study ought to be required reading on Capitol Hill. Most importantly, it raises the question of how much anyone really knows about what America's trade with China is. Critics of trade data, including us, have long argued that bilateral statistics are misleading. As the bilateral deficit with China grew, deficits with South Korea, Taiwan and Singapore declined, confirming that China's comparative advantage lies in the assembly into finished products of components manufactured around the region, due to its low-wage, low-skilled labor."


How about that last paragraph? Is that not insane?

For years we've been wringing our hands over trade imbalances with other nations, only to now learn that, sorry, ooops.....we don't actually account for specific value-addeds on an incremental basis.

So we really have no idea what any country's bilateral trade is with any other country? Why, because keeping track at the component or assembly level is too much trouble?

How can we realistically conduct trade policy or even correctly model the US economy if our fundamental data on international trade flows is basically wrong?

For me, this puts a huge hole in the econometric models predicting quarterly GDP growth. Back when I was in college and grad school, international trade wasn't a major component of GDP. Now, it is. Or so we think. Maybe we really don't know exactly how big it is, if we are crediting other countries with the entire cost basis of an assembled product which passes through that nation for one stage of production.

This valuable information buried in the Journal's editorial provides a big wake-up call regarding the quality of international economic trade data, does it not?

A Financial Plumber Speaks In Favor of Managed Trade

At the end of last month, John Cochrane wrote a great editorial in the Wall Street Journal entitled Geithner's Global Central Planning. I wrote about it here. So Geithner & Co.'s nonsensical ideas about global trade central planning, in concert with exchange rate management, is not news.

Never the less, Geithner recently wrote another defense of these bad ideas in the Journal. It was the same basic set of themes, i.e., set balance of trade flow targets, get other countries to appreciate their currencies so the US can depreciate its dollar.

Cochrane exposed them as stupid and unfounded theories then, and nothing has changed about his critique in the past three weeks.

However, there's a deeper issue here, as well. That is the question of Geithner's credibility. As I have written in prior posts, there's nothing in Geithner's background to suggest that he is anything but a financial systems plumber. When he's had a significant policy-level position, such as running the New York Fed, he botched the job. Remember, in that capacity, he let himself be out-maneuvered by Goldman Sachs and a couple of French banks, resulting in his using taxpayer dollars to fully repay those parties for their AIG exposure.

I don't recall Geithner authoring oft-cited, learned papers concerning international trade theory. Or theories of currency policy and management.

In fact, everything about his recent articles attempting to defend his wacky notions of international trade and currency valuations smacks of expediency and, as Cochrane notes, unfounded, un-normed concepts prone to political manipulation.

Frankly, I just don't think Geithner, a guy who couldn't even do his taxes correctly, or manage to hire a competent accountant, has the mental horsepower to comprehend the current dilemma of US monetary and economic officials.

Back some years ago, I believe in the late 1980s, in a Wall Street Journal editorial, a respected economist made the insightful observation that nations had only two policy levers- monetary and fiscal- with which to attempt to affect three phenomena- domestic economic growth, domestic inflation, and international trade balances. The latter former lever, monetary policy, is typically given the double duty of governing inflation and international trade and currency policies.

Stronger currencies, following from low monetary base growth and/or higher interest rates, tend to hurt economic exports and often bring in foreign investment flows. Pro-growth monetary policies, such as our current weakening dollar and zero interest rates, aid exports but cause global investors to seek other instruments. As a reserve currency, these policies do even more damage by causing global holders of dollars, as a store of value and commonly-accepted medium of exchange, to seek more stable exchange media.

This is where, in past times, gold was used as the third lever to automatically affect international trade flows and valuation. Not coincidentally, monetary base growth, being backed by gold, was restricted from over-expansion by the knowledge that a cheaper currency would only hurt a nation when foreign holders of that currency redeemed it for now-cheaper gold.

Geithner's transparent attempts to force global investors and other countries to overlook US devaluation of the dollar and management of trade flows to our benefit haven't fooled anyone. But, then, what do you expect from a guy who, as a financial plumber, is trying to work beyond his capabilities?

Is A Gold Standard Really Better?

Last Thursday's Wall Street Journal contained an editorial by Charles W. Kadlee, Gold vs. the Fed: The Record Is Clear, contending that a gold standard are associated with better US economic performance. His piece begins with this paragraph,

"When it meets next week, the Federal Open Market Committee (FOMC) is widely expected to signal its desire to increase the rate of inflation by providing additional monetary stimulus. This policy is based on a false—and dangerous—premise: that manipulating the dollar's buying power will lead to higher employment and economic growth. But the experience of the past 40 years points to the opposite conclusion: that guaranteeing a stable value for the dollar by restoring dollar-gold convertibility would be the surest way for the Federal Reserve to achieve its dual mandate of maximum employment and price stability."



Regardless of accepting, at least initially, Kadlee's assertion about gold, he paints the Fed's obviously economically unlikely hopes starkly. Whether it was once true, in today's world of copious data and information, nobody really believes simple currency devaluation will fool global investors.

Kadlee then lays out the empirical bases of his argument in these following passages,

"From 1947 through 1967, the year before the U.S. began to weasel out of its commitment to dollar-gold convertibility, unemployment averaged only 4.7% and never rose above 7%. Real growth averaged 4% a year. Low unemployment and high growth coincided with low inflation. During the 21 years ending in 1967, consumer-price inflation averaged just 1.9% a year. Interest rates, too, were low and stable—the yield on triple-A corporate bonds averaged less than 4% and never rose above 6%.


What's happened since 1971, when President Nixon formally broke the link between the dollar and gold? Higher average unemployment, slower growth, greater instability and a decline in the economy's resilience. For the period 1971 through 2009, unemployment averaged 6.2%, a full 1.5 percentage points above the 1947-67 average, and real growth rates averaged less than 3%. We have since experienced the three worst recessions since the end of World War II, with the unemployment rate averaging 8.5% in 1975, 9.7% in 1982, and above 9.5% for the past 14 months. During these 39 years in which the Fed was free to manipulate the value of the dollar, the consumer-price index rose, on average, 4.4% a year. That means that a dollar today buys only about one-sixth of the consumer goods it purchased in 1971.


Interest rates, too, have been high and highly volatile, with the yield on triple-A corporate bonds averaging more than 8% and, until 2003, never falling below 6%. High and highly volatile interest rates are symptomatic of the monetary uncertainty that has reduced the economy's ability to recover from external shocks and led directly to one financial crisis after another. During these four decades of discretionary monetary policies, the world suffered no fewer than 10 major financial crises, beginning with the oil crisis of 1973 and culminating in the financial crisis of 2008-09, and now the sovereign debt crisis and potential currency war of 2010. There were no world-wide financial crises of similar magnitude between 1947 and 1971."


Interesting data, but I can't help wondering why Kadlee leaves a four year gap, 1967-71, not assigned to the gold standard years. Isn't that the period during which US stagflation began? I recall it as when the stock market crashed from the Nifty Fifty go-go years, LBJ levied the income surtax of 10%, and the US tried a 'guns AND butter' approach to economics. All while still on the gold standard. My guess is Kadlee's gold standard-era economic performances look much worse if measured all the way through 1971, when Nixon closed the gold window.

As Kadlee presents the post-gold standard data, he mentions an innocuous detail. His gold standard data cover 20 years, while the post-gold standard era comprises 39 years. So when he declares that we've had the three worst post-1930s recessions in the non-gold standard era, right away, one should note that the chances of more bad recessions since 1971 could be doubled anyway, as a null hypothesis, simply because of the length of the era.

Still, his point is seductive, is it not? Because, gold standard or not, what is co-extensive with going off the gold standard is floating exchange rates. And, in a sense, the Fed's unconstrained ability to print money without worrying about losing all its gold as cheap dollars show up to take advantage of the bargain that only 35 of them would buy- an ounce of the precious yellow metal.

Kadlee continues his case by turning to exchange rates,

"And what of the seductive promise that a floating dollar would make American labor more competitive and improve the nation's trade balance? In 1967, one dollar could buy the equivalent of approximately 2.4 euros (based on the pre-euro German mark) and 362 yen. Over the succeeding 42 years, the dollar has been devalued by 72% against the euro and 75% against the yen. Yet net exports have fallen from a modest surplus in 1967 to a $390 billion deficit equivalent to 2.7% of GDP today."


Again, compelling. But also really the result of the post-gold standard floating exchange rates. And, once again, there's that troubling use of 1967, rather than, say, 1970, for the endpoint of the gold standard era. What difference would those 3-4 years have made? I don't know, and don't wish to engage in empirical research to find out. It simply bothers me when authors tailor time periods incorrectly for comparisons, and fail to disclose why.

There's no doubt, however, that the past 40 years of US deficit spending and dollar depreciation have eroded our purchasing power versus every other major currency. What is eye-opening for me, though, is his claim that  during the period, our net exports, which, in trade theory, should have boomed with the currency depreciation, have moved from surplus to large deficits of our GDP.

His summarizes his points thus,

"Economists and pundits may disagree on why the gold standard delivered such superior results compared to the recurrent crises, instability and overall inferior economic performance delivered by the current system. But the data are clear: A gold-based system delivers higher employment and more price stability. The time has come to begin the serious work of building a 21st-century gold standard for the benefit of American workers, investors and businesses."Again, Kadlee engages in some overstatement. Would we really say "a gold-based system delivers," or is it more correct to write, "a gold-based system is associated with,"

"higher employment and more price stability?"

And, as for "price stability," isn't that circular reasoning? Even a non-gold standard system of fixed exchange rates would have performed well. The problem, of course, is enforcement of such fixed rates in the absence of the natural punitive nature of the gold standard. That was the idea behind SDRs, but, with the abandonment of fixed rates, their replacement for gold in that role was obviated.

I think Kadlee's points are sensible and valid for an argument against floating rates, rather than for gold. Despite the troubling statistical legerdemain involving the missing 1967-71 data for comparisons, I'm quite willing to believe Kadlee's general thesis that some sort of enforced fixed exchange rate scheme would have constrained America's monetary profligacy over the last 39 years.

When I began studying economics in the mid-1970s, the warnings of excess American dollars and their inevitable effect on the US economy were already a decade old. But, back then, our trade deficits were still positive, as was our net foreign investment.

Nearly half a century of reckless deficits have reversed those two measures, and resulted in substantial loss of value in the dollar. You can't argue with that, gold standard or not.

On Global Central Economic Planning & Currency Management

University of Chicago finance professor John Cochrane wrote a rather scorching editorial this past Tuesday in the Wall Street Journal entitled Geithner's Global Central Planning. He begins with a simple, scathing assessment of the recent G-20 finance ministers' conference,

"Economists are full of bad ideas. Terrible ideas seem to emerge when the gurus get together to talk about coordinating their bad ideas. Last week's public letter from Treasury Secretary Tim Geithner to the G-20 finance ministers is a great example."

To begin to provide detail, he refers to language in a Geithner proposal emanating from the conference,

"Mr. Geithner starts with a dramatic proposal: "G-20 countries should commit to undertake policies consistent with reducing external imbalances below a specified share of GDP [later reported to be 4%] over the next few years." "

For some perspective as to ill-informed Geithner's idea is, Cochrane provides this classic example,




"Since when is every trade surplus or deficit an "external imbalance" in need of correction? It makes sense for a country that has good investment prospects to import a lot of goods, run trade deficits, and borrow money. Years later, the country puts the resulting products on boats to pay the lenders back. The U.S. borrowed abroad to finance our railroads in the 19th century and ran surpluses when Europe was rebuilding after World War II. Were these "imbalances"?"



Cochrane makes a very good point. How is it that Geithner is so skilled at judging what's an imbalance needing correction, versus a natural trade flow of capital and goods?

Then he considers the very real current situation of the US and China,

"Or consider a country (say, China) with a lot of middle-aged workers who need to save for retirement. It makes perfect sense for them to put stuff on boats and send it to a second country (say, the United States) whose people want to consume the goods. The people in the first country invest their earnings, say, by buying the bonds issued by the second country. And as they retire, they cash in the bonds and buy goods flowing the other way.



Do these and similar stories exactly account for current trade patterns? I don't know. But nobody else does, either. In particular, the army of economists in the basements of the International Monetary Fund (IMF) has no clue exactly how much each country should be saving, or where the best untapped global investment opportunities are around the world—including whether trade patterns are "normal" or "imbalanced." "

Just so. Cochrane continues by turning to Geithner's new idea,

"So what policies would Mr. Geithner have countries undertake to bring economies around the world into his idea of better balance? He says that G-20 "countries running persistent deficits"—that's the U.S.—"should boost national savings by adopting credible medium-term fiscal targets consistent with sustainable debt levels."



So Mr. Geithner knows that trade surpluses in the end come down to saving and investment. And he knows that in the U.S. people are trying to save right now. Our government is undoing their efforts with massive fiscal deficits. Mr. Geithner recognizes that most of the trade "imbalance" comes down to a big fat fiscal imbalance centered in Washington, D.C. But there's the catch. "Medium term" means "not now" and "not long-run entitlements." "Target" means "promises." Even if a target would make a difference, who believes in targets from our government? We don't know what the rate of taxation will be in three months!


Mr. Geithner goes on to say that "countries running persistent deficits" should "strengthen export performance," but he doesn't say how, or what other "performance" we should weaken to get it. Is this a code word for export subsidies, devaluation and industrial policy, and a plea that the rest of the world should let us get away with it?


His advice to the other G-20 countries, those "with persistent surpluses," is that they "should undertake structural, fiscal, and exchange rate policies to boost domestic sources of growth and support global demand." In particular, "G-20 emerging market countries with significantly undervalued currencies and adequate precautionary reserves''—have you figured out this means China?—"need to allow their exchange rates to adjust fully over time to levels consistent with economic fundamentals."


He argues for a brave new system, coordinated by the IMF, of international discretionary currency interventions: "G-20 advanced countries will work to ensure against excessive volatility and disorderly movements in exchange rates.""

You can see the problems already, can't you? None of this is reducible to practical, believable policies. And, even if it were, it's economic central planning on a grand, i.e., international scale. Anybody remember how that idea worked out for Russia during the last century?

Without a doubt the funniest passage in Cochrane's piece is also the most sobering in terms of the prospect of economic conflict between the US and China,

"What's the right policy toward China? They put a few trillion dollars worth of stuff on boats and sent it to us in exchange for U.S. government bonds. Those bonds lost a lot of value when the dollar fell relative to the euro and other currencies. Then they put more stuff on boats and took in ever more dubious debt in exchange. We're in the process of devaluing again. The Chinese government's accumulation of U.S. debt represents a tragic investment decision, not a currency-manipulation effort. The right policy is flowers and chocolates, or at least a polite thank-you note."

And we wonder why the Chinese are exploring more diversified baskets of assets into which to trade their depreciating US dollars?

Cochrane sums up Geithner's loopy idea with this concluding passage,



"This is all as fuzzy as it seems. Markets and exchange rates are not always right. But it is a pipe dream that busybodies at the IMF can find "imbalances," properly diagnose "overvalued" exchange rates, then "coordinate" structural, fiscal and exchange rate policies to "facilitate an orderly rebalancing of global demand," especially using "medium-term targets" rather than concrete actions. The German economics minister, Rainer Brüderle, called this "planned economy thinking." He was being generous. Planners have a clearer idea of what they are doing. "



The scary part for me is that this isn't some private economic white paper circulated among Geithner's staff. This crazy idea is out in public, proposed to the G-20, as if it's actually workable, or even desirable.

The 1930s: Could It Happen Again?

Tuesday's Wall Street Journal carried a rather innocuous staff editorial entitled A Game of Trade Chicken.

In it, the staff wrote,

"The U.S. and China are slouching toward a trade war, with the House of Representatives aiming to vote this week on a bill to impose duties on Chinese goods if Beijing doesn't revalue its currency against the dollar. Two can play at that game, however, as China is proving as it responds to earlier U.S. protectionism.


China's Commerce Ministry Sunday unveiled its final order in an antidumping investigation against U.S. poultry. Effective yesterday, Beijing is levying duties ranging from 50% to 104%, depending on the producer, on imports of products such as chicken feet. The Chinese government claims U.S. companies sell in the Chinese market at a price less than their cost of production. In a separate case in August, Beijing slapped countervailing duties of between 4% and 31% on the imports, claiming U.S. agricultural policies unfairly subsidize chicken production in America.

These moves must be about politics because the economics of the cases make no sense. Far from dumping, U.S. poultry producers can sell chicken products in China at a premium over the American market because Chinese consumers prefer parts of the bird that Americans don't like—especially the feet, a delicacy known as "phoenix claw." And while it's hard to dispute that subsidies distort the U.S. agricultural marketplace far beyond anything Adam Smith would recognize, to the extent China feels the effects they amount to a U.S. subsidy for Chinese consumers.

This case also came after years of Chinese frustration with an unrelated move on Capitol Hill to block imports of cooked Chinese chicken over misguided safety concerns. Chinese chicken producers had complained about U.S. practices for a long time. In the face of mounting American protectionism, Beijing simply couldn't say no to its own domestic lobby anymore.


As for American lawmakers—and Mr. Obama—the chicken case is a warning. Merely because retaliation hurts China's own economy doesn't mean Beijing won't give in to political pressures to respond to American protectionism.



We're blithely told that a full-scale trade war a la the 1930s can't break out again because everyone knows better. But that's what we were told about the other lessons of Depression economics, and our leaders have already remade nearly every one of those mistakes. In a game of trade chicken, everybody will lose."


This case has hardly made the major media headlines, yet, for its potential consequences, it surely must be one of the most chilling and important news items of the past week.
 
That last paragraph says it all, does it not?
 
"...because everyone knows better. But that's what we were told about the other lessons of Depression economics, and our leaders have already remade nearly every one of those mistakes."
 
Worth repeating to really let it sink in.
 
We've had, by now, $1 trillion of nearly-pointless so-called stimulus spending. All that borrowed and printed money, which will have to be repaid somehow, has done no more to reduce unemployment, create jobs, than FDR's myriad make-work spending programs after which the stimulus was explicitly modeled.
 
Economists have criticized the stimulus bills for ignoring the reality that today's consumers, as taxpayers, realize that Keynesian fiscal pump-priming has to be repaid from higher subsequent taxes, so they feel poorer simply by watching such programs enacted.
 
While it's true that Bernanke's Fed hasn't shrunk the money supply as his predecessor did in the 1930s. If anything, he has erred on the side of excessive easing, creating a liquidity trap with 0% interest rates.
 
And now we have our Congress embarking on a trade war with our major creditor.
 
Smart. Really smart.
 
Between the new, beggar-thy-neighbor currency devaluations among major nations, and this new tilt toward tariff and trade wars, we're well on our way to repeating much of what made the US depression of the 1930s last so much longer and be so much more severe than it was in other countries of that time.
 
What was that about those who don't learn from the past are destined to repeat it, especially their prior mistakes?

Mr. Citrus Opines on Chinese Imports, Gold & The Recession

I ran into a friend on Sunday with whom I had a fascinating 'catch up' conversation.

While I thought I'd first written about him almost two years ago, it seems, when I search this blog for references to him, I can't find any. So I must have only intended to write the post I imagine recalling.

For both anonymity, and appropriateness, I shall call my friend Mr. Citrus.

You see, he owns and operates the dominant fresh citrus juice-for-cooking-and-beverage business in the US. You know those little lemon- and lime-shaped plastic squeezie things you find in the produce aisle? That's him.

And of all the gyms in the world, he happens to belong to mine. Well, my old one, and, probably, soon, my new one, as well.

One day, I'll write more elaborate post about Mr. Citrus, but for now, suffice to say he's a European immigrant of more than a decade. He conceived his business- the importation of fresh, dated lemon and lime juice- shortly after arriving in the States. While it's been a long haul, he has overtaken the once-king of the market, RealLemon.

Just in case someone from a competitor finds this post via Google, I will keep the information he shared with me somewhat disguised.

Mr. Citrus told me that January sales were up at one of the highest rates ever. To him, it is logical, as he saw sales growth like this during a prior recession.

I asked about a similar-looking squeezie product I'd recently seen, and he dismissed it as a knock-off which isn't coming close to bothering his business. When I observed that I found it at a local, large grocery chain, where his products are absent, he snorted and said,

'(That chain) has the most corrupt buyers in the business. They have a supplier of lime juice who is local to their corporate headquarters, and someone is getting paid off to stock them. Therefore, they only want my lemon juice.'

Back a few years ago, when he explained the nature of his operations, which I'll share in another post, I asked him why a local premium grocery chain's fresh, soft fruit prices were double that of the other major chains. He replied that, due to a quirk in that chain's distribution process, they double-shipped those fruits to a local warehouse, then back to each store, incurring added costs.

From such small details, pricing gaps can occur.

On Sunday morning, however, our discussion turned to US macroeconomics, the recession and the 'stimulus' package. Being from Europe, still traveling there frequently, and a quintessential small, entrepreneurial businessman, I was interested in Mr. Citrus' opinions.

First, he agreed that the so-called stimulus won't work. But, thanks to global economic weakness, he doesn't think the immense added US debt will drive the price of the dollar down. Rather, he felt, it will drive up interest rates to fund the debt, as well as stoke inflation.

He continued by sharing that he had observed what asset strategies did well in the 1930s. Consequently, he's buying residential real estate in Switzerland, for use as a main residence, if necessary, as well as precious metals. This is a guy who has at least one other local business besides citrus distribution, and could easily afford to scoop up local, undervalued real estate. But he's not.

Then he launched into a well-reasoned argument, in common with some leading economists, that the US is about to foolishly rely on an unfriendly power, i.e., China, to hold and continue funding our debt. Being European, he is fairly sensitive to currents of international economics and influence.

On that subject, he began to recount a recent business event which ended with him impassioned and red-faced.

Mr. Citrus' business practices all adhere to ISO 9000 standards. As he put it, they are the international gold standard for importation. So when a Federal inspector visited his offices recently to inquire as to his various certifications for importation, Mr. Citrus greeted him by saying something like,

'I'm glad someone finally asked to see my ISO 9000 certificate. You're the first person who has done so.'

He was shocked when the government agent replied,

'Well, that's very nice. But it doesn't meet our USDA rules.'

I won't bother with the details of the apparently-heated interchange that followed, which left Mr. Citrus agitated just in retelling the story.

But he made two very interesting points.

First, he noted that by insisting on a totally separate set of import rules, the USDA risked making US businesses globally less competitive, since they would focus on a rule set unique to the US, but inappropriate for global business.

Second, as he noted to the government agent, the USDA rules allow one exception- China. If you ship anything from China, the importation rules are suspended.

Mr. Citrus then drew the obvious conclusion. China, he said, had used its financial influence with America to obtain for itself carte blanche exemptions to import regulations and standards to which all other countries are held.

In his conversation with the agent, Mr. Citrus noted the expense he incurred to comply with ISO 9000. And that, maybe now, he'd simply reroute all his shipments through China, in order to lessen costs and quality.

He doesn't really intend to do this, but the threat was ironic.

And his story was very eye-opening. If this has already happened prior to flooding global financial markets with another trillion dollars in US obligations, what other standards will Congress and the current administration relax, on the quiet, in order to fund our debt?

The Long Term Consequences of Unending US Bailouts of Private Sector Companies

This is the first part of a loosely-envisioned two part series of posts.


The larger topic, which will be the subject of the second post, concerns the long sweep of US economic and business experience from post-WWII to now. How our larger corporations and senior business executives have had incomplete, sheltered and misleading experience such that, in times of challenging circumstances, few of them are qualified and experienced to manage through this environment. And, most importantly, since the days of FDR's Social Security program and the Truman-led wage and price controls during WWII, our society has engaged in deferred promise-making on a scale never before seen in recorded history.


What happens when those two themes collide, and our society cannot possibly fulfill economic promises made by various groups to each other, and, sometimes to ourselves? When promises made in anticipation of straight-line GDP growth and naive hopes of everlasting corporations meet realities of economic cycles, coincident capital market panics and economic recessions, bankruptcies, and temporary value destruction in both real and financial assets?


But, to today's topic,

What might be the global implications and consequences of the ongoing, large-scale US Federal government's Federal Reserve and Treasury outpouring of US dollars, through both borrowing and printing?

I've been pondering this since the TARP bill was conceived and fought over in Congress.

If one were viewing the global financial implosion of the past year from outside of the environment, like some sort of Einsteinian 'thought experiment', what would one have seen, and what conclusions might you draw?

On a broad scale, the US financial markets would have begun to dramatically lose value, beginning with the 'mark to market' impacts on and of the two failed Bear Stearns mutual funds in the summer of last year. As trading ceased in various structured financial instruments composed of mortgages, the most recent of which were increasingly lower-quality 'alt-a' and subprime in nature, the market value of many financial assets plunged, as financial institutions began to sell better assets in order to either raise cash for redemptions or take gains to offset 'mark to market' losses in the structured financial instruments.

Having started, globally, with above-average leverage, financial institutions bearing these losses had comparatively less equity capital with which to absorb the now-outsized losses on exotic securities and, increasingly, more mainstream equities.

As confidence lost in structured finance instruments spread to those institutions operating outside of the Federally-supported banking system, i.e., investment banks, brokerages and hedge funds, their equity values plummeted, counterparty risk rose, and leverage across the entire global financial system effectively began its inexorable shrinkage.

Since leverage, a function of debt, implies confidence in the future returns of loans placed with various enterprises, its unwinding corresponds to a loss of such confidence. The forced reduction in this leverage began, understandably, with the short-term borrowing instruments of both financial and non-financial instruments- commercial paper, most notably.

As this massive de-leveraging of fixed income instruments occurred, the simultaneous drop in real estate values and equity market values caused several consequences.

First, large-scale losses in US, and other nation's market, i.e., societal capital stocks, valued notionally, plunged. Those who previously owned the capital suffered large losses. In the US, the Treasury and Fed moved to support the Federally-registered banks via direct preferred equity purchases and, separately, takeovers of Fannie Mae, Freddie Mac and AIG.

From our external perspective, then, it was as if, following the observance of massive equity and debt capital losses in US society, and others holding US instruments, the US government, choosing to believe that earlier, higher values, were justified, to some extent, simply printed more money and issued liability instruments in order to reflate the financial sector and, indirectly, the business economy.

Whether those choosing to hold US government debt would feel this was purely inflationary, or merely a transfer of wealth from those whose capital value had evaporated, to the US government, is, to some extent, still to be determined.

Yesterday's plunging T-bill yields suggest that, for the moment, the market seeks safety in notes issued by the government of the globe's largest, most free economy, more than it cares about the debauching of the value of the dollar.

The second major consequence of the calamitous drop in price of many stores of value- real property, equity, debt- coupled with the deleveraging, was the cessation of bank lending. Thus, a financial crisis, partially unleashed by a narrowly-defined 'mark to market' rule in a single US law, Sarbanes-Oxley, led to the real effects on non-financial sectors of the US economy. As banks struggled to deleverage their assets in order to both conserve remaining equity from further losses, and abide by regulatory capital requirements, lending suffered. This became a self-fulfilling act, as, starved of normal, short-term operating liquidity, more and more businesses began to reduce operations and cut staff.

The third unforeseen consequence, then, to complete the circle, was the rising joblessness as the economy was already softening, of its own accord, by early 2008.

This last link in the circle of economic causes and effects has now driven a dramatic drop in consumer spending, due to: rising unemployment, lower home values as a source of personal household net worths, and lower financial asset portfolios as a source of personal household net worths.

Viewed again from a perspective outside the global financial and business system, the effect of the market and economic events of the past 18 months has been to dramatically reduce overall investor and consumer confidence in near-term investing and employment conditions, leading to rapid deleveraging and, thus, a reduction in effective money supply.

Since, by Fisher's equation, MV=PO, the fall in the effective quantity of M, assuming, at best, a stable V, must drive a reduction in physical output, price levels, or both. It is now becoming both.

To reverse this effect, as any economics student, Treasury Secretary or central bank chairman knows, assuming velocity has fallen, as has been observed via the freezing of bank lending, M must rise at the rate which one desires PO, or global nominal GDP, to rise.

And that is why central banks are flooding the globe with liquidity, heedless now of later inflation. And, given the notional destruction of so much original capital value, as of early 2007 levels, it is not clear that there will be a consequent inflation. There's simply less market-valued capital and current production available to drive said inflation.

Thus, having fleshed out this thought experiment thus far, to our current situation, what might be the most likely answer to my initial question?

For now, it seems that the flood of US-government-printed dollars will not lead to near-term inflation. And, absent another country of with a democratically-elected government, reasonably-stable protection of property and other rights, the economic size and diversity of the United States, it seems global investors have little choice but to buy and hold the dollar for the foreseeable future. What are their other options, the Euro or Yuan? Hardly.

If there had remained an investor or consumer group totally outside of the now-globally-interdependent economic and financial services web, the US might soon experience a rapid decline in the dollar's value, skyrocketing interest rates, and a loss of appetite for US debt- publicly and privately issued. In short, a severe comeuppance for the largest single economy on the globe.

But that doesn't actually appear to be in the cards, thanks to such tight, fast global interdependencies.

How the US government conducts its retreat, assuming it makes one, from the various large-scale intrusions into the financial and banking sectors, and exchanges its investments for cash which is returned to the Federal Treasury, will govern how the longer term effects of its massive funding efforts have an impact on US and global inflation.

The Dollar's Value, Foreign Investment & Innovation

Last weekend in the Wall Street Journal, former Dallas Fed President Bob McTeer wrote an insightful editorial entitled "Valuing The Dollar."


In his half-page piece, McTeer gave a learned, yet comprehensible tutorial on various factors affecting exchange rates. He differentiated capital flows from trade flows, explaining why sometimes the former offset effects one would expect from the latter.


Near the end of his editorial, McTeer wrote,


"The accumulation of massive dollar reserves in China led to worry that they would diversify those holdings at some point, a diversification that would involve moving the dollar into other currencies, especially the euro -- with such a sell-off depressing the dollar and leading to higher U.S. interest rates. Instead, the diversification so far has been from Treasury securities into private-sector dollar assets. To continue the current account deficit is to continue the fire sale of U.S. assets to foreigners.


They want to get into U.S. assets when the dollar is cheap and get out when the dollar is dear. The more the dollar depreciates, the sooner it will be expected to reverse, and the sooner foreign investors will resume their participation in the most dynamic, creative economy in the world."


The term 'fire sale' caught my eye. McTeer, like so many other learned, experienced businessmen or economists, wail about the sale of US economic assets to foreigners at distressed prices, due to the dollar's current value, relative to other currencies a year or so ago.

I would like to argue the proposition that the assets being bought 'on sale' are, for the most part, assets that are no longer as valuable as they once were, and probably not the most dynamic, attractive part of our economy.

For example, the 'fire sale' of US banking assets- Citigroup, Merrill Lynch, and Bear Stearns- is often used to prove the point that we are selling ourselves to foreign countries, companies or individuals.

However, Goldman Sachs, Lehman, Wachovia, and many private equity groups and hedge funds have not sold interest in themselves to foreigners.

Furthermore, how hard would it be for the healthier private firms to compete with the publicly-held, weakened banks and brokerages? This is a business which, we are reminded, has its most important assets walking out of the doors every night.

What is so special about an ailing Citigroup or Merrill Lynch that can't be duplicated, or improved upon, by fresh capital behind better managers in new companies doing the same things.

By contrast, nobody seems to be buying our economy's more successful and innovative firms, such as Google, H-P, FreeportMcMoran, bio-pharmas or manufacturers.

Could it be that Schumpeterian dynamics is at work here? The weak firms are being bought by foreign acquirers, while the stronger firms remain above the fray.

Then there is the issue of dynamism. To wring one's hands over our economy being 'bought' by foreigners is to ignore our pace of innovation and value creation.

Firms like Google weren't anywhere near as strong and dominant even five years ago as they are now. Five years from now, new companies we've yet to completely understand will be joining them as dominating forces in their business sectors.

It seems to me that, for example, the financial services firms which are the target of overseas investment are engaged in mostly commodity businesses. And poorly managed at that. What's the fuss about?

Are we worried that foreigners will do a large amount of US unsecured consumer lending? Or corporate lending? These businesses are easily started by competitors, if that is a problem.

Are we worried about foreigners' access to the US financial system? They already have it. And they already must submit to US regulatory scrutiny. It's unlikely that we will suffer because Citigroup sells more diluted equity to some Arab interests.

Are we so sure that the companies being 'lost' to foreigners are where we have sustainable competitive advantages which will result in long term, consistently superior total returns?

Personally, I think we are not so sure.

Mr. McTeer's excellent article opened my eyes to a key point that has, I believe, been overlooked in the current panic over the dollar's value, foreign investment, often via 'sovereign funds,' and US economic innovation.

Even with a currently weaker-than-recently US dollar, our vital engines of economic growth and competitive advantage seem to be firmly in US hands, while lesser companies fall to investment by foreign interests.

From The Files: Edward Prescott on 'Competitive Cooperation'

When it's been a slow couple of days for business strategy or equity markets news, I often turn to a pile of choice articles I have saved from earlier editions of various business publications.

Today, I want to touch on an excellent piece by Nobel Laureate, and periodic Wall Street Journal contributor, Edward Prescott. Back on February 15 of this year, Prescott wrote about 'competitive cooperation,' with the just-turned-50 European Economic Union, the product of the 1957 Treaty of Rome.

Among the many pieces of economic data Prescott cites, these are some of the most compelling. The original six Common Market countries progressed from having a productivity level that was 55% of that of the US, to having achieved rough parity twenty-five years later. However, three countries which did not enter the pact- Denmark, Ireland and the UK- but were near parity on productivity with the six in 1957, fell behind. The same trends held true for subsequent signatories to the Treaty in in the 1980s, '90s and this decade.

Prescott continues the analogy by noting the progress made in Australia and its trading partners in Southeast Asia. The glaring laggard geographic area is Latin America. There, Prescott cites the region's preference for protectionism as having predictably 'poor' results and consequences. Specifically, referring to research by some of his Minneapolis Fed colleagues, he writes,

".....from 1950 to 2001, per capita GDP for Europe increased 68% relative to the US; Asia increased by 244%, while Latin America decreased by 21%. This is all the more striking when we realize that Latin America's per capita GDP actually exceeded Asia's by 75% in 1950."

Prescott sums up his article by noting that protectionism's short term seductiveness inevitably has disastrous long term consequences for relative and absolute wealth creation. Getting the flywheel of economic development and growth going is key, and protectionism tends to slow that flywheel down and cement existing economic conditions in place, while the rest of the competitive global economies move forward.

With this point in mind, I will close this piece with a quote from the beginning of Prescott's editorial,

"If the government has any economic role at all, surely, this.......(to protect US industry, employment and wealth against the forces of foreign competition).....must be it. Actually, no. Government has a higher calling in this country...which is to provide the opportunity for people to seek their livelihood on their own terms, in open international markets, with as little interference from government as possible."

While Prescott is understandably vague on the particulars, I'll be more blunt. At a time when the US Congress has been taken over by liberal Democrats, and their economic protectionist and income redistribution agenda, this sage advice is more crucial than ever. It's a big mistake for government to attempt to manage the how of economic activity, in hopes of attaining a collective economic welfare. The names we have historically used for that vary, but include socialism and fascism.

Rather, the US has historically allowed its citizens to determine the organization of economic resources, as well as own them, while simply setting some minimum, and minimally changing, guidelines within which to pursue their individual economic welfares. If we depart from that history to any great degree, thanks to the current Democratic Congressional agenda, I fear that Prescott's warnings will ring true in America quite soon.