Tuesday, September 23, 2008

Bernanke and Paulson - the Dynamic Duo?

The world is waiting nervously to see whether the bailout of the financial system will actually go ahead, with ever more dissent coming from congress in the United States. If the article I have cited is correct, it is not economics in the driving seat, but politics. Bearing in mind that the economists have got it so wrong in the past, perhaps (for once) that is a good thing.

Meanwhile, one of the curiosities of recent days is that oil has risen in price. This really is quite baffling, though not in the sense that it is rising through hidden unknown mechanisms. The baffling part is that oil is not something that can be stored, and has to be sold according to a price that is set by demand. Unless those investing in oil know that there will be a cut in supply, it is not entirely clear how they seek to profit, or even find safety in this commodity. Oil prices were falling previously for a good reason; that demand across the OECD was falling back. As such, they now have the oil, but they need to actually sell it to end users at a price that will cover their buying price. As ever, those who got in early stand to profit from this, but the followers will surely lose money - unless I am missing something critical here? On the other hand the flight to gold makes more sense, as gold is currently being driven by sentiment (a flight to safety), and can be held over the long term. At this point, you may ask for the difference. In crude terms, gold can be locked away and be held over long periods of time, whereas oil can not be stored in significant quantities. As I have said, perhaps I am missing something here, but I do not think so.

This situation perhaps illustrates the underlying fear in the market. On a related issue it appears that there are tremors over the state of the emerging markets:

'"The big surprise in store is what could happen in China. The potential for a deep recession in the US is already on the radar screen, but people will be stunned if China's economy contracts, as I believe it will. Investors could be massively caught out," he said.

"The consensus has a touching belief that emerging markets will prove resilient despite a deep downturn in developed economies. My view is that an outright contraction in global GDP is entirely possible next year."'


'The gloomy forecast comes as Fitch Ratings warns of mounting distress for banks in China, where debt has been shunted off books to circumvent state limits on credit growth.

The pattern looks eerily like the use of "conduits" by Western banks at the height of the credit bubble'

I have mentioned before that China is opaque, and whether it would be pulled down by the crisis was not entirely clear. I recommend you read my original post on China, as it covers both the positives and negatives in the Chinese economy, and explains why it is that it is so difficult to see the economy clearly.In my original post on China, I had the following to say in conclusion to my discussion of Chinese banks (having pointed out that their commercial and domestic property were looking like a bubble):

'In light of this, I must conclude that there may still be some suspect lending from the Chinese banks. This is pure speculation, but is based on experience 'on the ground'. This raises the possibility that there is also bad lending into business, in particular to the state owned firms. Such lending is not so visible, so it is impossible to say if this is the case.'

However, before writing off the Chinese economy, I would suggest taking a look at the post, as there are significant strengths. The fact that the problems of the US and Europe would hurt China was always evident (and something I predicted). However, whether the damage from the West is enough to pull back the Chinese economy into recession was my question. If it is correct and, as I suspected, the Chinese banks have continued their poor lending, then the balance tilts towards serious problems for China. This is a very worrying thought, as the legitimacy of the Chinese Communist Party is built largely on economic growth and nationalism. If economic growth fails.....

The same article is suggesting that there may be a worldwide recession, and readers of my posts will find this to be no surprise. The real question is how the pain will be spread, and it has always been my belief that the West is going to be where the real hurt happens. However, if we throw unrest (Revolution? War?) into the Chinese equation, then all bets are off. At that point we will enter a state of chaos from which anything may emerge. It was one of the points made in my original post. However, this is just one report, and as I have emphasised, China is opaque; call it a wild card if you will.

What of investing in Asia? I have already suggested that their markets will fall along with Western markets, but that there currencies will see strengthening, which should offset the pain of the falls for those who move their money into the emerging economies early. However, if China does fall, then political risk across Asia will be sky high. It is for these reasons that I have been emphasising that there is no real safe haven at the moment, except possibly gold. In the short term I suspect that we will see some strange market movements. The flight to safety into oil suggests that there is a considerable degree of panic, and panic does not aid rational thought.

In the meantime, the world waits on the success or failure of the 'dynamic duo' of Paulson and Bernanke. However, their intervention does not promise to save the day, because no super heroes are large or powerful enough to overturn economic reality. The curious point for them is that, whatever they do, history will be kind to them. If they fail, and the anyway inevitable crisis ensues, everyone will suggest that 'if only they had been listened to', and if they succeed the economy will still crash, and it will be seen as a valiant effort, but just not enough. In short, the idea that something could be done will persist.

An analogy for this is to think of a company that has long been successful. The management of the company changes, and they cut back on investment, increase the pay of their workers, and enjoy the comfort of market leadership. As time goes on, they fail to note that new companies are entering their markets, taking market share, and fail to react. Instead, they raise ever more money on the markets, and the market keeps paying. However, they are loading up with debt, and they are starting to use debt to pay back debt. Can anything be done to stave off disaster in the short term? They are broke - their revenues are falling, they have lost market share, and their lack of investment has left them poorly equipped to fight back. No one wants to lend anymore...

So, can our dynamic duo save the day? I will let you draw your own conclusions.

Note 1: I was posting on a forum and dug out one of the useful resources that I occasionally dig into for information. The resource can be found here. It is the Bank of England document on recent developments:
'Chart 1 shows the extent to which the United Kingdom’s gross external assets and liabilities have grown since 1990. In this 13-year period, both assets and liabilities
have increased by more than £2.6 trillion, at an average annual rate of more than 11%. This easily outstripped the 5.4% average annual growth rate of nominal UK
GDP over the same period. At end-2003, external assets stood at £3.55 trillion and external liabilities stood at £3.60 trillion.'
When we factor in that they include the multiplier effects from increase in debt are factored into economic growth, such that the GDP figures are completely removed from the the reality of real growth, then we have a very worrying situation indeed (these are problems discussed through various places in the blog).

Note 2: Just a quick comment on Gordon Brown cleaning up the City and the world financial system:
'Mr Brown will call today for global regulation. "Because the flows of capital are global, then supervision can no longer just be national but has to be global. And if we make these changes I believe London will retain its rightful place as the financial centre of the world.'
The first problem is that (as I have argued previously) it is actually regulation causing all the problems. The second problem is one of practicality. How can different systems across the world all find a common standard. The third problem is that, if all the world uses the same system, then the entire world system will all go down at once if there is a major failure in that system (an analogy that comes to mind was a historical calamity in which the whole of the US used the same variety of wheat, such that when a disease struck the whole years crop was devastated). As it is the system is interconnected, but at least different systems will have different vulnerabilites and exposures.

Happily, as trying to set up such a financial system will be akin to herding cats, it is very unlikely (I hope) to succeed. As such it is probably just grand standing, to be seen to be doing something; and an attempt to portray gravitas. As for the idea of regulation of banking pay, I have yet to see any solid proposal that goes beyond rhetoric, but the idea of government control of remuneration is one which brings the word 'despair' to mind. The banks may have been foolish, but much of the root cause for the foolishness was that all the banks were 'sound'.....and the reason that they were sound was because they met regulatory requirements. The fact that their capital base was built upon toxic waste slipped the regulators by....and now there is talk about regulation of remuneration?

Note for Tin Hat: In reply to your question, I have no secret investment tips. I just arranged my life such that (hopefully) the crisis will mostly pass me by.

Last Note: Just a point on the valuation of emerging market investments. A simple way to look at it is imagine you invest $1 in a US stock, and $1 in an asian stock, and both stocks fall equally in percentage terms in their markets. If the Asia currency is appreciateing against the dollar, even though the Asian stock has dropped in value, at least part of your wealth has been retained through the fact that when you sell that stock, the currency will ameliorate the effects of the fall in the stock value, as the value is measured against local exchange rates. Sorry, to mention this if it is obvious to you all, but just in case....

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