Zero Hedge

From the UK Telegraph: Latvia government collapses amid economic crisis

The People’s Party, the largest group in a five-party coalition, walked
out amid disputes over how to cope with the country’s severe problems.

Unemployment has now hit 20 per cent and the economy contracted by 18
per cent last year.

The People’s Party quit after its action plan failed to get the backing
of Valdis Dombrovskis, the Latvian prime minister, who labelled it
“populist”.

Mr Dombrovskis warned the People’s Party’s departure could cause yet
further economic instability.

“Any contradictions in the government are immediately reflected in the
financial markets, and they directly affect the fiscal stability our
country… a policy that is truly responsible for the country cannot be
self-centred,” he said.

But he said remained confident that an emergency IMF bail-out worth
£6.7bn would remain unaffected by the political instability.

New Era, Mr Dombrovskis’s party, confirmed it had already extended
invitations to other parties to join a new coalition in an attempt on
gain the majority in Latvia’s 100-seat parliament.

It attempted to play down concerns about the prospect of a minority
government at the helm of country in severe economic turmoil.

Laila Dimrote, a spokeswoman for New Era, said: “This is not a big
deal. Latvia has had many minority governments in the past, and often
this is the case prior to elections.”

Hopefully, subscribers and readers are taking full advantage of the
research at hand. This plays into the fact that Latvia, and its
neighboring countries, are
in a depression. This economic contagion will be both converted into
financial contagion through the banking system and transmitted as both
financial and economic contagion to the wealthier western countries that
have large economic claims on Latvia and do trade with them. 

Click to
Enlarge… 

 

Click any
graphic to enlarge…

For more opinion and analysis, see:

 

• The

  Depression is Already Here for Some Members of Europe, and It Just
  Might Be Contagious!

• and Financial

  Contagion vs. Economic Contagion: Does the Market Underestimate the
  Effects of the Latter?

I will be publishing the foreign claims model (which will tie all of the
myriad global risks into one, cogent risk model) and my analysis of
Italy early next week for subscribers, along with a free accompanying
analysis for non-paying subscribers and readers.  Ireland, the UK and
Spain are on tap. Earlier installments of the Reggie Middleton’s Pan-European Sovereign
Debt Crisis

1. The
   Coming Pan-European Sovereign Debt Crisis - introduces the crisis
   and identified it as a pan-European problem, not a localized one.
2. What
   Country is Next in the Coming Pan-European Sovereign Debt Crisis? -
   illustrates the potential for the domino effect
3. The
   Pan-European Sovereign Debt Crisis: If I Were to Short Any Country,
   What Country Would That Be.. - attempts to illustrate the highly
   interdependent weaknesses in Europe’s sovereign nations can effect even
   the perceived “stronger” nations.
4. The
   Coming Pan-European Soverign Debt Crisis, Pt 4: The Spread to Western
   European Countries

5. #993300; font-weight: normal;”>
   The
   Depression is Already Here for Some Members of Europe, and It Just
   Might Be Contagious!

6. The
   Beginning of the Endgame is Coming???

7. I
   Think It’s Confirmed, Greece Will Be the First Domino to Fall 

8. Smoking
   Swap Guns Are Beginning to Litter EuroLand, Sovereign Debt Buyer
   Beware!
9. Financial
   Contagion vs. Economic Contagion: Does the Market Underestimate the
   Effects of the Latter?
10. “Greek Crisis Is Over, Region Safe”,
    Prodi Says – I say Liar, Liar, Pants on Fire! 
11. Germany Finally Comes Out and Says,
    “We’re Not Touching Greece” – Well, Sort of…

12. The Greece and the Greek Banks Get the Word “First”
    Etched on the Side of Their Domino  

More articles from Zero Hedge….

I have been asked to repeat some of my past post on the stock market. In particular they wanted to see this long term chart of the S&P 500 price/earnings ratio. Until the 1990s bull market a PE of over 20 on trailing earnings was always a signal of an impending bear market as a PE of over 20 was never sustained. There is a long pattern of the market PE swinging from over 20 to under 10. Moreover, even though many Wall Street strategist talk about the long term average PE of about 15, there is no central tendency for the market to converge on the average of 15 and it really does not stay around 15 any longer than around any other value. Prior to 1926 the data is from Robert J. Shiller’s Irrational Exuberance . From 1926 to 1989 it is from S&P and after 1989 I calculate it from S&P’s estimated operating earnings data.

I use operating earnings because it is what most professional investors use and I believe that the estimate of on going operations is the most relevant measure to value future earnings. Of course, right now it does not make much difference as operating EPS and reported EPS are about the same. Last year’s big difference between the two measures stems largely from the massive write-offs by financial firms . Moreover, much of the recent big snap back in earnings is the write-offs rolling out of the four quarter trailing earnings data.

But as these write-offs rolled out of the data is generated a big drop in the market PE based on trailing earnings to about 19. In my valuation model that makes the market fairly valued to cheap.
In a highly cyclical environment as we are now experiencing many people like to use an estimate of “normalized earnings” to eliminate cyclical earnings distortions. So if you use the 7% trend growth in the above chart of operating vs reported earnings to estimate the market PE you get very similar results. Shiller, and some commentators at this blog use the 10 year trailing earnings. When you are dealing with an individual company where the long term earnings growth trend can change, that rule is a very good practice and builds in a measure of safety. But the long term earnings growth for the entire market is unlikely to change rapidly, so I feel comfortable with this approach.
If the economy is in a Japaneses deflation trap of course the trend earnings would be lower.

So maybe we should look at the prospects for earnings. The recent productivity report received much attention. But I did not see anyone point out that the spread between nonfarm corporate prices and unit labor cost was 5.25%, the widest spread on record.
This spread is the single most important variable driving corporate profit margins and implies that you should expect major positive earnings surprises.

In addition, corporate profits are very much a function of deviations from trend in real GDP growth. So with margins extremely wide and reasonable prospects for above trend growth, profits should continue to rebound strongly.

With the big margins improvement profits in the national accounts have already rebounded to above trend.

The other thing investors worry about that could be a major threat to the market is inflation. I’m in the school that believes sufficient excess capacity in the economy, whether measured by the output gap, the unemployment rate or capacity utilization, to keep inflation under control for the time being.
However, there may not be as much excess capacity as many believe. Much of the unemployment is structural . Moreover, the Fed estimates that industrial capacity is actually contracting and the growth of potential real GDP is at record lows.
For this year, I do not expect this to impact many prices outside of basic commodities, but in the out-years it could become a significant problem.

Contrary to many claims, the reason capacity creates a potential problem is weak business fixed investment. Despite low marginal tax rates and record profits real
business fixed investment was extremely weak over the last cycle. I will not go into a whole litany of reasons for weak investments, but I will just point out that in the 1960s, 1980s, 1990s, and the 2000s that capital spending was inversely proportional to marginal tax rates.

So, I’ve given everyone a wide range of topics to discuss and debate. Have fun.

Read more….

As the states’ credit crisis deepens, four states have initiated bills for state-owned banks, and candidates in seven states have now included that solution in their platforms.

“Hundreds of job-creating projects are still on hold because Michigan businesses and entrepreneurs cannot get bank financing. We can break the credit crunch and beat Wall Street at their own game by keeping our money right here in Michigan and investing it to retool our economy and create jobs.”

–Lansing Mayor Virg Bernero in the Detroit News, May 9, 2010

Struggling with 14% unemployment, Michigan has been particularly hard hit by the nation’s economic downturn. Virg Bernero, mayor of the state’s capitol and a leading Democratic candidate for governor, proposes that the state relieve its economic ills by opening a state-owned bank. He says the bank could protect consumers by making low-interest loans to those most in need, including students and small businesses; and could help community banks by buying mortgages off their books and working with them to fund development projects.

Bernero joins a growing list of candidates proposing this sensible solution to their states’ fiscal ills. Local economies have collapsed because of the Wall Street credit freeze. To reinvigorate local business, Main Street needs a heavy infusion of credit; and publicly-owned banks could fill that need.

A February post tracked candidates in five states running on a state-bank platform and one state with a bill pending (Massachusetts). There are now three more bills on the rolls – in Washington State, Illinois and Michigan – and two more candidates on the list of proponents (joining Bernero is Gaelan Brown of Vermont). That brings the total to seven candidates in as many states (Florida, Oregon, Illinois, California, Washington State, Vermont, and Idaho), including three Democrats, two Greens, one Republican and one Independent.
The Independent, Vermont’s Gaelan Brown, says on his website, “Washington DC has lost all moral authority over Vermont.” He maintains that:

Vermont should explore creating a State-owned bank that would work with private VT-based banks, to insulate VT from Wall Street corruption, and to increase investment capital for VT businesses, modeled after the very successful State-owned Bank of North Dakota.

The Bank of North Dakota, currently the nation’s only state-owned bank, is the model (with variations) for all the other proposals on the table. The Bank of North Dakota acts as a “bankers’ bank,” including doing “participation loans” with other banks, allowing them to compete with larger banks. In a participation loan, the community bank originates the loan and takes responsibility for it, while the participating bank contributes funds and shares in the risk and profits. The Bank of North Dakota also makes low-interest loans to students, farmers and businesses; underwrites municipal bonds; and serves as the state’s “Mini Fed,” providing liquidity and clearing checks for more than 100 banks around the state.

Three New Bills Pending for Publicly-owned Banks
Proposals for publicly-owned banks in other states have now gone beyond the campaign talk of political hopefuls to be drafted into several bills.

The Michigan Development Bank

The Michigan bill has gotten the most press. Introduced into the legislature earlier this month, it mirrors Bernero’s state bank idea. According to a press release issued by Senate Democrats on March 9, the bill’s aim is to “keep Michigan’s money in Michigan” by putting tax dollars into a proposed “Michigan Development Bank”. The Bank would function like a traditional bank but would focus on economic development rather than profit. The press release quoted Senator Gretchen Whitmer (D-East Lansing):

Investing in the state’s economy is the greatest way to create jobs, and this proposal will provide small businesses and entrepreneurs the funding they need to invest and grow. Our economy has stagnated due in part to stale thinking in Lansing, and this is just the type of innovative idea we need to create real economic change, using our own money to rebuild the state.

Senate Democratic Leader Mike Prusi (D-Ishpeming) stated:

Michigan’s economy has been suffering, and working families in the state have had difficulty keeping up with credit card bills, college tuition prices and mortgage payments. Establishing the Michigan Development Bank will keep our hard-earned dollars right here in the state to invest in small business, create good-paying jobs to get people back to work, and help protect the middle class.

Also quoted was Senator Hansen Clarke (D-Detroit):

With the current state of our economy, every dollar counts, yet we’re depositing our money in other people’s pockets by investing in big corporate banks without seeing much lending in return. It’s time for the Mitten State to lend itself a helping hand and establish a bank that is willing to invest in our small businesses and offer the financial support necessary to see job growth.

For startup capital, Senate Democrats suggested that Michigan could sell voter-approved bonds. With an initial capitalization of $150 million, they estimated the bank could lend up to $1 billion to small businesses, students and farmers, and offer low-interest credit cards to consumers. For deposits, the bank could follow the model of the Bank of North Dakota and use state revenues. So says Gene Taliercio, a Republican candidate for the state Senate, who has also put his weight behind the Michigan Development Bank. In a video clip on the website of the local Oakland Press, he says:

We’re talking about restructuring the whole tax system, in the sense that the way its set up is that all taxes are going to go into this central bank. . . . Every dollar that the state of Michigan makes goes into this bank.

The State Bank of Washington

A similar bill, HB 3162, was introduced to the Washington State Legislature on February 1. The bill has generated so much interest that Steve Kirby, chair of the Financial Institutions and Insurance Committee, has scheduled a special work session on it. According to John Nichols in The Nation, the State Bank of Washington was formally proposed by House finance committee vice chair Bob Hasegawa, a Seattle Democrat. Nichols quotes Hasegawa:

Imagine financing student aid, infrastructure, industry and community development. Imagine providing access to capital for small businesses, or otherwise leveraging our resources instead of having to do it with tax incentives. Imagine keeping our resources local instead of exporting them as profits, never to be seen again–that’s what this bank could do.

Leveraging rather than taxing is how private banks have been creating “credit” for centuries. States could do the same thing, cutting the middlemen out of the equation, saving significant sums in interest and fees and generating revenue for the state.

A nonpartisan analysis of the Washington bill prepared for the state legislature noted that the bank would be the depository for all state funds and the funds of state institutions, and that these deposits would be guaranteed by the state. The bank would be run by a board of 11 members and would be chaired by the State Treasurer. It would have the same rules and privileges as a private bank chartered in the state. To get the bank off the ground, voters would have to approve amendments to the state Constitution, since current law prohibits the state from lending credit and investing in private firms.

The Community Bank of Illinois

A third bill, introduced by Illinois Representative Mary Flowers, is on its way through the legislative process in Illinois. According to the Illinois General Assembly website, the Community Bank of Illinois Act would establish a state bank with the express purpose of boosting agriculture, commerce and industry. State funds and money held by penal, educational, and industrial institutions owned by the state would be deposited in the bank and would serve as reserves for loans. The bank could also serve as a clearinghouse for other banks, including handling domestic and foreign exchange; and it could buy property under Eminent Domain. All deposits would be guaranteed with the assets of the state. The Bank would be managed and controlled by the Department of Financial and Professional Regulation, with input from an advisory board representing private banking and public interests.

An amendment to the initial bill would enable the Community Bank of Illinois to make loans directly to the state’s General Revenue Fund, helping the state cope with its current budget challenges.

A Massachusetts-owned Bank

On March 12, the Associated Press reported that a jobs bill sponsored by Massachusetts Senate President Therese Murray also includes a call to study a Massachusetts-owned bank. She told a business group that a state-owned bank has worked in North Dakota, helping to insulate that state from the worst of the recession while also keeping its foreclosure rate down. A state-owned bank could spur job creation and free up lending to Massachusetts businesses.

Grandfather of the Concept: The Bank of North Dakota

All of these proposals take their inspiration from the Bank of North Dakota, which was founded in 1919 to resolve a credit crisis like that facing other states today. Last year, North Dakota had the largest budget surplus it had ever had; and it was the only state that was actually adding jobs when others were losing them. In March 2009, when 46 of 50 states were in fiscal crisis, North Dakota was in the enviable position of discussing tax cuts and looking for ways to spend its surplus.

By January 2010, according to a National Public Radio news clip, only two states could still meet their budgets – North Dakota and Montana. On February 8, however, the Montana paper the Missoulian reported that the Montana State Legislature’s chief revenue forecaster foresees a budget deficit by mid-2011, leaving North Dakota the only state still boasting a surplus.

North Dakota’s riches have been attributed to oil, but many states with oil are floundering. The sole truly distinguishing feature of North Dakota seems to be that it has managed to avoid the Wall Street credit freeze by owning and operating its own bank. According to the North Dakota Department of Commerce, the BND turned a profit in 2009 of $58.1 million; and this money goes into the state’s General Fund. North Dakota’s economy is ten times smaller than Michigan’s, suggesting that Michigan could generate $500 million per year in this way; and Washington State and Illinois present similarly inviting possibilities.

That defuses the objection raised in a March 15 editorial in The Detroit News, arguing that Michigan can ill afford the $150 million capital investment to start a bank. If operated like the BND, the Michigan Development Bank would soon be a net generator of state revenues. There are other possibilities besides a bond issue for providing the capital to start a bank, but that subject will be reserved for another article.

The BND’s 90-year track record of prudent and profitable lending defuses another objection to state-owned banks: that a public agency cannot be trusted to act responsibly in managing public funds. The Detroit News editorial concluded that Michigan should “leave banking to the bankers,” but it is precisely because the bankers have destroyed the economy with their reckless lending practices that the public needs to step in. We need a “public option” in banking to set standards and keep private banks honest.

The True Potential of Publicly-owned Banks

North Dakota broke new ground nearly a century ago, but the true potential of publicly-owned banks remains to be explored. Nearly all of our money today is created by banks when they extend loans. (See the Chicago Federal Reserve’s “Modern Money Mechanics“, which begins, “The actual process of money creation takes place primarily in banks.”) We the people have given away our sovereign money-creating power to private, for-profit lending institutions, which have used it to siphon wealth from the productive economy. If we were to take that power back, we could generate the credit we need to underwrite a whole cornucopia of projects that we don’t even consider because we think we lack the “money.” We have the labor and we have the materials; we just lack the “liquidity” necessary to put them together to create products and services.

Money today is just a ticket, a receipt for work performed and goods delivered. We can fund the work we need done by creating our own credit. The real promise of publicly-owned banks is not that they can bail out subprime borrowers but that they can jumpstart the economy by creating real wealth. They can provide the liquidity to put labor and materials together, allowing the economy to build and grow. Our private, profit-driven banking sector has been bleeding wealth from the rest of the economy. Public-interest banks can transfuse the economy with the credit it needs to flourish and be productive once again.

For more updates on the movement for publicly-owned banks, see http://www.public-banking.com. To sign a petition for a citizen-owned bank in California, go to http://www.change.org/actions/view/help_the_terminator_save_california.

Niko Kyriakou contributed to this article.

Read more….

By Michael Pettis, China Financial Markets

The Chinese new year has only just started, and already trade tensions are ratcheting up. This is perhaps appropriate — astrologers tell us that the year of the Tiger is often a year of instability and conflict — and I suspect things will almost certainly get worse. The timing of various domestic political events in the US, China and Europe will make it harder than ever for any of these countries to back down before 2012 (by which time, presumably, the world will have ended anyway).

Last Thursday President Obama made a fairly strong speech in which he urged China to adopt a “more market-oriented exchange rate”. The timing of the speech was important. On April 15 the US Treasury department will release its report stating whether or not China is a “currency manipulator”, and it is hard to believe that the Treasury department is not facing some pretty stiff pressure.

China’s response to Obama’s speech was pretty rapid and pretty angry. According to an article in the Saturday issue of the Financial Times

What it means to “politicise” the currency policy wasn’t made clear, but on Sunday Premier Wen also jumped into the fray. He denied that the RMB was undervalued and, in the words of an article in Monday’s Wall Street Journal, added the following:

Wen is absolutely right. Undervaluing or depreciating a currency certainly is a form of trade protectionism, but that, I think, is exactly the point. In a world of sluggish growth and rising unemployment, everyone’s currency policies are legitimately going to be scrutinized over whether they constitute trade protection.

An article in the People’s Daily has Wen also warning that “China opposes accusations and even forceful measures that press for yuan appreciation, which will not benefit the exchange rate reform.” The claim that external pressure will never advance reforms in China is now much debated in Europe and the US, and may be less widely believed abroad than it has been in recent years.  We’ll see.

These are murky political waters into which I do not want to dip, but it is hard to escape the politics of the debate.  The same issue of the People’s Daily had another article pointing out that US debate on the currency was driven mainly by domestic considerations and that the only reason Obama brought up the subject of the RMB was to address domestic polls.

There is, as always, a certain amount of nonsense in these articles. For example the exchange rate itself affects the ratio between savings and investment, so while the first part of Zhao’s statement is more or less right — although not as a “fundamental reason” but rather as part of an accounting identity — the second part is certainly wrong and probably meaningless.  More interestingly, it seems a little weird to argue that one of the benefits that China has provided the world with its undervalued exchange rate is low consumer prices that allow countries like the US “to consume excessively”. Aside from the fact that this pretty explicitly acknowledges that the currency is undervalued, since excess consumption is exactly the problem in the US, and since Chinese per capita consumption is much less than 10% of that of the US, it seems that China should be more approving of US attempts to return the favor and allow Chinese consumers the benefit of subsidized US prices.

Everything is politicized

Still, I do think the People Daily’s article is right to say that the RMB is becoming an important domestic issue for Obama, and that it is domestic US politics that is driving much of the recent noise and the rancor. Obama’s popularity has dropped considerably, and ahead of the upcoming elections he needs to show that he is addressing fundamental economic problems. And of course it is also always easy to get votes by bashing foreigners — this is one of the many attitudes that the US and China share.

But even though the People Daily’s criticism is correct, perhaps that doesn’t change anything meaningful. The concern over the effect of the RMB on US employment may still be a perfectly valid one, and the fact that Obama is under domestic pressure to address the currency is not an especially good reason to dismiss his concerns. On the contrary. Obama has little wiggle room, and as Paul Krugman pointed out in a fiery, and probably influential, speech last Sunday, the US may hold the stronger cards in any showdown. According to the relevant article in Business Week,

Krugman elaborated further Monday in the New York Times in an article, and then in a follow up article Wednesday, both of which are likely to be much quoted and widely read. Although Premier Wen noted again in his speech Sunday that China is “worried” about the value of its US dollar reserves, perhaps as a warning that China would counteract any US trade move by selling off USG bonds, Krugman doesn’t seem especially worried about this threat.

He may be right. Aside from the fact that it is not clear how China can dump Treasury bonds, he claims that it would only help the Fed in its quantitative easing, and would probably do far more damage to Europe (since China would presumably have to buy euros) than to the US.

The latter point is almost certainly correct. China’s Selling dollars and buying something else would allow the US to get even more bang for its protectionist buck, probably at poor Europe’s expense.  I would also add that the main long-term impact of dumping USG bonds might be no more than to cause a liquidation of Chinese assets at very low prices, and an equivalent transfer of wealth from China to the US (or to others likely at some point to buy cheap dollar assets).

Remember that at the beginning of WW1 something similar happened. In an urgent attempt to raise gold reserves to pay for the war, in the late summer of 1914 European belligerents dumped onto US markets what amounted to a far greater share of US assets than China currently holds. This caused about six months of havoc, and many sleepless nights in New York and Washington. But the US responded by putting into place temporary capital and stock market controls, and when the dust settled, the net effect was one of the most massive short-term transfers of wealth ever recorded from one group of countries, the European belligerents, to another, the US.  European dumping caused a collapse in prices, and US investors ultimately scooped up the assets up very cheaply.

That doesn’t mean that there will be no cost for the US if China dumps, but rather that the cost might be absorbed fairly comfortably over a reasonable time period. I suppose I will be very unpopular for pointing this out — especially with people in the US Treasury department and among Chinese cold warriors — but please don’t blame the messenger.  I am just trying to use the limited historical precedents to figure out what is likely to happen.  We have seen asset dumping before, and on an even larger scale, and the US capital market is deep enough that it might easily absorb it.

Where I disagree with Krugman is with his claim that the chance of triggering a trade war is small. In fact, the day Krugman published his article, 130 US Congressmen sent an open letter to secretaries Timothy Geithner (Treasury) and Gary Locke (Commerce) demanding that China be designated a currency manipulator.  They called for duties to be imposed on Chinese imports to counter the effect of the undervalued RMB.  This raises pressure significantly, and I am sure in the next week or two there will be a lot more.  There are also strong rumors of some high-powered and relevant Congressional session next week.  Stay tuned.

Of course regular readers of my blog won’t be surprised by any of this.  The logic behind a prediction of trade war is almost unchallengeable, and the two countries are simply the two most visible in a world in which trade tensions must inexorably rise.  Just ask the Germans and their European partners.  Trade relationships will continue to get much worse, largely because the cost of trade war for high-deficit countries is so much lower than for high-surplus countries, and there seems to be no real attempt on either side to tone down aggressive actions or rhetoric. We seem to be caught in a downward spiral, and the longer it goes on the harder it is for anyone not to participate.

But while I think the economic effect of a tariff war on the US is likely to be smaller than many expect (and much smaller than that indicated by some of the outraged yelping I saw on a CNBC show dedicated to the subject today), and maybe even employment-positive in the short term, I do not think it is in the longer term interest of the US.  I think trade war would be very painful for China, and forcing them into such a difficult position will poison the relationship for many years.  This is likely to be the most important global relationship of the next few decades, and we really need a better way to resolve these very thorny issues, but that almost certainly isn’t going to happen.

To return to the People’s Daily article, I think many in China have argued that a revaluation of the RMB may have a significant effect on China’s trade surplus without having an equivalent effect on the US trade deficit. The same would be true of tariffs on Chinese goods.  In either case, say many in Beijing, China loses, but the US doesn’t gain, so why is the US so determined to force this outcome?

I think this claim is probably correct. An RMB revaluation in itself might not have as big an impact on the US deficit as many think. To see why, I thought I would try to outline what the impact of an RMB revaluation would be for China and the world by asking a few basic questions and coming up with my best possible answers. Here goes:

What will the balance sheet effect of an RMB revaluation be on China?

There are broadly speaking two different classes of revaluation effects, the economic effect and the balance sheet effect. By the former I just mean the impact a revaluation will have on the future development of China’s economy, and by the latter I mean the immediate balance sheet losses and gains for China. Obviously these two are related.

Let me begin with balance sheet impacts. Two weeks ago I posted a rather long entry on that very subject. For those who can’t bear reading or re-reading such a long post, the quick answer is that, contrary to common perception, a revaluation of the RMB is likely to have a very small, and probably positive, overall balance sheet impact on total Chinese wealth.

That is, however, not the end of the story. There is a significant transfer within China of wealth, which will create clear winners and losers. Basically any economic entity that is explicitly or implicitly long dollars (by which I mean any foreign currency not pegged to the RMB) and short RMB, will lose in a revaluation. Conversely, any entity that is explicitly or implicitly long RMB, and short dollars, will win. In my earlier entry I pointed out that the PBoC is the single biggest loser. It is long, if correctly counted, roughly $3 trillion in dollars, against which it is short an equivalent amount of RMB.

Exporters and manufacturers in the tradable goods sector will also lose. Their expected revenues (which can be conceptually capitalized as an asset) are mainly in dollars whereas their expected costs are partly or mainly in RMB. This means that the value of future revenues will drop relative to the value of future expenses, and so they will take a loss.

Finally in that entry I pointed out that any wealthy Chinese individual with a substantial amount of honest or ill-gotten gains stuffed in bank accounts abroad will also lose. But I forgot to mention another big group of losers — anyone in China who has stockpiled inventories of goods or commodities whose prices are set in international markets. Those prices will immediately drop in RMB terms upon a revaluation, and if the asset purchases were financed by RMB borrowing or assets, there will be a loss. So to the extent that companies or individuals are stockpiling iron, copper, chemicals, or anything similar, they will also take an immediate loss.

So who wins in a revaluation? Nearly everyone in China who has at least part of his consumption basket consisting of imported goods, which basically means every one in China except pure subsistence farmers. Because the rise in the value of the RMB causes the price of all imports automatically to fall, a revaluation increases the wealth of Chinese households by increasing the real value of their current and future assets and income.

This is the key point. A revaluation shifts wealth from the Chinese government and the manufacturing sectors (and some wealthy Chinese) to Chinese households — which, by the way, is pretty much what is meant by “rebalancing” in the Chinese context. There are many other ways besides revaluation to shift income this way. The PBoC can raise deposit rates, wages can rise faster than productivity, companies can be privatized by giving away shares to the pubic, and so on. They all have the same effect. They shift resources to households and away from producers, infrastructure investment, and real estate developers. This allows household income to grow relative to national income, which ultimately increases the consumption share of GDP.

What will the economic effect of an RMB revaluation be on China?

So as things stand currently, the reason an undervalued RMB distorts international trade is because it transfers income from Chinese households (they have to pay more for imports) and subsidizes Chinese manufacturers in the tradable goods sector. This is one of the many mechanisms by which households are forced to subsidize production and investment.

A revaluation, then, is part of the rebalancing mechanism. It helps to reduce subsidies to manufacturers and returns the income to Chinese households, who can then increase their relative consumption. But there is a cost to this rebalancing. China’s current industrial policies sacrificed household income in order to spur manufacturing growth, and this had the obvious secondary effect of speeding up employment and, with it, household income. So in a way by repressing household income growth China was paradoxically able to achieve rapid growth in household income. Neat trick, eh?

But of course this growth wasn’t unencumbered. Much Chinese growth was based on concealing the true costs behind hidden subsidies, so that real economic growth was likely to be lower than recorded economic growth. More importantly, because everything in the world must balance, the imbalances within China required the opposite imbalances outside of China — which mostly meant in the US.  Just as this global system implicitly taxed Chinese household consumption to subsidize Chinese manufacturing and employment growth, it also implicitly taxed US manufacturers in order to subsidize US consumers. American consumers got cheaper (foreign) goods, American manufacturers had to compete against lower (foreign) prices.

So Americans over-consumed and Chinese over-saved. The system worked well for quite a while, until, as with Japan in the late 1980s, US debt levels and employment rose to economically and politically unacceptable levels.

For China and the US to adjust means both of them unwinding this trade-off. Beijing will have to enact policies that reduce the subsidies to manufacturers and return the income to Chinese households. But this automatically means depressing economic growth and, more importantly, depressing employment growth.

This shouldn’t be a serious problem if it happens slowly. As Chinese manufactures gradually lose their subsidies, they will rely more than ever on the consequent rising Chinese consumption, and so domestic consumption will replace subsidized foreign demand as the source of growth. Not only will China have a safer and more balanced economy, but it will be more innovative (consumption tends to drive innovation, not production) and much more efficient.

But China cannot adjust too quickly. If Beijing removes the implicit subsidies, including those caused by the undervalued exchange rate, too rapidly, that could force large-scale bankruptcies as Chinese manufacturers found themselves unable to compete globally or at home. If these bankruptcies forced up unemployment, then paradoxically even as the transfers from households to businesses are being reversed, household income would nonetheless decline as unemployment soared. In that case Chinese manufacturers would find themselves becoming uncompetitive in international markets just as domestic markets are collapsing.

The conclusion? A rebalancing is necessary for China, as nearly everyone in the leadership knows. This will involve, among other things, a significant revaluing of the currency. But rebalancing cannot happen too quickly without risking throwing the economy into a tailspin.  That cannot and should not be a part of the US or Chinese policy objective.  By the way if China is forced to revalue the currency too quickly, it will have to enact countervailing policies — lower interest rates, suppress wages, increase credit and subsidies — to protect the economy from falling apart, and these will exacerbate other imbalances that may be even worse than the currency misalignment.  Currency revaluation, then, should be part of a broader adjustment process.

So how can the global system adjust?

If we abstract for a moment, and call all trade-deficit countries the United States, and all trade-surplus countries China, there are broadly speaking two ways the system can adjust. Remember that each domestic imbalance requires the other, so that if China adjusts, the US must adjust too, and if the US adjusts, China must adjust too.  (For those more technically inclined, by the way, this is one of the points that Krugman makes in his second article, although using different terms: China’s exporting of capital must create capital imports somewhere else, and these capital imports are the obverse of the trade deficit.)

One way in which the system can adjust is for China to take the lead and reverse the policies that cause households to transfer resources to its manufacturers. As a consequence consumption will no longer be taxed to subsidize production. This will cause household consumption to rise as share of GDP — the good way by a surge in consumption, the bad way by a collapse in economic growth.

Either way, the rebalancing in China will force an equivalent rebalancing in the US. As the price of Chinese goods rise, the net impact will be to transfer resources from US consumers, who have to pay more for their imports, to US producers (US producers become more globally competitive). The rise in Chinese consumption relative to Chinese production would be necessarily matched by a rise in US production relative to US consumption. (Some readers will notice that I am ignoring the role of investment in economic growth, and of course changes in investment matter, but over the medium to long term the basic argument is unchanged.)

The second way in which the system adjusts is if the US drives it. The US can put into place policies that favor manufacturers at the expense of consumers. These include consumption taxes, manufacturing subsidies, penalties for consumer borrowing, subsidies for investment, or, more ominously, import tariffs. These can all have the same aggregate effect on the US trade account by shifting the relationship between how much Americans produce domestically and how much they consume. And of course as the US adjusts, China must also automatically adjust.  Tariffs just on Chinese goods, by the way, will have a minimal impact on the US adjustment since trade may very well just shift to other countries.

Note that in either case both countries will rebalance, but rebalancing says nothing about how rapid economic growth must be. I addressed this in a blog entry last week when I discussed Japan’s dismal post-1990 rebalancing. In this context rebalancing just means that in China economic growth will be less than consumption growth, and in the US consumption growth will be less than economic growth. The problem is that China will try to adjust by pushing the cost of the adjustment onto the US, and the US will try to adjust by pushing the cost onto China. Each country can strive towards the good outcome (rapid economic growth) or find itself facing the bad outcome (declining consumption). This is why policy coordination and gradualism is so important.

Will a revaluation cause China’s trade surplus to decline?

Yes, all other things being equal, but of course all other things are not equal. Within China there are several things that will affect the trade surplus. Remember that the trade surplus exists because of the imbalance between Chinese domestic production and Chinese domestic consumption (technically the surplus is the difference between savings and investment), and so anything that affects the subsidies to manufacturers, or that affects household income, will also affect the trade surplus.

I have already argued that interest rates and wage growth that is lower than productivity growth can affect the trade surplus as much as the undervalued currency. In that case, if the RMB revalues, and at the same time real interest rates are forced down by a sufficient amount, or wage growth is restrained, the net result can easily be a rise, not a decline, in the trade surplus. It depends on the relative magnitude of the different factors.

The external environment also matters. If US interest rates decline for example, unlike in China where declining deposit rates is likely to spur savings, US consumption may rise even as the cost of Chinese imports rises because of a surge in the RMB.

Quite a lot of defenders of RMB stability have made the point that the rise of the yen after 1985 and the rise of the RMB after 2005 were most emphatically not associated with declining trade surpluses. According to their arguments, this clearly proves that the currency doesn’t matter.

This is nonsense, and even if it were true it seems more an argument in favor of revaluing than an argument in favor of not revaluing. But it isn’t true because in both cases there were countervailing changes.  Perhaps most importantly, local interest rates in Japan and China declined in real terms, thus reducing local consumption, and US interest rates also declined, spurring US consumption (I know, I know, this sounds strange, but the wealth effect of interest-rate changes in the US is the opposite of that in Japan and China because of the differing structures of household balance sheets). All that happened in both cases was that the rebalancing effect of the currency revaluation was swamped by the exacerbating effect of other factors. The only thing that Japan after 1985 and China after 2005 prove is that the currency is not the only thing that matters.

Will a decline in China’s trade surplus cause the US trade deficit to decline?

Not necessarily. Beijing has pointed out many times that a contraction in the Chinese trade surplus does not necessarily mean an equivalent contraction in the US trade deficit. All it requires is an equivalent contraction in the rest of the world’s net trade deficit. This could easily happen with an improvement in the trade balances of Vietnam, Mexico, Korea or anyone else, enough fully to absorb the reduction in China’s trade surplus. In that case, the US trade balance does not improve, and the US gets none of the employment benefit of the RMB revaluation. China will simply import fewer jobs from abroad and some other countries will import more, or export fewer, jobs.

Remember that if the RMB revalues, this is the same as if all the currencies of the rest of the world depreciate. This will cause a shift in the rest of the world so that households will see a small reduction in their real income, and non-Chinese producers in the tradable goods sector will see a small increase in their competitiveness vis a vis the rest of the world (largely because Chinese producers becomes less competitive). This will reduce non-Chinese consumption and increase non-Chinese production, and the distribution of these changes among different countries, including the US, will depend on a vast array of factors.

So Beijing is absolutely correct in arguing that an RMB revaluation might not have a major impact on the US trade balance, although there is one important caveat. A number of other developing countries, especially in Asia, are concerned about excessively loose domestic monetary policy and inflation, and would like to raise the values of their own currencies. They cannot do so, however, until China does. During the crisis China has expanded its share of global net demand at their expense. If an RMB revaluation causes revaluation in other countries with large trade surpluses, the net impact on the much smaller “rest of the world” will be much bigger, and so simply as a function of arithmetic the US is bound to benefit.

This fact again argues in favor of globally coordinated action rather than an excessive focus on RMB bashing. If China is forced to revalue the RMB, in order to gain the optimal global rebalancing it should be done as part of a general realignment of currencies (although of course cynics will point out that surest way to ensure that something doesn’t get done is to coordinate it globally).

Is it only China that must act?

China will rebalance, but it cannot do so quickly. If it does, as I discussed above, it may easily fall into a spiral of declining competitiveness leading to rising unemployment leading to declining domestic consumption leading to more unemployment. Clearly this is not in China’s interest.

There is another problem. There are several countries with structurally low consumption and high production — Germany, Japan and China being the most important (and I leave out the OPEC countries for obvious reasons). Simply forcing China to adjust, in that case, might cause damage to Chinese growth prospects without helping the US rebalancing effort.

For example, a sharp rise in the RMB, especially if accompanied by a rise in other Asian currencies, will take depreciation pressure off the dollar. Since currently most of that depreciation pressure is borne by the euro, a revaluation of the RMB could easily also result in a decline in the euro, whose economies will then see a sharp improvement in their net trade balance. This means that a significant part of the benefits of Chinese revaluation may accrue to Germany, a country that has yet to resolve its own internal imbalances.

So limiting the whole rebalancing discussion just to China and the RMB may end up not helping much. It is true that the US could force through a rapid domestic rebalancing of its own, including by raising import tariffs generally (and not just on Chinese goods), if it really wanted to, and the benefits to the US would be a surge in employment and manufacturing at probably little real long-term economic cost. But unilateral action on the part of the US risks creating at least some problems for the rest of the world, especially China, Japan, and parts of Europe.

So what must be done? Clearly there is a problem with the undervaluation of the RMB and with Chinese domestic imbalances. But just as clearly there are also problems with a number of other major over-consuming and over-producing countries. In addition Chinese producers have become so addicted to a wide variety of implicit subsidies, besides the currency, that they cannot possibly adjust very quickly. It will take years of continuous adjustment to wean them away from an undervalued currency, too-low interest rates, excessive credit aimed at SOEs, and sluggish wage growth.

That suggests that if we want to resolve the global imbalances in an optimal way that maximizes global growth and equity, we would need all the major problem countries to work out a program, perhaps over 8 to 10 years, in which China, Japan and Germany take concrete measures to shift subsidies away from manufacturers and return the income to households, and the US, the UK and other deficit countries shift income from households to investment.

Of course the cynic in me says getting a global solution will prove impossible. Each country that benefits in the short term from stonewalling on any aspect of the complex adjustment process will do so. So I guess that just leaves trade war. This is the year of the Tiger, after all.

More articles from China Financial Markets….

Wall Street Cheat Sheet submits:

by Carolyn Austin

This winter’s plethora of snow and bad weather was behind much of the economic news lately, from unemployment claims to retail sales. Housing starts are no exception.

Read more…. »

Here is my dissection of the March 16 Fed Statement

FOMC Statement March 16, 2010

Information received since the Federal Open Market Committee met in January suggests that economic activity has continued to strengthen and that the labor market is stabilizing ( upgraded “from deterioration in the labor market is abating”). Household spending is expanding at a moderate rate but remains constrained by high unemployment ( upgraded from weak labor market), modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software has risen significantly ( upgraded from appears to be picking up). However, investment in nonresidential structures is declining, housing starts have been flat at a depressed level( concern about housing returns) , and employers remain reluctant to add to payrolls. While bank lending continues to contract, financial market conditions remain supportive of economic growth. Although the pace of economic recovery is likely to be moderate for a time, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability.

With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period ( here are the words again). To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve has been purchasing $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt; those purchases are nearing completion, and the remaining transactions will be executed by the end of this month ( Fed ending asset purchases). The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability ( New!).

In light of improved functioning of financial markets, the Federal Reserve has been closing the special liquidity facilities that it created to support markets during the crisis. The only remaining such program, the Term Asset-Backed Securities Loan Facility, is scheduled to close on June 30 for loans backed by new-issue commercial mortgage-backed securities and on March 31 for loans backed by all other types of collateral ( Fed ends liquidity facilities!).

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Donald L. Kohn; Sandra Pianalto; Eric S. Rosengren; Daniel K. Tarullo; and Kevin M. Warsh. Voting against the policy action was Thomas M. Hoenig, who believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted because it could lead to the buildup of financial imbalances and increase risks to longer-run macroeconomic and financial stability ( Hoenig elaborates on dissent).

Read more….

“On Monday, a non-profit organization that has been researching foreclosure trends in Chicago released a report that painted a dismal picture for Chicago homeowners–and claims the foreclosure crisis is “still raging on” in Chicago.”

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By Karl Denninger, The Market Ticker

You know it’s going to get good when LIESman says something like “there is a point in time when ignorance goes from being amusing to being dangerous” to a grizzled trader like Santelli.

Well, Liesman did, and…. (we’ll do facts after the video)

Now for the facts:

Any government can pump stock prices of insolvent institutions for a while by allowing them to lie on their balance sheets.  The poster child for this is, of course, Lehman brothers.  I reproduce for your edification a chart showing two quarterly reports during which Lehman was arguably insolvent (light gray) and then (in pink) a further period of time spanning more than a month when their counterparties knew they had no cash, yet FRBNY and The Fed, including but not limited to FRBNY, Paulson, Geithner and every other bank they dealt with knew they had no money.  Yet their stock continued to trade, the company continued along, and Dick Fuld was on CNBS saying he was going to “burn the shorts.”

What was the outcome Steve?  Was it “all ok in the end” even though for a period of more than six months the stock continued to trade and in fact after that first report went up significantly?

What caused the collapse?  They ran out of cash flow.

Now about those other large banks and their balance sheets….

As a corollary to the above governments can also pump markets generally by replacing private demand in GDP with borrowing and spending, just as you can by using your credit card even though your income has been cut off.  This can and does lead to huge market rallies – for a while.  However, unless you can manage to increase credit in the system generally, meaning that private parties “come back” and take over from government, eventually the government becomes unable to sustain such a practice, just as you become unable to sustain such a practice.  In point of fact the government has borrowed and spent ten percent of GDP (in addition to all that it was spending before) for the last two years.  This has prevented the recognition of an economic depression in the “statistics” put forward by government, but that replacement of private demand is not, in fact, private demand!  Thus you have unemployment and underemployment, even under the government’s statistics (among those who want jobs), hovering near one person in five in the economy, and only 60% of the labor force is actually working.  The other 40% of working-age, non-institutionalized people, are not working – which means they’re drawing on social programs of some sort.  This, of course, exacerbates the demand for the government to continue borrowing and spending that additional 10% of GDP.

What will cause this to collapse?  The same thing – recognition that the banks are in fact broke (and there are a bunch of them that are), inability to sell or roll over enough debt to satisfy the leaches in society, one of the rating agencies growing a pair of balls and downgrading the United States and more.  Indeed, a lockup in the credit markets could easily occur just as it did in 2008, and for the same reasons – a recognition that “heh that jackass over there has no good collateral!”

Can the government keep this from happening forever?  No.  

Can it do so for “an extended period of time”?  Sure, but for exactly how long?

That’s the key, isn’t it?  We’re not running an 89% debt-to-GDP ratio, it’s in fact over 500%.  We’re lying just as Lehman was lying, but on a grader scale.  Yet when Rick Santelli brings this up, the pump monkeys go nuts.

Why?

Well gee, if you want to sell something to someone that is based on a fraudulent premise, how much luck will you have if the truth is exposed?

‘Nuff said.

 

More articles from the Market Ticker….

The projections from the Fed, the Congressional Budget Office and the Obama administration all show the unemployment rate remaining unusually high for years into the future. This may cause listeners to wonder how the pessimistic view of employment growth from Lawrence Mishel, the president of the Economic Policy Institute (my former boss), became the “dissenting opinion.”

–Dean Baker

Read more….

The Daily Reckoning

“Masked youths…attacked the head of Greece’s largest trade union, who was addressing the crowd, and hurled stones at the police. GSEE union boss Yiannis Panagopoulos traded blows with the rioters before being whisked away, bloodied and with torn clothes.”

The Daily Mail account put the blame for these disturbances on Germany’s finance minister, who warned the Greeks that “the German government does not intend to give a cent.” At least Bild, a popular German newspaper, was trying to be helpful. It suggested that Greece sell Corfu…and that Greeks get up earlier and work harder.

Meanwhile, from Iceland comes news that every voter with an IQ above air temperature has cast his ballot against a bailout plan. The Icelanders were slated to make good $5.3 billion in bank losses. But why shackle common voters to the banks’ losses? The plan was so outrageous and so unpopular that Iceland’s normally compliant Prime Minister called for a referendum. Given a chance to vote on it, 93% said no. The other 7% probably read it wrong.

Insurrection is in the air. In England, government employees are preparing the biggest strike since the ’80s. In America, dissatisfaction with Congress is at record highs; four out of five of those polled say, “Nothing can be accomplished in Washington.”

Herewith, an attempt to deconstruct the rebel yell. By way of preview, it’s not the principle of the thing, we conclude; it’s the money.

There are more clowns in economics than in the circus. They invented an economic model that has been very popular for more than 50 years – particularly in the US and Britain. It began with a bogus insight; John Maynard Keynes thought consumer spending was the key to prosperity; he saw savings as a threat. He had it backwards. Consumer spending is made possible by savings, investment and hard work – not the other way around. Then, William Phillips thought he saw a cause and effect relationship between inflation and employment; increase prices and you increase employment too, he said.

Jacques Rueff had already explained that the Phillips Curve was just a flimflam. Inflation surreptitiously reduced wages. It was lower wages that made it easier to hire people, not enlightened central bank management. But the scam proved attractive. The economy has been biased towards inflation ever since.

Economists enjoyed the illusion of competence; they could hold their heads up at cocktail parties and pretend to know what they were talking about. Now they were movers and shakers, not just observers. The new theories seemed to give everyone what they most wanted. Politicians could spend even more money that didn’t belong to them. Consumers could enjoy a standard of living they couldn’t afford. And the financial industry could earn huge fees by selling debt to people who couldn’t pay it back.

Never before had so many people been so happily engaged in acts of reckless larceny and legerdemain. But as the system aged, its promises increased. Beginning in the ’30s, the government took it upon itself to guarantee the essentials in life – retirement, employment, and to some extent, health care. These were expanded over the years to include minimum salary levels, unemployment compensation, disability payments, free drugs, food stamps and so forth. Households no longer needed to save.

As time wore on, more and more people lived at someone else’s expense. Lobbying and lawyering became lucrative professions. Bucket shops and banks neared respectability. Every imperfection was a call for legislation. Every traffic accident was an opportunity for wealth redistribution. And every trend was fully leveraged.

If there was anyone still solvent in America or Britain in the 21st century, it was not the fault of the banks. They invented subprime loans and securitizations to profit from segments of the market that had theretofore been spared. By 2005 even jobless people could get themselves into debt. Then, the bankers found ways to hide debt…and ways to allow the public sector to borrow more heavily. Goldman Sachs did for Greece essentially what it had done for the subprime borrowers in the private sector – it helped them to go broke.

As long as people thought they were getting something for nothing, this economic model enjoyed wide support. But now that they are getting nothing for something, the masses are unhappy. Half the US states are insolvent. Nearly all of them are preparing to increase taxes. In Europe too, taxes are going up. Services are going down. And taxpayers are being asked to pay for the banks’ losses…and pay interest on money spent years ago. Until now, they were borrowing money that would have to be repaid sometime in the future. But today is the tomorrow they didn’t worry about yesterday. So, the patsies are in revolt.

Several countries are already past the point of no return. Even if America taxed 100% of all household wealth, it would not be enough to put its balance sheet in the black. And Professors Rogoff and Reinhart show that when external debt passes 73% of GDP or 239% of exports, the result is default, hyperinflation, or both. IMF data show the US already too far gone on both scores, with external debt at 96% of GDP and 748% of exports.

The rioters can go home, in other words. The system will collapse on its own.

Bill Bonner
for The Daily Reckoning Australia

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More articles from The Daily Reckoning….