Bailout May Be Misunderstood but Must Not Be Misused

The trillions of dollars in various "bailout" and stimulation initiatives are not intended to bail out wrong-headed investors or executives. In the case of Bear Stearns, notwithstanding the "bailout," shareholders still lost 90% of their investment. It is true that some lousy executives got away with undeserved golden handshakes and I agree this is wrong. Avoiding moral hazard, however, requires placing responsibility where it is due, and that means holding the decision makers responsible and accountable for their mistakes. I had been disappointed with the decision of Paulson not to "bail out" Lehman Brothers on that fateful September weekend, and that is not because I wanted Paulson to bail out the wrong-headed decision makers who brought Lehman to its knees. I was wary of the effects of the fallout of the bankruptcy of Lehman on innocent people, and events that unfolded proved me right.It is easy to say that we should let businesses fail if they cannot survive on their own. But policy makers have to worry about the chain effects each business failure brings about. If the cost of a business failure proves bigger than the cost of a "bailout," the bailout makes sense. I must repeat: such "bailout" is not intended and should not be misused to bail out or reward wrong-headed executives. The latter should still be held accountable.Some commentators say that Americans need to save more. I said that more than ten years ago. Exactly because this is so important, we need to spend the trillions of dollars of "bailout" money. If they helped save jobs, Americans will then have the income from which they can save. Without jobs, Americans cannot save.Some commentators also are "sure" hyperinflation is inevitable. I can assure them that hyperinflation is not going to happen. Hyperinflation is always caused by too much spending. During all episodes of hyperinflation such excessive spending is indeed financed by the printing of money. But printing money in itself does not imply excessive spending. Right now any printing of money earmarked for "bailout" or "stimulation" serves only to make up for inadequate spending. Because anemic spending is going to continue for quite a while because of the collapse in asset prices worldwide, how can hyperinflation take place?Finally, some commentators worry that the "bailout" money will create another bubble. Again, the various bailout packages serve only to fight deflation and to re-establish full employment. Can anyone find any sign that a bubble is forming because of a bailout?

Bailout May Be Misunderstood but Must Not Be Misused

The trillions of dollars in various "bailout" and stimulation initiatives are not intended to bail out wrong-headed investors or executives. In the case of Bear Stearns, notwithstanding the "bailout," shareholders still lost 90% of their investment. It is true that some lousy executives got away with undeserved golden handshakes and I agree this is wrong. Avoiding moral hazard, however, requires placing responsibility where it is due, and that means holding the decision makers responsible and accountable for their mistakes. I had been disappointed with the decision of Paulson not to "bail out" Lehman Brothers on that fateful September weekend, and that is not because I wanted Paulson to bail out the wrong-headed decision makers who brought Lehman to its knees. I was wary of the effects of the fallout of the bankruptcy of Lehman on innocent people, and events that unfolded proved me right.It is easy to say that we should let businesses fail if they cannot survive on their own. But policy makers have to worry about the chain effects each business failure brings about. If the cost of a business failure proves bigger than the cost of a "bailout," the bailout makes sense. I must repeat: such "bailout" is not intended and should not be misused to bail out or reward wrong-headed executives. The latter should still be held accountable.Some commentators say that Americans need to save more. I said that more than ten years ago. Exactly because this is so important, we need to spend the trillions of dollars of "bailout" money. If they helped save jobs, Americans will then have the income from which they can save. Without jobs, Americans cannot save.Some commentators also are "sure" hyperinflation is inevitable. I can assure them that hyperinflation is not going to happen. Hyperinflation is always caused by too much spending. During all episodes of hyperinflation such excessive spending is indeed financed by the printing of money. But printing money in itself does not imply excessive spending. Right now any printing of money earmarked for "bailout" or "stimulation" serves only to make up for inadequate spending. Because anemic spending is going to continue for quite a while because of the collapse in asset prices worldwide, how can hyperinflation take place?Finally, some commentators worry that the "bailout" money will create another bubble. Again, the various bailout packages serve only to fight deflation and to re-establish full employment. Can anyone find any sign that a bubble is forming because of a bailout?

Averting a Major Global Economic Meltdown

If two things are implemented, I am positive the world's financial markets will rebound, and the global economy will stop slipping.

The foremost is to have a credible plan that puts a floor on housing prices. I have suggested that the US Government offer a buy back program for existing homes below the median price, at the market price as of October 2008, calculated as the original purchaseprice plus or minus a percentage reflecting the price change since then, as indicated by the national housing price index or local price index, subject to minor reappraisal for fine-tuning.

The second is to have a joint effort to bring the exchange rates in line with growth sustaining levels. Currently the Yen is too strong for exporters to survive. The Yen has appreciated 30% against a basket of currencies since Jan. 1 2008 according to my figures. If the Japanese economy falters, the world suffers. The central banks can sell Yen together.

Once these two plans are announced, global financial markets will certainly rebound, confidence will revive, as gloom for US’s financials and for Japan’s manufacturing will disappear over night.
These two are worrying investors the most.

A Plan to Prevent Further Slip in the US Housing Market

A Plan to Prevent Further Slip in the US Housing Market

Everybody agrees that the economy faces a critical moment. What investors and practically everybody fears the most now is that the housing market may continue to slip, notwithstanding the massive bailout plan. This would reduce the quality of assets that financial institutions hold and erode their chances of survival, and would undermine the quality of the toxic assets that the government acquires with the bailout funds. Such fears reduce the credibility of the bailout plan. It is imperative that we stop the further slip of the housing market with a fool-proof plan.

My proposal may sound drastic. But it will cost the US taxpayers the least money and will produce the greatest bang for the buck.

To be specific, I propose that the US Government, with backing from the Fed., announce that it stands ready to buy any housing unit that costs below the national median price at a price equal to the last actual transaction price indexed against the national housing price index. The government will hold any units thus acquired until the market is ready to absorb them at a price no lower than this acquisition price.

Now let me analyze the effects of this proposal.

Given the backing from the Fed., the announcement is credible. It immediately puts a floor on the housing prices of the cheaper 50% of the second-hand units currently on the market.

The announcement will at once strengthen the confidence of homebuyers for the cheaper units. The prices of these units will not slip any more. Financially able homebuyers will resurface. Some sellers of homes will withhold their units. Some homeowners who plan to default will think twice. The actual number of units that the government has to acquire will be much smaller than might be thought.

The announcement will also benefit more costly homes indirectly. Some of the owners of the cheaper units, upon selling their units, may buy the more expensive homes that they can afford.

The announcement will immediately improve the prospect of the “toxic assets” held by financial institutions. The outlook of these firms will improve at once. The stock market will advance, further boosting confidence.
Confidence worldwide will rebound. Global capitalism is saved.

Finally Paulson and Bernanke Did the Right Thing

Paulson and Bernanke finally moved to restore investor confidence by effectively underwriting or buying many of the bad loans that had been undermining the health of financial institutions in the US. The financial markets worldwide cheered with close to 10% jump in two days.

This behavior of the financial markets once again confirmed the importance of confidence. When confidence comes back, firms that otherwise would fail are saved. When confidence collapses, firms that otherwise were healthy could fail.

I had lamented Paulson's failure to act as a guarantor to facilitate the takeover of Lehman Brothers by potential buyers because that really rocked the financial market and triggered a "tsunami" across the world's financial markets. If this time around Paulson and Bernanke failed to act promptly, it is entirely possible that the US and the world slip into the second Great Depression.

For now the world is saved. I am sure despite the cost in terms of direct taxpayers' money, taxpayers will thank Paulson and Bernanke for what they did.

I hope, though, that they will still take necessary action against real moral hazard: i.e., whose who win big if their bets are right and have little to lose if their bets are wrong. If they are sincere about guarding moral hazard they should be after the decision makers who created the mess, and not the innocent savers both in the US and in the rest of the world.

Paulson Made a Mistake

In allowing the demise of Lehman Brothers instead of salvaging it with taxpayers’ money Paulson and his associates claim that this is to avoid moral hazard, so that risky investors will not be protected from the results of their own risky ventures. The fact, however, is that the risky ventures were undertaken by other people without the knowledge of the shareholders. It is ironic that the decision makers get away from dire consequences while the innocent suffer in the name of avoiding moral hazard. With Wall Street falling over 500 points it is clear that taxpayers are losing far more than what they possibly “ saved” if the government had stepped in to facilitate the orderly take-over of Lehman Brothers by the suitors. This is yet another instance of the lack of understanding about systematic effects or what I had called the ecology of market economy.

The fact of the matter is that global capitalism requires a good dose of common sense. Who in their right mind would believe that the mortgage loans are “backed” by collaterals, when borrowers have hardly any down-payment or equity in their homes in the first place? Who in their right mind would believe that the market can self-regulate, when market participants are subject to a conflict of interest. There is no need for a “financial engineering” degree to tell that we need effective safeguards when a few people are playing with huge sums of other people’s money. Without proper safeguards, it is not surprising that “rogue traders” like Jérôme Kerviel and Nick Leeson would take advantage of the loopholes that are there to benefit themselves. Without proper safeguards, we have seen fake transactions inflating balance sheets and yielding handsome fees to officials of some thrifts during the 80s contributing to the Savings and Loans Crisis in the US. Without proper safeguards, we have seen how the auditor conspired with company executives in the case of Enron.

The market place offers both crooks and innocent people opportunities. But the opportunities of the crooks are the risks of the innocent. Our choice is definitely not over having more versus having less regulation. Our choice is over appropriate regulation versus inadequate or inappropriate regulation. Some say that too much regulation stifles markets. The fact is that the right kind of regulation enables markets to run smoothly and fairly.

Inflation Fight with Inflation-Indexed Interest Rates

One problem with traditional monetary tools is that as inflation heightens, real interest rate falls, which actually fuels inflation because inflation reduces expected real interest rates. Central banks have then to raise interest rates, but with inflation expectations uncertain, how much nominal interest rates need to be raised is not clear. As a result, there is a tendency for gradualism, as central banks need to take one step at a time and watch what happens. It is anybody's guess as to where the interest rate hike is going to reach, and conversely when interest rates are to fall, it is anybody's guess as to where the interest rate decline is going to end up.

With a currency anchored to the WCU, or with indexed instruments, however, real interest rates will not fall when inflation rises. So there is an automatic check against borrowing on the assumption that inflation will relieve real borrowing cost. With a currency anchored to the WCU or with monetary policy directly determining real interest rates using indexed instruments, therefore, the inflation fight will be easier.

An Announcement: A new quotations page soon

We are now testing a new quotations page. Watch out for new features in the quotations page in about a month's time.

We hope that by revamping the quotations page the meaning of the different columns will become clearer. Quotations on the value of the Canadian dollar and that of the Australian dollar in terms of the WCU will also be available.

I have been watching the WCU price of the RMB for quite some time. The recent surges are extremely worrying for the trade and industrial sector of the Chinese economy. On the other hand, weaknesses in the pound sterling and an impending interest rate drop could help the British economy steer away from a recession.

Speculation and Commodity Prices

When speculation is rampant, spot prices may also rise, but a rise in spot prices must imply some form of hoarding. In the absence of hoarding, spot commodity prices are determined by supply and demand, where demand refers to demand by the users of the commodities.

When intense speculation pushes up oil futures prices, suppliers who do not believe the prices can sustain may want to sell in the futures market. If they do not believe that the high prices will sustain, it makes sense to sell in the futures market while prices are still high. On the other hand, if further price rises are expected, then suppliers may want to withold some of their supplies now; at the same time some users may also want to buy more now and hold them in inventory. This will push up spot prices, and the final users of commodies will then suffer for having to pay higher prices.

Speculation without a surge in real demand however cannot sustain. Without a surge in real demand by users, speculative price increases must lead eventually to a price crash. Inventories have to be disposed off some day. Real demand must also fall with higher prices, adding pressures on inventory accumulation.

It is unfortunate that today commodities have become a vehicle for fighting inflation and a declining US dollar. That is to say, the prospect of higher inflation encourages hoarding and speculative demand for commodities. If commodities are priced in WCU2000 or WCU2005, however, real prices would not need to change as the effects of inflation and US dollar depreciation would be completely offset, leading to more stable commodity markets.

RMB surging against WCU2000

Although RMB has been "depreciating" against the US dollar over the past 10 days or so, the RMB is actually becoming the strongest currency around for this year to date. This is because of the rapid appreciation of the US dollar against most currencies. In the first half of this year, the strongest currency had been the Swiss Franc. As of today, the RMB has gained over 3 per cent against the WCU2000 while the Swiss Franc has gained by less than one per cent since January 1. Relative to the benchmark basket of WCU currencies(GDP2005 weighted), the RMB has gained 6.13 per cent since the beginning of the year. The Swiss franc has only gained 4.03 per cent. The US dollar has lost only 0.34% against the benchmark currency basket. The British pound is now the weakest of the currencies listed in our Quotations table as of today.

The strength of the RMB is expected to put downward pressure on inflation on the mainland. At the same time it is going to be a major drag on the economy as exports are expected to decline dramatically over the rest of the year.

World Inflation Soon to Fall

Andy Xie recently wrote in the South China Morning Post that the world is now facing a decade of inflation fire. The reason is that the central banks around the world, especially the Fed, have been overly expansionary. According to him the US has been engulfed in piles of debt, and asset values are declining to the extent that “the US financial system may be bankrupt as a whole.”

It is true that the US has been engulfed in piles of debt. In fact, the corporate sector, the household sector, and the government sector are all net debtors. It is also true that the Fed has been very aggressive in providing liquidity to the financial system since August last year. However, I had determined that the Fed had been overly slow in responding to signs of trouble. If the Fed had started easing early last summer, the calamity would have been scaled down considerably. But better late than never: thanks to the Fed’s aggressive actions, the financial system has been saved. If the Fed had set its eyes on containing inflation single-mindedly instead as some analysts had advised, a repeat of the Great Depression in the 1930s could not be ruled out. Inflation would be contained, and deflation would set in, and unemployment from 15 to 25% could become reality, with tens of millions of people around the world falling into bankruptcy.

Although the Fed has been aggressive in injecting liquidity to the financial system, the assumption that this would cause inflation is wrong. The liquidity served mainly to counteract a contraction, so that the economy could continue to grow. The Central Bank has acted wisely, and has taken its lessons from the Great Depression. Thanks to Ben Bernanke, the humble student of the Great Depression, this time around the Fed will not take any chances.

It is true that many speculators had placed their bets on oil and commodities, and thus fueling a spectacular price surge. But speculative demand cannot go against the law of supply and demand forever. Speculative demand in the final analysis has to be supported by concrete demand for the hard commodities. With a slowing economy, the required buoyancy of demand was simply not there. Consequently commodity prices including oil prices have fallen sharply in recent weeks.

In the final analysis, inflation is a phenomenon of supply against demand. It is true that if money expansion keeps pulling demand beyond supply, inflation will flare up. But demand depends on many factors. The major declines in asset prices is in itself a demand-suppressing force. The rise in unemployment is another demand-suppressing force. The surge in the pricing of risk is yet another demand-suppressing force. Investment is slowing down; consumption is slowing down. US exports have been strong so far, but are expected to weaken considerably with the European and Asian economies slowing and the US dollar strengthening. With the strong RMB the Chinese economy will slow down very rapidly over the next few quarters. All of these factors are eroding aggregate demand, so that real growth has slowed down and will remain very mild over the next few quarters. The injection of liquidity is only preventing the slow-down from aggravating into a fully-fledged recession or even depression.

Three cheers for Ben Bernanke! His innovative and bold ways of lending support to the fast weakening financial system are needed. His proposals to tighten up regulations especially in the lending practices and to improve the governance of financial institutions are both required. He has my full support, and I am positive inflation will not flare up as Xie predicted. Instead, inflation is going to ease considerably. The world economy has been saved!

Greenspan's Remarks about Regulation and Financial Crises

Alan Greenspan recently rebutted allegations about his excessively expansionary monetary policy giving rise to the housing bubble and remarked that regulations would not reduce financial crises.

I agree that monetary policy is indeed not the cause of the US housing bubble. It is also true that regulations cannot eliminate financial crises. But inadequate regulations will certainly lead to more crises.

With the subprime crisis, inadequate regulations certainly played a role. Indiscriminate lending, with loans generously extended to people who did not have any financial commitment to the homes they bought, and who might not even have the ability to service the loans, reduced the quality of the “collateral.” This should not have been allowed.

Because there is often no or very little down-payment with many subprime loans, there was really no real collateral. Borrowers have little commitment to service their loans should home prices head south, and lenders had virtually no margin of safety.To say that regulators had little responsibility behind the turn of events that led to major write-downs among banks and investment houses is irresponsible. If the US had followed the HK Monetary Authority in requiring banks to lend at most 70% or even 60% of appraised values(the latter, more conservative, ratio applies to luxury homes) there would have been no crisis. The HK Monetary Authority requires borrowers to buy default insurance if the loan ratio exceeds these ratios.

Inflation in China Set to Decline

With the RMB appreciating against the WCU2000, there is little doubt that inflation on the Mainland is going to decline rather noticeably in the next few months.

The RMB is now one of the strongest currencies around. Imports are getting cheapter; domestic demand is easing--especially investment; exports growth is declining.

The economy is going to slow down markedly. World commodity prices are easing. Pressures for further monetary tightening are easing.

There is of course a chance that the RMB could stop appreciating against the USD. But in the foreseeable future it is unlikely for the RMB to weaken against the WCU2000. Accordingly, quite independently of the course of the US dollar, I still expect inflation on the Mainland to slow down considerably.

Poor Governance, Not Easy Money, is the Cause of Current & Many Other Crises

Former Fed chairman Alan Greenspan, as well as current chairman Ben Bernanke, have been blamed for following an easy money policy that was supposed to have engendered and aggravated the current financial market crisis. But these accusations are almost certainly misplaced.
While money was probably eased excessively at one point, that is not the reason why many CDOs went sour and why mortgaged backed securities lost value plunging many banks and financial companies into a relentless decline, with not a few actually falling under.
The main reason is poor governance. This was also the reason behind the S&L crisis during the eighties, the collapse of Enron in the fall of 2001, and dozens of other disasters.
Many academics have tried to design various warning indicators. But warning indicators are no substitute for good governance. Poor governance will lead to disaster sooner or later. When there is a conflict of interest and the person making important decisions looks after his personal interest ahead of the interest of the corporation, the corporation suffers. When there is a conflict of interest and the corporation making important decisions looks after its self interest ahead of the social responsibility entrusted to it, society suffers. Thus an auditor is supposed to do its job on behalf of society, but his fees are paid by the firm audited by him, there is a strong temptation for him to compromise his professionalism. There is now a report from Reuters saying that Freddie Mac Chief Executive Richard Syron refused to heed warnings about risky loans that were issued as early as 2004. Buying the questionable loans and other choices initially paid off for Syron, who “collected more than $38 million in compensation since 2003, the NY Times said.” Earlier on, some commentators had pointed to the conflict of interest besetting rating agencies, whose ratings may well have been contaminated by financial incentives.
One must ask why loans were made to people without the ability to repay the loans. Why were financial institutions allowed to lend to home buyers without the ability to come up with a reasonable down-payment? The fact is: if lenders had lent only 70% of the market value of homes, all the mortgaged backed securities would still have been able to maintain their market values. Bear Stearns would still have been a viable company. We need to relearn the same lesson we thought we had learnt before: we need good corporate governance and common sense risk management.

Commentary: Price of Oil

The real price of oil broke its historical high(0.7 WCU2000) when the nominal price hit US$100 a barrel early in the year. As it continued to surge and approached US$150, ocean- going fishing vessels were held back, flights were cancelled, SUVs were dumped, people switched to public transport, and the world’s stock market crashed. All this is suggesting that at least for the time being, the price of oil at 1 WCU2000 per barrel is probably a short term limit.
There are still people who argue that sky is the limit for crude oil. Many of these cited M.K.Hubbard, who argued that the production of oil would soon hit a peak. Production would then be impossible to expand much further. With world demand rising, the shortfall will translate into price spikes.
There are others who looked at statistical estimates of demand elasticities and suggest that price increases may not check the growth of demand, given the low price elasticity of demand of oil.
These hypotheses directly challenge a basic assumption in economic theory: that higher prices will lead to economizing among consumers and efforts to produce more, and thus price adjustments will bring about real adjustments.
The fact is that as the price elasticity of demand is not a constant. As price increases more and more, one moves up the demand curve, and the price elasticity of demand increases. Moreover, over the longer run, consumers will switch to substitutes, and will change their behavior. The demand curve will shift inwards.
Supply will also rise. There will be more oil exploration, and more effort on alternative energy. The technology for alternative energy will gradually mature and then the demand for oil will decline.
I personally do not believe that there is any chance for the price of oil to hit 1.2 WCU2000 (around USD175 at today’s exchange rates) within the next five years, except in the event of a major conflict. In that event, the price could momentarily breach that, but such a price will still be unsustainable. A major world recession and a gigantic plunge in the real price of oil will be in the cards should this happen.
July 29, 2008