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Archive for July, 2009

Predicting Corporate Events

Friday, July 31st, 2009

A client called yesterday, and asked one of my colleagues whether I could create a model that predicted corporate events.  Corporate events are typically purchases and sales of assets or subsidiaries that change the nature of a company, or wholesale change in the capital structure of a company on the whole.

My comment to my colleague was on the order of, “So, another client asking for the impossible again?  It’s one thing to try to do risk arbitrage after deal announcements; it quite another to try to predict deals.  Most of the successful risk arbs stick to confirmed, announced deals.  The guys who try to predict deals, or work with unconfirmed deals have tended to not do so well.”

Then I thought about my old Master’s Thesis, and how it predicted stock splits (another corporate event) with reasonable accuracy.  What worked?  Momentum, valuation, and maybe a few other oddities like insider trading.  Perhaps the same would be true of other corporate events.  After all, highly valued companies use their stock as currency to buy stocks with lesser valuations, and stocks with low valuations tend to buy back stock or increase dividends.

But then I thought about my series, “If you get to Talk to Management.”  Management teams tend not to change over their tenures, unless a change process has been designed in the hearts of a company.  Those few companies that have the change process have a lot of corporate events, and that is built into the stock price.  Those companies can be found by a general search of EDGAR, looking for the most filings reflecting capital changes.  I’m not sure it would be of much use, because they regularly do this; the markets are used to it.

For most companies, given the laziness of managements to do wholesale changes of strategy, it takes a replacement of a significant amount of the management team, i.e., the CEO and/or the CFO to create a lot of corporate events.  Why is this?  Most management teams implicitly assume that there is one way to get business done, and have a limited number of variables to which they are ready to respond. They are also more reputationally and emotionally invested in the mistakes of the past.  It takes real humility to admit to errors and move in a different direction.

As an aside — Perhaps that gives me a good Rumsfeld-esque nonsense question for asking a management team, “What risks are out there that you haven’t considered yet?”  ;)  But better to ask a bunch of companies, “What risks are you ready for that most of your competititors are not ready for?”

Ergo, it often takes a new management team to achieve large changes.  So, tracking management changes could be a leading indicator of corporate actions, and perhaps, excess returns, if combined with a little analysis for undervalution of the assets of the company.

I don’t want to overplay this one.  There are a lot of links in the chain here; I’m not trying to minimize the difficulties here, which include:

  • Successfully setting up news retreival sources that sort through the news for major companies, catching the significant news while not getting a lot of unwanted news that doesn’t fit the paradigm.
  • Being able to sense the significance of the management change.
  • Analyzing the potential increase in value of assets used differently than before, and/or changes in financing.

This doesn’t promise to be easy, but maybe it will surface some promising ideas — I’ve made money on turnarounds before; perhaps this will help with the future.

A Call For Accounting Integrity

Thursday, July 30th, 2009

This post is not one where I go through one of my “pet issues” in accounting (e.g. fair value accounting, goodwill accounting, pension accounting, or employee stock option accounting).  Rather, I am writing to encourage all finance bloggers, and those that read me to write Mary Schapiro at the SEC, and encourage her to appoint Jack Ciesielski to be Chief Accountant at the SEC.

Why do I write this?  I only track the blogs of two accountants, Jack Ciesielski, and Tom Selling.  Tom has written a post supporting Jack for the position of Chief Accountant for the SEC.  Here is a confirmation of the possibility in this Bloomberg article.

I first met Jack Ciesielski in 1997 at a lunch for the Philadelphia Financial Analysts.  I immediately appreciated his acumen.  After that, when I moved down to Baltimore, I got to know him better at the Baltimore Security Analyst Society (Now Baltimore CFA Society) meetings.  I have learned a lot from him.

Now, I have nothing to deprecate the other fellow being considered, the acting Chief Accountant.  He may be a wonderful choice for the position, but Jack is a CFA Charterholder, so he understands the concerns of investors.  Further, his newsletter has pointed out flaws in accounting methodologies for over a decade.  Jack is not merely a critic, but he understands where US GAAP and IFRS accounting are weak.  He has not “gone along to get along,” but has offered helpful criticism on accounting standards.

To my fellow bloggers out there, please link to this post, and ask your readers to petition the SEC Chairman to appoint Jack CiesielskiThey can do so here.  To my readers, please also petition the Chairman of the SEC, and ask her to appoint Jack.  It doesn’t have to be anything fancy, just that you know that Jack has supported accounting integrity for many years.  If there is any doubt look in the deep past on his blog, where his musings went to everyone, not just clients.

I will write my own missive to Ms. Schapiro tomorrow.  If it is any good, I will post it here.

Book Review: Mr. Market Miscalculates

Wednesday, July 29th, 2009

Since the first time I read him, I have been a fan of James Grant.  He helped to sharpen my focus on how money and credit work in the long run, and how they affect the economy as a whole.  Reading one of his early books, Minding Mr. Market: Ten Years on Wall Street With Grant’s Interest Rate Observer, I gained perspective on the increasingly complex financial world that we were moving into.

But not all have shared the opinion of Mr. Grant’s wisdom.  When I worked for Provident Mutual, the Chief Portfolio Manager (at that time new to me, but eventually a dear colleague) said to me, “feel free to borrow any of the publications we receive.”  For a guy who likes to read, and learn about investments, I was jazzed. But, when I came back and asked whether we subscribed to Grant’s Interest Rate Observer, I got the look that said, “You poor fool; what next, conspiracy theories?” while she said, “Uh, noooo. We don’t have any interest in that.”

Now the next two firms I worked for did subscribe, and I enjoyed reading it from 1998 to 2007. But now the question: why buy a book that repeats articles written over the last fifteen years?

I once reviewed the book Just What I Said: Bloomberg Economics Columnist Takes on Bonds, Banks, Budgets, and Bubbles, by another acquaintance of mine, the equally bright (compared to James Grant) Caroline Baum.  This book followed the same format, reprinting the best of old columns, with modest commentary.  In my review, I cited Grant’s earlier book as a comparison, Minding Mr. Market.

As an investor, why read books that will not give an immediate idea of where to invest now?  Isn’t that a waste of time? That depends.  Are we looking to become discoverers of investment/economic ideas, or recipients of those ideas?  Books like those of Grant and Baum will help you learn to think, which is more valuable than a hot tip.

Here are topics that the book will help one to understand:

  • How does monetary policy affect the financial economy?
  • Why throwing liquidity at every financial crisis eventually creates a bigger crisis.
  • Why do value (and other) investors need to be extra careful when investing in leveraged firms?
  • What is risk?  Variation of total return or likelihood of loss and its severity?
  • Why financial systems eventually fail at compounding returns at rates of growth significantly above the growth rate of GDP.
  • Why great technologies may make lousy investments.
  • Why does neoclassical economics fail us when trying to understand the financial economy?
  • How does one recognize a speculative mania?
  • And more…

The largest criticism that can be leveled at James Grant was that he saw that he would happen in this crisis far sooner than most others.  Being too early means you eventually get disregarded.  The error that the “earlies” made, and I knew quite a few of them, was not recognizing how much debt could be crammed into the financial economy in order to juice returns on fixed income assets with yields lower than likely default losses.  That’s a mouthful, but the financial economy had not enough good loans to make relative to the amount of loans needed to maintain the earnings growth expectations of the shareholders of financial companies. Thus, the credit bubble, facilitated by the Fed and the banking regulators.  You can read all about it in its many facets in James Grant’s book.

You can buy the book here: Mr. Market Miscalculates: The Bubble Years and Beyond.

Who would benefit from the book?

  • Those that have assumed that neoclassical economics adequately explains the way our economy works.
  • Those that want to understand how monetary policy really works, or doesn’t.
  • Those that want to learn about equity or fixed income value investing from a quirky but accurate viewpoint.
  • Those that want to be entertained by intelligent commentary that proved right in the past.

As with other James Grant books, this does not so much deal with current problems, as much as educate us on how to view the problems that face us, through the prism of how past problems developed.

Full disclosure: If you buy anything through the links to Amazon at my blog, I get a small commission,  but your costs don’t go up.   Also, thanks to Axios Press for the free review copy.  I read the whole thing, and enjoyed it all.

Seven Notes on the Current Market Mess

Monday, July 27th, 2009

1)  Avoid short-cycle data.  When writing at RealMoney, I encouraged people to ignore short-term media, and trust those that gave long-term advice.  After all, it is better to learn how to invest rather than get a few hot stock picks.

In general, I read writers in proportion to their long-term perspective.  I don’t have a TV.  I rarely listen to radio, but when I do listen to financial radio, I usually feel sick.

I do read a lot, and learn from longer-cycle commentary.  There is less of that around in this short-term environment.

When I hear of carping from the mainstream media regarding blogging, I shake my head.  Why?

  • Most bloggers are not anonymous, like me.
  • Many of us are experts in our  specialty areas.
  • Having been practical investors, we know far more about the markets than almost all journalists, who generally don’t invest, or, are passive investors.

Don’t get me wrong, I see a partnership between bloggers and journalists, producing a better product together.  They are better writers, and we need to get technical messages out in non-technical terms.

We need more long-term thinking in the markets.  The print media is better at that than television or radio — bloggers can go either way.  For example, I write pieces that have permanent validity, and others that just react to the crisis “du jour.” Investors, if you are focusing on the current news flow, I will tell you that you are losing, becuase you are behind the news flow.  It is better to consider longer-term trends, and use those to shape decisions.  There are too many trying to arb the short run.  The short run is crowded, very crowded.

So look to value investing, and lengthen your holding period.  Don’t trade so much, and let Ben Graham’s weighing machine work for you, ignoring the votes that go on day-to-day.

2)  Mark-to-Market accounting could not be suppressed for long in an are where asset and liability values are more volatile.  Give FASB some credit — they are bringing the issue back.  My view is when financial statement entities are as volatile as equities, they should be valued as equities in the accounting.

3)  Very, very, weird.  I cannot think of a man that I am more likely to disagree with than Barney Frank.  But I agree with the direction of his proposal on CDS.  My view is this: hedging is legitimate, and speculation is valid to the degree that it facilitates hedging.  Thus, hedgers can initiate transactions, wtih speculators able to bid to cover the hedge.  What is not legitimate is speculators trading with speculators — we have a word for that — gambling, and that should be prohibited in the US.  Every legitimate derivative trade has a hedger leading the transaction.

4)  I should have put this higher in my piece, but this post by Brad Setser illustrates a point that I have made before.  It is not only the level of debt that matters, but how quickly the debt reprices.  Financing with short-term dbet is almost always more risky than financing with short-term debt.

Over the last six years, I have called attention to the way that the US government has been shortening the maturity structure of its debt.  The shorter the maturity structure, the more likely a currency panic.

5)  Look, I can’t name names here for business reasons, but it is foolish to take more risk in defined benefit pension plans now in order to try to make up  the shortfall of liabilities over assets.  This is a time for playing it safe, and looking for options that will do well as asset values deflate.

6)  Junk bonds have rallied to a high degree; at this point I say, underweight them — the default losses are coming, and the yields on the indexes don’t reflect that.

7) Peak Finance — cute term, one reflecting a bubble in lending/investing.  Simon Johnson distinguishes between three types of bubbles — I’m less certain there.  Also, I would call his third type of bubble a “cultural bubble,” rather than a “political bubble,” because the really big bubbles involve all aspects of society, not just the political process.  It can work both ways — the broader culture can draw the political process into the bubble, or vice-versa.

The political process can set up the contours for the bubble.  The many ways that the US Government force-fed residential housing into the US economy — The GSEs, the mortgage interest deduction, loose regulation of banks, loose monetary policy, etc., created conditions for the wider bubble — subprime, Alt-A, pay-option ARMs, investor activity, flipping, overbuilding, etc.  In the process, the the federal government becomes co-dependent on the tax revenues provided.

I still stand by the idea that bubbles are predominantly phenomena of financing.  Without debt, it is hard to get a big bubble going.  Without cheap short-term financing, it is difficult to get a stupendous boom/bust, such as we are having.  That’s just the worry behind my point 4 above.  The US as a nation may be “Too Big To Fail,” to the rest of the world, but if the composition of external financing for the US is becoming more-and-more short-term, that may be a sign that the endgame is coming.

And, on that bright note, enjoy this busy week in the markets.   Last week was a tough one for me personally; let’s see if this week goes better.

The Lost Post

Thursday, July 23rd, 2009

I lost an 800-word post last night, and WordPress did not keep a backup as it usually does.  Occasionally, I have also rescued posts by grabbing the post from the RSS feed, but the RSS feed was a blank as well.  So, no post from last night.  If it’s any consolation, a large part of the post dealt with the rating agencies, and my views are well-known there — most of the so-called solutions fail to serve the market as intended, because:

  • ratings are needed for regulatory capital levels
  • there is no concentrated interest to pay for ratings aside from the issuer
  • sophisticated investors do their own analyses and ignore ratings
  • creation of a public rating agency will suffer the same fate as the the NAIC SVO — if one thinks the analysts were weak at S&P, Moody’s, and Fitch, they were weaker at the NAIC SVO.
  • regulators were asking the impossible of the rating agencies in asking them to rate immature securities that never been through a “bust” in the credit cycle.
  • At the bust in the credit cycle, there is always some embarrassing error that causes the rating agencies to whipsaw.  It may be CMBS today; it was ratings triggers and covenants in 2002.
  • It is rough for anyone relying on ratings during the bust of the cycle, because the philosophy shifts from “ratings are made over a full credit cycle” to “ratings should last until lunchtime, maybe, uh, look the stock price is down 5%, post a downgrade.”

That’s why I think that most of the solutions will fail.  The present system has its problems, but the problems are well-known and sophisticated investors know how to deal with them.  New systems will have new problems that we don’t immediately know how to deal with, particularly if they don’t reflect the realities that I listed above.

Okay, there’s one-third of the post back, but I can’t remember the rest.  I delete bookmarks after I do links, and Firefox does not send them to the recycle bin; they just disappear.  Maybe I should do my posts in a word processor, and then post them at the end.  Trouble is, when I do that, the formatting often doesn’t work out right.

Odd Question

Enough of my troubles.  I do have one odd question for my readers before I close off here.  Does anyone know of any financial institution actively lending to churches today?  My congregation is in the midst of a building project.  10,000 minds are better than one, and I hope one of you has some knowledge here that  I don’t.

Duh.

Wednesday, July 22nd, 2009

Duh.  I don’t like saying “Duh.”  There’s something dumb-sounding about it.  The only thing worse is saying “Duuuuh,” or “Duuuuuuhh.”

Yet, when I read Dr. Bernanke’s Op-Ed in the Wall Street Journal today, my initial response was “Duh, of course, in order to exit all ya gots to do is do the opposite of what ya did to enter.  It will be cheap and simple.”

Why should the Fed think that doing the opposite will be easy?  Take the Fed’s forelorn policy tool, the Fed funds rate.  When has it been easy to raise the rate?  Only very bold central bankers would act before it was clearly needed.

Wait, Give Dr. Bernanke a chance.  What did he say?

First, the Federal Reserve could drain bank reserves and reduce the excess liquidity at other institutions by arranging large-scale reverse repurchase agreements with financial market participants, including banks, government-sponsored enterprises and other institutions. Reverse repurchase agreements involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date.

Second, the Treasury could sell bills and deposit the proceeds with the Federal Reserve. When purchasers pay for the securities, the Treasury’s account at the Federal Reserve rises and reserve balances decline.

The Treasury has been conducting such operations since last fall under its Supplementary Financing Program. Although the Treasury’s operations are helpful, to protect the independence of monetary policy, we must take care to ensure that we can achieve our policy objectives without reliance on the Treasury.

Third, using the authority Congress gave us to pay interest on banks’ balances at the Fed, we can offer term deposits to banks—analogous to the certificates of deposit that banks offer their customers. Bank funds held in term deposits at the Fed would not be available for the federal funds market.

Fourth, if necessary, the Fed could reduce reserves by selling a portion of its holdings of long-term securities into the open market.

Each of these policies would help to raise short-term interest rates and limit the growth of broad measures of money and credit, thereby tightening monetary policy.

Overall, the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so. As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period. We will calibrate the timing and pace of any future tightening, together with the mix of tools to best foster our dual objectives of maximum employment and price stability.

What is his first method?  Suck cash out of the system temporarily, and hold fixed-income assets while waiting.

The second method is to let the Treasury suck cash out of the system temporarily, perhaps compromising Fed independence somewhat.

Third?  Make a good offer to the banks so that they lend to the Fed and not to customers, slightly longer-term.

Finally, the Fed could suck in cash by selling the Treasury, Agency, and Mortgage bonds they have acquired, perhaps raising longer-term interest rates in the process.

It all sounds easy.  But tightening the Fed funds rate is not easy, particularly toward the end of the cycle.  What of these new policy tools?  Will they face similar difficulties?

Yes, and maybe more.  The Fed lacks experience with these tools.  As I have said before, policy accommodation is like a drug: easy to receive and hard to withdraw.

As the withdrawal occurs, there will be pain, and more so as the withdrawal continues.  Can you imagine what happens to the bond markets when they realize the Fed is selling?  It will be ugly.  Welcome to the asymmetry of the markets, Dr. Bernanke.

One thing that was neglected were all of the specialized lending programs.  How do they get unwound?  I’m not sure, but I believe the same pain thresholds apply, only that special interests will complain privately.

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Making the markets happy is a fool’s bargain, Dr. Bernanke.  Doing that leads into a liquidity trap, as your acquaintance Dr. Greenspan left you with.  The markets need to be jolted every now and then to know that you aren’t their slave.  Without that, the markets grow complacent, realizing that the Fed exists for their aid and comfort.

In the short-run, Dr. Bernanke, it is always easier to please that fickle mistress, the markets.  Dr. Greenspan learned that all too well.  The markets will eat until they are obese — even beyond that, until they are regurgitating breakfast.  In a macroeconomic sense the markets are not efficient — they will take whatever the government gives, and beg for more, until it kills them, like a drug overdose.

In that sense, the long term is not the sum of short terms.  Rather the seemingly optimal short terms can lead away from what would be optimal long term.

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With that, I end this piece.  On the off-chance that you are reading this, Dr. Bernanke, Ben, I would simply say that removing policy accommodation is easier said than done.  There are always tensions, regardless of the method, and political and economic pain to boot.  Embrace the pain, and let elected officials deal with the consequences.  You’re a brave man, but it is their responsibility — let Congress deal with the crisis.

Seven Miscellaneous Notes

Sunday, July 19th, 2009

1) I am proud of my two middle children, Peter and Jonathan (#4 and 5 out of my 8 ) who have started an “odd jobs” business in this environment, doing yard work, pet sitting, etc.  As other neighbors in our area have seen their good work, all of a sudden, they are gaining a lot of new business.  They are both workers, and hard work pays off.

2)  I appreciate this article in Barron’s where the thoughts of Doug Kass are featured.  I have very high respect for Mr. Kass, because he marries two qualities: he has a keen sense of market timing, and yet a sense of relative value also.  I agree with him the intermediate-term returns should be blah, because it is more difficult to lever up at present.

3)  The states are in more trouble than the US Government, because they have to run balanced budgets, and can’t print money.  California can send out IOUs, which aren’t a currency (yet).  Philadelphia can stiff vendors for now, but what of the future?  California may come to some sort of short -term agreement that postpones real troubles until next year.  Same for Philadelphia.  And, true for many municipalities that are finding cash to be short, because capital gains, sales, and real estate taxes are flagging.

Unlike Gregor (bright man that he is), I do not think that the US Government will bail out California.  Why?

  • Every state will ask for a bailout.
  • States have no bankruptcy code, so those pressing them for money have few options.  (That said, say goodbye to the municipal bond market.)
  • The US Government has enough problems as it is — if you want help, take a number and get in line.

As it is California is a basket case, with dysfunctional politics from the referendum process.  Let California get its own house in order, and reform its government, including the initiiative process.  If it still has problems once it is in as good a shape as other states, fine, let it petition the Federal Government.  It won’t get there anytime soon.

4) Regarding the Fed, I’m not the only one suggesting that there be more regulation.  You can listen to Allan Meltzer, or William Greider.   I give Dr. Meltzer more weight here, but one thing is clear — the Fed is an undemocratic institution with few avenues for accountability.

5)  Will we have robust growth soon?  Former Federal Reserve Governor Laurence Meyer, thinks we won’t see full employment until 2015.  Truth is, with aging demographics, we may not see full employment for a longer time, as baby boomers that can’t afford to retire continue to work.

6)  Aside from regulatory sloppiness, why does Goldman Sachs get a free pass on their VAR calculation (and also here)?  What is VAR for, except to constrain risk?  No one should get exemptions.

7)  My view is that derivative and cash positions should be treated the same in a regulatory sense.  But derivatives were unregulated compared to cash positions.  Investment decisions with the same economic result should be equally regulated.  Much as I am not crazy about government regualtion, with regulated institutions, derivatives should be decomposed into their cash equivalents, and regulated the same way.

Industry Ranks

Saturday, July 18th, 2009

I’m working on my quarterly reshaping — where I choose new companies to enter my portfolio.  The first part of this is industry analysis.

My main industry model is illustrated in the graphic.  Green industries are cold.  Red industries are hot.  If you like to play momentum, look at the red zone, and ask the question, “Where are trends under-discounted?”  Price momentum tends to persist, but look for areas where it might be even better in the near term.

If you are a value player, look at the green zone, and ask where trends are over-discounted.  Yes, things are bad, but are they all that bad?  Perhaps the is room for mean reversion.

My candidates from both categories are in the column labeled “Dig through.”

Now, as a bonus to Aleph Blog readers, I’ll share with you my second industry rotation model, which I put out weekly to clients.  This model looks at the S&P 1500 Supercomposite, and using price momentum, among other factors, encourages the purchase of equities that have done well over the past  year.  Comparing it to the first model, this report always works in the red zone, because price momentum tends to persist in the short run.  This is a short term model.

If you use any of this, choose what you use off of your own trading style.  If you trade frequently, stay in the red zone.  Trading infrequently, play in the green zone — don’t look for momentum, look for mean reversion.

Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.

Huh?  Why change if things are working well?  I’m not saying to change if things are working well.  I’m saying don’t change if things are working badly.  Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes.  Maximum pain drives changes for most people, which is why average investors don’t make much money.

Maximum pleasure when things are going right leaves investors fat, dumb, and happy — no one thinks of changing then.  This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year.  It forces me to be bloodless and sell stocks with less potential for those wth more potential over the next 1-5 years.

Anyway, consider this, and if you have more good ideas on industries, share them with the group.  I can always learn more.

China, the Wild Card — Seven Notes

Friday, July 17th, 2009

1) Is China really growing or not?  Wait, is that a stupid question, or what?  Of course China is growing, and pulling the global economy out of the ditch as well.  Read this report from Time.  Uh, maybe not.  What if it is all a lending bubble?

What seems to be happening is that the powers that be in China are encouraging banks to lend aggressively.  Firms in China aren’t finding a lot of opportunities in export markets, so they build up inventories “that they know they will need eventually.”  Financial counterparties and individuals speculate on financial assets like real estate and stocks as they find cheap financing available.  (Example)

That’s my view of China at present.  I think those that are arguing for a resurgence in China at present are missing the similarities to the late 1980s with Japan where large amounts of productive capacity were built up with no markets large enough to sell the incremental production to.

I could be wrong, but this is leading me to lighten up on cyclicals.  Maybe some utilities…

2) With all of the noise of those looking for a replacement for the US Dollar as the world’s global reserve currency, I have two questions:

  • Are the surplus nations looking to reduce their surpluses, and thus suck in fewer foreign assets?
  • Is there a new deficit nation that is politically stable, militarily strong, etc., that is capable of running current account deficits for some time?  Surplus nations need a safe place to invest.

3) In the meantime, the US tries to assure trading partners that their purchasing power is safe.  We remember the laughable assertion of Tim Geithner trying to assure the Chinese that they did not have to worry about devaluation of the dollar.  Well, now he is saying the same things to the Saudis.  At least with the Saudis, we are doing their bidding in the Middle East, by bottling up Iran,  so perhaps he does not have to worry so much there.

4) Back to point 2.  Are the current account surplus nations willing to consume from the rest of the world and flip around to deficit conditions, letting their currencies appreciate, and killing their politically powerful export industries?  That’s what it will take to replace the US Dollar.  I don’t care who is arguing against the US as a reserve currency.  The reserve currency must by nature offer high quality securities on net to the surplus nations to invest in.  It must run current account deficits on average.

That’s why China can’t be the world’s reserve currency.  China isn’t willing to stop export promotion, or encourage domestic consumption.  India and Russia may kvetch as much as they like, but both are in the same boat as China, but to a lesser degree.

Oddly, the best policy for most of the complainers would be to allow/encourage imports, and stop export promotion.  Freed from these distortions, the global economy would start to normalize.  Cross-border capital flows would decline because exports would not need to be balanced out.

5) The US has no interest in selling Yuan-denominated debt yet.  China eagerly buys Treasuries today.

6)  Does the one child policy fuel excess savings in China?  Maybe, but I doubt it is a big factor.  Dowries are unlikely to eclipse the actions of the central bank and government.

7) A final note from Andy Xie — there is a lot of momentum in China, but little underlying change in the fundamentals.

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My summary is this:  To the degree that the recent upturn is driven by expectations that China pull the global economy out of the ditch, the move is mistaken.  As my friend Cody Willard asked me three years ago, what happens if Chinese growth proves to be a sham?  Can you trust their statistics?

My answer was that I wasn’t certain, but that things would get more clear if that were the case — and I think things are clearer now.  My policy implication is to move assets out of export-driven sectors, and those driven by China demand.  Utilities, here I come. ;)

Central Bank Independence is Overrated

Thursday, July 16th, 2009

Central Banks, should they exist, should be able to do what is right for monetary policy, which includes regulation of credit.  In a fiat money world, where credit exists as electronic entries, credit is money.

But wait, what if central bank independence is compromised from within?  What if voluntarily becomes the lap dog of the President, Treasury, or Congress?

It takes a bold man to stand up to the powers that be, and the Fed has had its share of them.  Marriner Eccles opposed Truman.  William McChesney Martin, Jr. stood up to Presidents and Congress for his long term as Chairman.  Paul Volcker blew cigar smoke at representatives and Senators as he restored sound money to the US amid screams of pain in the economy.

Central bank independence doesn’t mean squat unless the central bank uses it!

In the name of independence, for fear that the President or Congress would restrict the central bank, many Fed Chairmen have given in to the powers that be:

  • Ben Bernanke, rescued entities that he should not have rescued, and established lending programs that use the national credit to benefit a minority of participants.  These actions should have been taken by Congress, if done at all, so that the voters could decide whether it was right to do it or not.  Bernanke validates the idea that the government keeps the Fed around to do what it cannot do constitutionally.
  • Alan Greenspan threw liquidity at every little and big problem, and was slow to withdraw liquidity, pushing the US slowly but surely into a liquidity trap, which Ben Bernanke was saddled with.
  • G. William Miller and Arthur F. Burns, who facilitated the inflation of the ’70s, at the behest of Nixon and Carter.
  • Daniel R. Crissinger and Roy A. Young, who facilitated the loose monetary policy of the ’20s.

Central bank independence means risking your own tenure for the good of the institution.  Marriner Eccles and Paul Volcker did not get reappointed because they offended the President.    Central bank independence does not mean compromising in order to protect against micromanagement.  Independence means being a man, and telling the President and congressmen that you will do what is right to preserve sound money, regardless of the consequences.

The Fed as Systemic Risk Regulator

I have suggested in the past that the Fed should regulate systemic risk as an aspect of its mandate only because they are the biggest creator of systemic risk through loose monetary policy.  I am not suggesting this on the basis of competence — that is ridiculous.  But on the basis of modifying the behavior of the Fed to make it more resistant to loosening rates early because of systemic risk concerns — that makes sense, because it will increase the emphasis on a sound currency.

Now, many economists are pleading with Congress to be gentle on the Fed because an independent Fed is critical to sound economic policy.  That would be true if the Fed were willing to take politically unpopular actions that were in the best interests of the economy.  Sadly, that is not true of the present Fed.  They do what the politicians want, and give the politicians cover, because the politicians can point at the Fed as the actor, via the rubric of “Central Bank independence.”

I say that the Fed needs more accountability and transparency to Congress, and ultimately to the American.  The quasi-public, quasi-private nature of the Fed needs to be changed to public or private.  Section 13.3 of the Federal Reserve Act, which allowed for the most egregious bailout actions, should be repealed. If bailouts need to be done, let Congress do them, and let them take the heat for their actions.

Not only should the Fed be audited as any large public or private organization, but if they are a public organization they should respond to the FOIA requests from major news organizations (Bloomberg, Fox Business, etc.) without hiding behind technicalities of protecting business secrets.  The insurance industry regularly reveals detailed data on their operating companies, with little seeming harm.  The banks can afford to do the same.

Power without accountability should be foreign to our republican form of government.  Control of our currency rightfully belongs to Congress, and Congress should tighten controls on the Fed so that its degree of independence is limited to the ordinary matters pertaining to a central bank — preserving the soundness of the currency.  Its competence there has been limited; but hey, at least focus on the basics would restore confidence in an institution that no longer has the confidence of the American people.

“Central Bank independence” is a nice phrase, but to the economists who petitioned Congress to preserve the status quo, I would simply ask this: How and from what should the central bank be independent?  To whom and in what ways should it be accountable?

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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