We Are Simply Too Full of Ourselves

China is taking over the economic leadership of the world and we are simply too full of ourselves to see what is happening. Actually we are just acting as typical humans who look at past events and extrapolate in a straight line into the future. However, this approach misses many key variables of the China Equation that will result in exponential change.

So what are the variables that need to be thrown into the China equation?

China's real GDP is 2 to 3 times larger than what is officially reported when examined on a purchasing power parity basis.

China's savings rate (49%) and foreign account balances ($2 trillion +) are extremely high.

In 2007 when the global economy over heated, China wisely raised bank capital requirements as well as interest rates, thereby avoiding the excessive financial leverage that helped to ruin our economy and thus allowing their banks to expand leverage today. (This is happening while our banks must de-lever and our government must act as the borrower of last resort.) China's banking institutions are growing stronger and more sophisticated while our banks are in a state of severe shock and disarray.

While China's bank loans have been criticized as excessive and creating new bubbles, do you really think they are allocating capital less efficiently than our Federal Reserve and deficit spending programs?

Their people have tasted the good life and are hungry to move up the economic ladder. Their labor force works harder and their students study harder.

China's economic policies are very rational (or "scientific" as their leadership prefers to say). They are not burdened by the bureaucratic regulatory/judicial delay mechanisms that discourage new investments in the Western World. They are not hindered by populist rhetoric, leftist anti-growth policies or right wing "balance the budget at all costs" dogma. They have already shown that they can move quickly to stimulate their economy and can adjust quickly to avoid inappropriate bubbles and excesses from forming.

The population for the most part is compliant - Eastern cultures view their leaders as benevolent "father figures" and defer to the leader's "sound and wise judgment" to care for their best interests. (How else can you explain a nation like North Korea existing)

The Chinese culture has demonstrated excellent business acumen in locations through out the world such as Taiwan, Singapore, Hong Kong, Canada and the United States.

There is huge pent up demand for goods and services. Already China consumes more cars, computers, cell phones, steel, cement, etc. etc. This consumption will only grow. Their domestic market is huge. Their population is over 4x and labor force is over 5x that of the USA.

Already China businesses are taking a leadership role in the manufacture (and design) of many leading edge technologies; Li batteries, LED chips, airplane assemblies just to mention a few.

The value added component of the Chinese economy is growing exponentially. Already China is undergoing a shift where low cost, low skill jobs are moving "offshore" while high skilled, high technology jobs expand.

While the United States is in its period of decline, China is ascending. China will dominate the 21st century and beyond. China has planned for this day for over 20 years although I suspect it has come to pass much earlier than they had expected.

We do not understand and will continue not to know what has hit us until after the fact as these changes(both China's ascent and the United States descent) are occurring too rapidly for us to comprehend. Further, much of this change is hidden under a blanket of improperly valued currencies - the Dollar is valued too high and the Yuan is valued much too low.

At some future point in time, China will rationally assess that it is in their best interests to promote a strong national currency and to transform the Yuan into a global currency.

Why? Because once their technical knowledge and fundamental business/economic/financial infrastructures are well established, and as they continue to consume an ever increasing share of the world's commodities and natural resources to feed and satisfy the consumer demands of their huge population, they will find that a strong currency is in their best interests.

In the meantime China will continue to aggressively establish a domestic demand component to their economy and promote the development of new export markets through out the world that will take the place of the permanently faltered USA consumer. This is already apparent in their actions to purchase and stockpile key commodities and to arrange long term loan agreements in exchange for future oil and natural gas production with emerging market economies.

We are simply too full of ourselves when we think that our problems are going to bring down China.

Yes these problems may put a damper on China's growth in the short-term but if anything they will accelerate China's ascension because, as their co-dependency relationship with the USA falters, they will need to learn to be self sufficient and march forward on their own two feet.

China has clearly shown that have the means and the will to do just that!

Investment Bankers and the "Flip Wilson Defense"

What really irks me is when bankers use the “Flip Wilson Defense”: “Greenspan made me do it. If interest rates were not so low I never would have done what I did.”

If you think back at how weak our economy was after the Dotcom Crash, 9/11, Anthrax Scare, SARS, etc., the economy was growing very slowly, companies had stopped investing and we were truly at risk of a deflation spiral. Now if you also take away the irrational credit expansion of the 30x leverage, the housing bubble and the related consumer binge and substitute in its place rational lending practices to individuals and more capital allocated for property, plant and equipment investments by the private and public sectors, then we would have had a very different outcome - higher productivity, a more competitive economy in the global marketplace, fewer bad investments in housing and commercial real estate, stronger household balance sheets and no financial collapse.

In other words the lower interest rates would have been used for efficient allocation of capital and would have been a “force for good” (as our good friends at Goldman like to say about themselves).

I am no Greenspan apologist. He royally screwed up with his hands off, self-regulation ideology and therefore history will correctly show that he shares in the responsibility for permitting the banks to promulgate a financial crisis.

But too much of the blame is being placed on his interest rate policies. It has become too easy for the banking community to deflect responsibility and to rationalize that it was Greenspan’s interest rate policy and not their own actions of taking advantage of a deregulated marketplace in order to engage in risky and indiscriminate behavior.

Bankers are wrong to say: “Greenspan made me do it.” They would be far more correct if they said: “I convinced Greenspan and the government to let me do it and boy did I screw it up.”

We Are Doing It All Wrong!

Why are we buying up trillions of dollars of toxic mortgage assets that we know they are going to fail when with a far smaller investment we could be saving homeowners and converting much of this toxic debt into refinanced investment grade paper? Our current approach seems to be illogical.

Millions of homeowners are being forced into foreclosure. These are individuals who will have their credit ratings ruined and who for the next 7 years will by necessity become renters (or will move in with relatives or worse become homeless). Thus we are seeing a permanent reduction to the demand side for housing at a time when we have a huge surplus of housing stock.

The alternative is to develop policies that will permit homeowners to keep their homes and protect their credit ratings. If a homeowner faces foreclosure because he/she can pay only, say 80% of his/her monthly mortgage, does it not make more sense to keep this 80% cash flow contributing towards the servicing of mortgage debt and finding some means to cover the remaining 20% until the homeowner has the where with all to return to self-sufficiency? Isn't this better public policy than to have the government buy their bad mortgages knowing full well that this debt will be worthless and its costs will ultimately land on the doorstep of either the taxpayer or the middle class in the form of a debased currency and lower living standards? Why are we so quick to look askance at the moral hazards of "too big to fail" banks, but yet we dig in our heels to enforce moral hazard risks against individual homeowners? Simply, we are doing it all wrong.

There are many ways that we can assist the individual homeowner and lessen the moral hazard risk. Perhaps we can take a public equity interest in the value of a home that is refinanced. Home prices will eventually appreciate again and mortgage principal balances decline over time thereby freeing up equity for eventual repayment. If the Federal Reserve is comfortable with subsidizing zero interest rates to banks, perhaps it should find greater comfort with subsidizing home mortgage interest rates to homeowners. Perhaps through a 5/30 variable/fixed product that reduces cash flow requirements of individual homeowners while they get back on their feet.

Obviously this is not a cure all. Millions of fraudulent mortgage loans were sold where the purchaser never intended to repay and the financers didn't care because the loans were packaged and sold to unsuspecting third party investors such as pension funds and foreign institutions. This fraud will burden our economy for decades to come and there is not much that we can do about it but learn and put into place the proper system of controls that will prevent future occurrences while not stifling our market based economy.

While everyone can share in the blame and greed that has gotten us to where we are today, it is not appropriate to place the preponderance of blame on the individual homeowner who was plastered with offers to refinance and take out home equity loans and who succumbed to these enticements. Who were the smart suits in the room who purportedly best understood the loan risks? Who were the ones who exerted pressure down through the financial system to continue to generate more and more mortgages that could then be profitably securitized? Who advocated for the use of subprime loans, no documentation "liar" loans, interest only loans, reverse amortization loans in order to keep the product flowing regardless of risks? Who influenced our governmental officials to deregulate and allow investment banks to leverage to irrational multiples? Who engineered the complex, high-risk financial products and off the books accounting schemes and special purpose vehicles? Who cajoled and essentially bribed the rating agencies into developing and then keeping unrealistic rating models even after the true risks became apparent? Who simply bought "insurance protection" in order to continue to perpetuate the failing model rather than self-regulate once the risks became apparent? Who secured governmental bailouts in order to keep their business as usual and their bonuses flowing even after the financial markets collapsed? Who manipulated the commercial banking regulations and secured exemptions to continue risky banking practices in the midst of the worst financial crisis this nation has perhaps ever seen? Who pressured the accounting standards board to rescind mark to market valuations thereby permitting the reporting of higher profits and providing cover for continued excessive bonuses and compensation schemes?

So I ask again, why are our governmental officials so keen on bailing out the banks and yet we will not bail out the homeowners when the total cost to our economy would be so much less and the benefits to the individuals who make up our society would be so far greater?

Education appears to be paramount as most people strongly oppose “bailing out” the homeowners while they do not object as much to buying the toxic debt simply because it is too complicated for them to understand. Rather than try to explain the true circumstances of our current economic and financial crisis and the best options going forward, our leadership instead are taking the path of least resistance and our politicians are ensuring that they do not "bite the hands" that continuously feed their need for campaign funding and personal gains and perquisites that they rationalize they are entitled to due to their positions of power. How many politicians do you suppose have received sweetheart mortgage loans or have had some kind benefactor acquire their property for a really good price over the years? Aren't these people now somewhat compromised - just as their benefactors had intended them to be?

I am not very optimistic that reason will prevail. Corruption on the other hand is likely to continue unabated.

Someone Tell the Federal Reserve - This Time It Really IS Different

The Fed is planning to phase out purchases of U.S. Treasuries. In doing so, it is taking its foot off of the pedal much too soon. It is making the same mistake that was made in the 30's. I guess it is human nature to be overly cautious even when times call for continuous and aggressive action.

Perhaps the Federal Reserve needed to announce an end to Quantitative Easing for "moral hazard" or "dollar protection" reasons. Clearly it cannot be based on fundamental economic strength.

The Fed did not foresee the severity of the housing collapse back in 2007 and today they are not seeing the severity of the consumption collapse.

Consumer behavior coming out of previous recessions cannot be used as a guide. We are truly in different times as bank credit tightens, consumers reduce their credit card and auto payment debt, demographics (aging) kick in, incomes diminish, income disparities grow more obvious, wealth dissipates, state and local governments downsize, bankruptcies and foreclosures curtail future credit access, oversupply brings new construction essentially to a stop, etc. etc. Heck, even illegal immigrants are returning to their homelands. Florida lost population for the first time in 60 years.

A fundamentally profound transition in under way. It is one that does not show up in the case studies of prior recessions. The American consumer is no longer. An economy that was built around this animal must now undergo a major and substantial overhaul. We are somewhere along the continuum of shock, disbelief, denial, anger, ...... but we have yet to reach the point of acceptance and moving forward.

If the consumer cannot bring us out of this recession, then what or who will? It cannot be the Government. Government deficits of the current magnitude can only be temporary fixes - to bridge the gap until new economic growth takes form.

Growth will have to come in the form of domestic production of goods and services for export and to serve as a substitute for imports. Fords and Florida vacations rather than BMWs and trips to Europe. California wines sold in France rather then French wines sold here (OK - that example is a stretch). Domestic energy production in all forms rather than energy imports.

This implies that either the global economy must grow rapidly to serve as the engine of growth or the dollar must be devalued to create new jobs in spite of less consumption.

I see two distinct advantages for Q. E. in this respect. First it prevents asset value depreciation from further exacerbating the already severe bank solvency and household wealth crises, and secondly, it lowers the value of the dollar thereby forcing other nations to stimulate their domestic economies rather than rely on the deficit spending operations of the United States.

Seriously, can anyone come up with any other way for the Fed to stabilize the economy and achieve the combined objectives of price stability and full employment?

Has Obama Blown His Chance at Greatness?

I am afraid that President Obama has lost his opportunity to achieve greatness. Perhaps he simply is too young and inexperienced. Perhaps he simply is too liberal in the big government, anti-business traditions of the left.

For what ever reasons, Obama has lost his chance. This is so unfortunate. Not only for the well being of our nation economically but also for the strength of our social fabric and the ties that bind the many diverse Americans together.

We are continuing to see even greater polarity between the left and the right at a time when many of us thought we were electing a President who had the capacity to further unite Americans.

So what went wrong? I see two distinct possibilities. First to set the stage. While leaders can be classified into many distinct sets and subsets of personality types and management styles, one classification set that applies here is to distinguish between the "philosopher leader" and the "tactical leader". The philosopher looks at the big picture and wants to believe that a greater common good can be achieved by all. The tactician, on the other hand, looks at the current political landscape and develops strategies to gain individual political advantage. Tacticians love to go up against philosophers because their motives and future moves are easy to discern and to strategize against. By the same token, philosophers usually make lousy tacticians because they find it difficult to comprehend that others value personal/political tactical advantage more than the higher moral ground.

So what went wrong?

Scenario #1. Obama is a centrist philosopher who understands and agrees with both the social objectives of the left and the personal responsibility and free market philosophies of the right. As a realist with respect to his inexperience in the hardball politics of Washington DC, he understood from the outset that he needed a tactical implementer and overcompensated in the name of Rahm Emanuel. Thus Obama's Administration has been hijacked by a traditional, far-to-the-left of center tactician who has steered the administration away from the center and towards achieving long standing liberal objectives.

Scenario #2. Obama is a dyed-in-the-wool, far-to-the-left of center, liberal. He hired the right man in Emanuel to implement his ideology. The Obama Administration has not been hijacked at all. Rather the electorate has been duped by an extremely clever and articulate individual who was raised in a conservative environment, understands how they think and knows just what to say to appease them, while all the time holding their views with contempt and implementing the liberal agenda of the "enlightened progressive class".

Sadly, the more I observe this administration, the more I must conclude that we are in Scenario #2. Obama is extremely liberal and extremely adroit in coming off as a centrist, but only for show and not for real.

I do not think Obama has had the life experiences to truly understand how an economy should be managed or what roles government can and cannot effectively play in achieving social goals. Further, he has jettisoned those advisers who do (after they helped him to get elected by appealing to conservative and moderate voters.)

Obviously this is just one facet of a very complex person and personality. But it is a significant enough facet to conclude that Obama will most likely go down in history as being yet one more mediocre President at a time when the nation truly needed a strong unifying leader.

Bernanke's Big Mistake

Yesterday the Federal Reserve announced that it would phase out Treasury Security purchases by October 2009. This is unfortunate. Quantitative Easing is essential during this time of fundamental changes to the structure of our economy. We are not in the throes of an ordinary recession. We are in the beginning phases of a deep and protracted economic adjustment.

Winston Churchill stated after defeating Rommel in North Africa; "This is not the end. It is not even the beginning of the end. Rather, it is the end of the beginning." The recent stabilization of global financial institutions should be looked at the same way. We have applied a tourniquet on the worst of the wounds, but we have not stopped the bleeding and the patient is still in intensive care.

Quantitative Easing is a proven means to maintain liquidity and asset demand during times of deleveraging. The deleveraging of our financial institutions, corporations, small businesses and consumers has just begun. If asset values are not reflated, the deleveraging will simply be even more prolonged and severe.

QE is one of the few tools that we have to counteract the actions by other Central Banks who are deflating their currencies and thereby discouraging the purchase of USA made goods and services.

It will take a number of years for the emerging economies of the world to develop sustainable domestic markets. Our domestic economy needs to "hang on" until this happens.

Inflation is not in the cards for decades, that is unless our economy collapses to the point where all faith in the dollar in lost. Sure, globally priced goods and services are going to rise, but labor and domestic pricing will not.

I suspect the Federal Reserve will reinstate QE at some later date, but not until even more permanent damage to our economy has occurred.