Tuesday, November 11, 2008

Calling the Bottom

Remember nine months ago, when economists were marvelling over an exceptionally well-performing world economy? Though energy and commodity prices were high, the overall picture seemed rosy. Consumer confidence was good, and all sorts of productive technologies were coming into application all over the globe. Steady increases in productivity, fostered especially by almost magical information technology, promised rising prosperity and increases in economic activity the world over.

What happened? The real estate speculative bubble burst, and the resulting jitters sent essentially everyone all over the globe to execute a generalized "run on the bank." Investments and assets of all kinds were suddenly being cashed-out. The fall in asset values across the board was thus the very definition of a deflationary crisis. An incredibly rapid contraction of the money supply thus fed this self-reinforcing spiral.

The crisis has been answered with reassuring speed and vigor by concerted central bank actions to re-expand the underlying money supply. Have the credit conditions been responding appropriately? Yes. The single best measure of the liquidity and health of the credit system is probably the "TED-spread." This is the difference in interest rates between Federal Reserve debt obligations and highest-quality commercial obligations for the same term. Effectively, Federal Reserve obligations are the working definition of zero-risk debt. The perceived risk of bonds of the highest quality, then, is effectively a good measure of overall economic confidence in future growth and ability of the entities to repay their obligations. If the spread between these two rates is small, there is confidence globally in the health of the global economy, and thus a willingness and ability to lend to good borrowers for good purposes. Though still rather high by historical standards, the spread as of today, November 11 is 1.75, falling very rapidly indeed from its mind-blowing, absolutely unprecedented peak of 4.64 on October 10, 2008.

By this TED-Spread measure, the current crisis started on the ironic anniversary, 9/11, when the spread stood at 1.21, already moderately high. One week later, it hit a new peak, 3.13, which was completely unprecedented. It had never in its history exceeded much over 2.0. Just another three weeks was needed for this to reach the mind-boggling peak of 4.64. See:

[courtesy of Bloomberg.com,

For a broader perspective, look at this measure over five years:

From the perspective of the credit markets (where this crisis originated and demolished the financial pillars of the "real economy"), the credit "crisis" is now just a moderate credit "crunch" and may well be back to fairly normal range within a week.

So, looking forward, what are the prospects for resumption of brisk growth? Excellent. Although willingness of consumers to spend may be dampened for some months, there is great benefit to having that income saved and re-invested rather than simply consumed. The underlying engine of economic growth--technology and it's inventive application to productive uses of all kinds all over the globe--never took a breather through this crisis. Great plans and ideas are sill on the drawing boards in every country on earth. Computing power and information transmission and processing capabilities are better now than they were a year ago.

There is one advantage right now that the global economy didn't have a year ago. Energy and raw materials are much cheaper. With access to capital for sound infrastructure investments, all those wonderful plans sitting on drawing boards can now be funded and carried out at substantially lower cost than they could have just one year ago. When in the history of economics have such investment opportunities existed before? Never. Never.

What we went through over the past two months is comparable in intensity to what happened during the Crash of 1929 and the Great Depression. The fairly mind-boggling difference is that we went from good times to abyss and now solidly on the way to recovery in two months rather than ten years.

How could this be? Simply, most money exists as information, not physical currency--account balances, ledger entries, contract obligations and the like. This is simply data. In this electronic information age, this data can be transported, recorded, verified, and exchanged all over the globe in the blink of an eye, in quantities that defy the ability of the mind to comprehend. The "positive feedback loops" of money creation and destruction now can now develop and reverse in days to weeks rather than months to years.

As long as the central banks can respond rationally, quickly, and vigorously, these self-reinforcing cycles of money creation and contraction (inflationary spirals and deflationary crashes) can be corrected with breathtaking speed. The central banks today sit at the tiller of a supersonic speedboat, instead of the great wheel of a stately steamship. Through the first eight months of 2008, they didn't realize the economy was drifting towards a deflationary crisis. Once the picture became clear, however, their actions were brisk, vigorous, rational, and concerted. Over this time, the central bankers look first pretty incompetent, and subsequently brilliant and courageous.

This morning, the economic future looks exceptionally bright. The "real economy" however, will surely take a few more months to reflect this reality; it hasn't had time to fully reflect the emergency (and near-catastrope) that has already happened in the financial markets.

In summary, Warren Buffet is surely correct that equity investments today represent an opportunity that may be of unprecedented value in the history of finance. It is time to invest.

Wednesday, November 05, 2008

How Vladimir Putin Selected President Obama

If you were a foreigner watching the unfolding US election, had a stake in the outcome, and had a few hundred billion dollars to spare, what would you do?

How many people have been in such a position in the current election cycle? Three: Vladimir Putin of Russia, President Hu Jintao of the People's Republic of China, and King Abdullah of Saudi Arabia.

Recent figures show dollar reserves of these three nations have been enormous, and rising briskly. Russia's dollar reserves recently stood at $260 billion. Saudia Arabia has banked over $800 billion. China holds over a trillion dollars. In all cases, current trade surpluses ensure that these reserves are guaranteed to increase briskly for some time to come--none of these autocratic rulers has any reason to be shy about using these funds for any reason of national importance.

Who would these powers prefer to win the US election, and how badly? In all cases, Obama, very badly. In Saudi Arabia's case, there are conflicting considerations. A McCain presidency might be viewed as more friendly to oil interests around the globe, not just domestic US oil company interests. McCain has had a long history of voting against alternative energy initiatives; Obama has supported vigorous support for alternatives to fossil fuels. As long as the US remains dependent upon oil for its transportation needs, imports are inevitable, regardless of how much "drill, baby, drill" unfolds. At first glance, McCain might be the preferred candidate for the Saudis.

But Saudi Arabia's rulers have interests more pressing than just keeping the oil money pouring in. The monarchy has never been entirely politically secure. Religious extremists within the kingdom routinely call for its downfall; al Qaeda has repeatedly called for an overthrow of the regime. More than anything else, the Saudi royal family needs to have political stability in the Middle east. From their perspective, a long-term presence of US troops in Iraq would likely continue to radicalize "the man on the Arab street," threatening the regime's security.

There is also the consideration of Iran. There is no love lost between the Sunni Saudis and the Shi'ite Ayatollahs of Iran. But a McCain administration would seem hell-bent on confrontation with Iran, quite plausibly leading to military strikes. Under such circumstances, the perception of an epic struggle between Islam and the Christian West would tend to overide narrower sectarian concerns; Sunni and Shia would unite in their fear and rage, and the Saudi royal family, being widely perceived as allied with US interests, would be at imminent risk of being deposed.

In contrast, an Obama administration promises a prompt (but not precipitous) withdrawal from Iraq, and dialogue with Iran that seems most likely to avert military conflict, while tending to keep Iran's potential influence in the region relatively reigned-in. This approach couldn't be more appealing to the Saudis if they'd written the plans themselves.

China's considerations in the election are similar, and possibly similarly compelling. On China's border sits North Korea, a nation of 23 million impoverished souls. McCain has publicly advocated a "get tough" policy with North Korea, opposing its removal from the US list of state sponsors of terror. McCain has also joked about engaging in military strikes against North Korea. The prospect of a renewed Korean War involving the US on its border must fill President Hu Jintao with dread. If nothing else, a war on its border would have a devastating effect on foreign investment in China. China would strongly favor a win for Obama.

The case with Russia is more compelling still. McCain has been a vigorous proponent of expansion of NATO within the borders of the former Soviet Union. McCain was especially bellicose during the recent war between Russia and Georgia. The tone of the McCain's commentary seemed to suggest the use of US troops to repulse the Russian invasion. The risk of such conflict between two nuclear powers might alarm the entire world, but nobody more than Vladimir Putin.

So, we have a list of suspects, we have established motive and ability. What would be the modus operandi for this detective mystery? The approach is straightforward. Beginning over a year ago, these three leaders would understand that a US economic downturn would tend to favor the Democratic challenger running against a Republican administration. It would also be obvious that Democratic campaigns have always been under-funded compared to the more wealthy and business-friendly Republican Party.

Two basic, simultaneous approaches would almost guarantee the desired outcome: funnel hundreds of millions of dollars into the Obama campaign, and engineer a severe economic downturn in the US.

Engineering the downturn would have been primarily accomplished by the Saudis. All they had to do (and did) was to dial down the spigots of oil output. Petroleum demand, being inelastic, promptly resulted in marked increases in prices. Overall, this strategy was no sacrifice for the Saudis...their reward for flat or decreased oil pumping was higher net revenues. With additional billions being pumped out of the US economy by oil imports, and with higher costs for economic activity, it is surprising that the economic downturn in the US didn't happen more quickly.

But all those vast holdings of US dollar-denominated assets could be used to push the economy down as well. Federal Reserve data has shown a fall in M3 "money supply" beginnning about a year ago, and accelerating since the summer. This could reflect cashing out investments, and holding currency in reserves in vaults or secured warehouses. There is a process of "money creation" in which currency in circulation expands many-fold as account balances that exist as ledger entries rather than paper bills. If $100 in currency is withdrawn from circulation, the fall in money supply is ten times greater. This piece of the economic maniupulation might have been accomplished most easily by the Chinese. Somewhere, there may be warehouses owned by China, packed with $100 bills withdrawn from the US economy.

The sale of stock and real estate holdings would also tend to depress the stock market indices and real estate prices. A rapid deflationary death spiral was triggered, then, that has been enormously greater than the initial stress to the economy. A firecracker was thrown into a dynamite factory, in effect. Those responsible probably only expected a loud bang. The actual explosion has shaken the entire global economy. Rapid, assertive central bank actions across the globe seem to be putting Humpty Dumpty back together again fairly promptly.

The other leg of the election strategy would have been accomplished by Putin's KGB friends. The goal would have been to funnel perhaps 100 million dollars or so into the Obama campaign without the origin of the funds being detected. KGB agents have long been active in the US, and have cultivated a vast range of contacts across the country. Distributing hundreds of briefcases full of $100 bills to contacts in organized crime syndicates, unions, and selected private groups could then translate into hudreds of thousands of "individual small donors." Donations of under $200 are not then reported by the campaign and would be ultimately untraceable in any case.

If this had actually happened, we would have seen the Obama campaign receive an unprecedented number of small donations, accounting for a remarkably high proportion of an enormous total campaign war chest. Is this what happened? You betcha.

Did the three foreign rulers act in concert, or each individually? Only the leaders of the three states know for sure. Each may have pursued such strategies independently, each unaware that the others were hoping to have a similar influence on the election outcome.

Would the Obama campaign have been knowing accomplices to these actions? Not a chance. There would have been no purpose to letting Obama know that his campaign was getting a foreign boost. If the information had gotten out prior to election day, the facts would have devastated Obama's chances. He'd have remained most effective if he believed all those small contributors were legitimate, patriotic US citizens.

Is there a shred of hard evidence to back up this interpretation of recent events? No. But if the plans had been executed carefully, there wouldn't be any convincing public evidence.

This could make a great movie. Secret plots, briefcases and warehouses full of cash, word leaders conspiring, scenes of Riyadh, Beijing, Moscow, and DC. Some James Bond character jet-setting around trying to piece together the clues, hounded by shadowy KGB agents....only, he discovers the plan only at the last minute, and is prevented from reporting the truth in time....stranded somewhere as the new world order unfolds, he and a beautiful KGB agent decide to make love, not war....

Anyway, globalization may have done more than give foreign nations a stronger interest in the outcome of US elections--it may have motivated actual interventions in the political process. A concern for genuine national security might favor a system of mandatory public campaign financing. Perhaps both parties might now embrace the concept.


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