Archive for Commenting the news

The ingrained socialism in the US economy

I think there is an interesting disconnect between the impression of free market forces dominating the US economy and the extend of government influence. And I am not basing this observation on the huge government spending programs to bail out financial institutions, their shareholders and bond holders (thanks, tax payers). Nor am I referring to the huge stimulus package that interestingly enough has no clear signature initiative to revive the flailing economy.

Instead let’s look at the automobile industry, the initiative to curb Co2 emissions and the price of fuel. The problem with the fuel price is that it pays for the cost of extracting the oil, processing it into fuel and shipping it right next door to you ready to be filled into your car. However the cost of burning the fuel which has an adverse impact on the environment is not included in that price. The cost of that is burdened on society instead. This is called an External Effect. It leads to a wrong market equilibrium as the price of the good (here fuel) it too cheap, as the external cost of burning the fuel is not included in the price. Therefore this cost is not included in the decision making process on how much to consume, i.e. how to drive (MPG of your car, distance driven etc.).

Economists can agree that a way to improve the market allocation and thereby total welfare is to increase the price of fuel to reflect this external effect – basically tax it. That would lead people to demand less by either buying more fuel efficient cars or driving less.

But instead of using the price of fuel and thereby market mechanism to improve the market equilibrium and in our example reduce CO2 emissions and reliance on oil imports, the US government for years has used Miles-per-Gallon standards that the car industry had to meet by its average fleet. So instead of using price and market mechanisms, the government tries to ‘tell’ the car makers what cars to build and consumers what cars to buy. That does not make any sense. It is not an efficient way to influence behavior, it has huge time lags to be enforced and most importantly it is easy to circumvent – as is the case with all large, cumbersome government regulations. This is why Detroit has lobbied for these kind of regulations – they have in the end little or no effect.

We see a similar notion in todays debate around the banks bailout plan. Lawmakers want to ‘tell’ the banks to start lending. Banks do lend to make a profit, if they can make a profit. In the current market environment they cannot open the siphons and start excessive lending again – there are enough toxic, i.e. non performing loans for a while (wasn’t that the whole problem anyway?). Instead of forcing banks to do something that is not in their profit making interest, the government needs to set the right framework that will allow banks to do business which will inevitable leed to lending (one should not forget that banks still lend – but they are much more careful and have only limited liquidity).

But there are three reasons why government seems to prefer to try to directly influence the behavior of market actors (companies) instead of setting incentives and using market forces:

It seems easy. Instead of understanding the complex framework of incentives that influences corporations and their customers, just draw up a bill that requires people to do stuff – no matter if it makes economic sense. Often it does not, otherwise you would not have to write a law.

– It is a quick fix. We live in fast times. Who remembers last years legislation. Who cares about next generation if re-election is around the corner. Roger Ehrenberg wrote a good post on short-termism that sums it up.

It can be influenced by the industry that is to be regulated. We saw that during the last 20 years with the introduction of MPG standards. Detroit did a good job in making sure they were not adversely effected. Unfortunately they missed the whole point that at some point fuel might become scarce.

To me this kind of behavior legislation is not too far off what could be seen in former socialists countries and you would expect to see in many parts of Europe but not in the US. Influencing behavior by setting the right incentives seems to me far superior than guiding somebodies hand.


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Thinking about the CLO market

An interesting Bloomberg article made me think about the CLO market. It seems that a lot of investors are throwing CLO’s, CDO’s and all other structured products together and are avoiding them alltogether. Complexity is not popular in times of panic.

Most investors that have these products on their books try to unload them at any price through any available venue with most markets being illiquid. But it looks like there is a small crowd that is cherry picking in this market, which is after all not completley dried up (I would guess in 2009 north of $100B in existing paper will be traded).  As in any illiquid market, there are high transaction costs imposed by the existing market players (all over the counter). So some players are able to extract significant rents right now – and some investors might see a bright upside at the end of their trade.

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I am calling the bottom (in case anybody cares)

We are at the bottom – more or less. The S&P500 declined around 50% from his highs, which makes this market one of the biggest bear markets in history (the much referred Great Depression being the only one that was worse). Here is my reasoning:

Chart by Doug Short

Chart by Doug Short

1. Horrible Retail Numbers, Auto Execs pilloried and Dooming Job Numbers – Nobody cares anymore

This week we saw retail numbers that were quite impressive. Auto sales in November down 41%  year of year . All kinds of consumer good categories down between 25% and 35%. Numbers not seen for 40 years. Given that the US economy is driven 73% by consumption one can roughly extrapolate the contraction that we will see in Q4. Then, this week a bail-out of the Detroit-Trio became unlikely – all these miles driven for nothing, maybe they should have car-pooled? And we saw job numbers exceeding even the worst estimates. Each of those three ‘surprises’ would have created a major stock sell off normally. But this week nobody seemed to care – in fact the S&P500 left the week slightly higher. When even historic bad news do not bring the market down anymore, the market does not want to go down.

2. Warren Buffet is always right (sort of)

This week Warren Buffet called the bottom (again – first time in October) – and he has never been wrong in the past, at least in the long-term. He is not a market timer (he admits he does not know how much longer this bear market will last) but a market ‘pricer’. Meaning that investments in  stocks (the right ones – please no financials or gas guzzlers) at current levels should get long-term above average returns. When I am wrong with calling the bottom, than at least I have prominent company. Clusterstock has a nice write-up and links to all the Warren Buffet articles where he is calling the bottom.

3. Shoeshine boy buys triple leveraged short ETFs

Joseph P. Kennedy (1888-1969) knew that it was time to get out of the market in 1929 when his shoeshine boy began giving him stock tips. When people like me start to play with double and tripple leveraged short ETFs (hello SKF, FXP, SDS etc.) then the party must be over. Retail investors get to these parties always too late – by then the cool crowd has moved on already. That means from here on it will go sideways or up, but not further (significantly) down.

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My 2 cents on the ‘Bailout’ or ‘Splurge’

Where to start? Yesterday we had the biggest point drop in the Dow Jones since 1987, triggered by a failed attempt by the US government to launch a rescue package to save the credit markets. But the package failed in the House of Representatives. How do you write a short post to sum up my point of view when many things are connected with each other? Let’s try.

First of all, I believe that until now the freezing of the credit markets has not been understood or felt by the population and law makers. It still seems to be very theoretical. The economy is not strong but right now it does not feel like we are in a bad recession. But things are changing:

Last week I got a letter from our bank regarding our home equity line. When we bought our house, this home equity line was ‘forced’ upon us even though we did not want or need it. The bank hoped to upsell, but we did not feel the urge to buy a new TV or car or else (I got a nice check books to pay for stuff with my home equity loan). Anyway, I guess many people use these lines of credits and live of them. Surprise: Now it is gone. The bank informed us that they deemed the value of our house to be too low to support the line and canceled it. If we received such a letter, I bet they were closing down all home equity lines in our area, state or even nation wide. These days banks are not so eager to give credit – cash is king.

This means the credit crunch has arrived – now it starts to get real for the individual consumer after 18 months. I read as well that last week American Express reduced the credit allowance of all its cards on average by 50%. The coming holiday season will be no fun for the retail sector.

But it makes sense: Savings rate have been negative in the US for many years. Why would you build a safety cushion for bad times, if you have $100.000 in credit lines you can always tap into? No more. As credit stops being available to consumers, they will have to cut down on spending even harder – not only have the stop to buy on credit, but they will try replace this safety cushion that is now gone by saving money.

This will kick off this recession people have been talking about. Consumers stop buying, companies stop selling, companies go broke, employees loose jobs and hence stop spending etc.

But not only that, the credit freeze impacts (and has been impacting for a while) businesses. Profitable companies that have financed investments with loans that might come up for renewals can suddenly not find anybody to renew the loan. This leads to bankruptcies, leading to people loosing jobs, reducing their spending etc.

Now: This ‘Bailout’ – who is it bailing out? Not the investment banker on Wall Street. They have been doing fine in the last years (and I am not going into the question who is responsible for all these complex credit products that blew up and lead to the credit freeze – not interesting right now where we are. This will have to wait for later). The ‘Bailout’ is paid by the consumer and eventually for the consumer. Because the average consumer is the person that will suffer from this if we go into full blown meltdown.

So Congress does not serve well its constituency by blocking a package that is aimed to get the credit markets that our economy / society is built on moving again. 5 weeks before elections, many representatives did not want to be seen as ‘bailing out’ the fat cats on Wall Street. So the problem is that the people that do not understand what caused the credit freeze (which I did not comment on in this post) do not understand what this bailout is for.

Having said that, the bail out plan was not perfect. But I agree with Paul Kedrosky: we do not have the time to come up with, discuss and mull about the best probable plan. We need ‘a’ plan. And leadership that can push this plan through.

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On the Irish referendum on Lisbon Treaty

The refusal of the Lisbon Treaty on Friday by an Irish Referendum stalls the progress of the EU process. The treaty is probably not dead yet, but it is in grave condition. The rejection of the treaty by popular vote made me think again about the merits of representative  vs. direct democracy.

In my opinion, that Lisbon Treaty is something that should not be presented to popular vote. Like many other legislative initiatives, it is too complex for the general electorate to form and express an educated opinion. That is the whole point of electing representatives: People you trust to make the best decisions on behalf of you.

When the US formed their system of representative democracy (which after WWII was successfully exported to Germany) the lack of communication technology might have been the major reason to have representatives elected and sent to Washington. However the major benefit of this system lies in the fact, that electing specialists that have the education and oversight to make the right decision in the long term – even if initially unpopular – will lead to superior decision.

I personally do not trust the general electorate – this might be called elitist. I  think elites are a good thing. As long as they are based on merits and are open.

Coming back to the Lisbon Treaty. The EU seems to be in a catch 22 situation. The current rules of the Nizza Treaty from 2001 are not suited to operate an enlarged EU that accepted 12 (!) new member states since 2004. So the system needs to be fixed. In the current situation, individual voters are concerned by the structural problems of the EU and the unclear impact the EU has on their personal lives. In the past 4 years, any referendum that was posted failed, blocking the way to fix the current situation.

One could argue that if the general electorate does not want the EU, it should be wrapped up. Why don’t we just shut it down for good? Well, the general electorate has no clue. One could point to the fact that the usual European way of conflict resolution (killing each other) has been replaced over the last 50 years with the peaceful institutions of the EU. One could point to the benefits that a stable common and strong currency is providing to Europe’s economy. One could point to the improved ways of doing business in a common market without customs duties and harmonized laws and regulations. One could point to the freedom of residence allowing any EU citizen to live and work (and locally vote) anywhere within the EU. And so on…

I am convinced: none of the above would have been achieved if placed in front of a popular referendum. People should vote for those representatives that they feel represent best their values and personal believe. Those representatives will make complex decisions. And the Lisbon Treaty should not be placed in front of the general electorate in any of the member states.

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