Tag Archives: gdp

China’s Economy is Hitting the Brakes

Much of the current global growth scenario is built upon the notion that China will continue to supply the fuel. Long term, this is a generational move that will happen as China demographically reinvents itself. However, I’m more interested in what may happen this year and how I can prepare myself for it. China’s economy has been growing at a break neck pace with several years of compounded double-digit returns. Even the economic crisis was merely seen as a speed bump on the way to 13% growth. However, over the last six months the make up of the top line growth numbers have been called into question.

The People’s Bank of China has become increasingly hawkish throughout 2010. They are concerned that their economy is overheating and they are actively attempting to pop the bubbles that have been forming as a result of the bifurcation of the economic policies of the government relative to the economic realities of its people. The Chinese people have increased their savings as their country’s trade surplus has grown and their personal savings rate now stands at 38% of their income. By comparison, our national savings rate shifted from negative to positive as a result of the economic meltdown and now stands at 3.8%.

Chinese government policy does not allow direct investment in foreign markets. Therefore, they are unable to repatriate, on an individual basis, their dollars for foreign stock and bond holdings. The Chinese population has been putting their money to work by investing locally in property, precious metals and the Chinese stock market in an attempt to cover the spread between the 2.5% Chinese banks offer on savings versus their inflation rate of 5.1%.

In response to their swelling domestic asset values, the Chinese government raised interest rates twice this year and increased their bank lending reserves six times in 2010, lowering their banks’ leverage by a total of 20%. They are also lowering their lending cap from more than 9 trillion RMB, approximately $1.36 trillion, in 2010 to a target of 6.5-7 trillion RMB for 2011. It is quite clear that they are willing to take whatever action is necessary to keep their economy from overheating while maintaining their domestic cash hoard.

These actions are starting to show up in their economic data. The Organization of Economic Development is pointing to a slowdown in China’s leading economic indicators. They’ve based their prediction on the declining velocity of shipping, fuel usage, fertilizer production, raw steel manufacturing, capacity utilization and stock market turnover. Rising interest rates and slower turnover are key signs of a slowing economy.

Albert Edwards of Societe Generale recently stated that the economic prosperity in China is without global precedent. He went on to say in England’s, Financial Times and The Guardian newspapers that China’s, “investment to GDP ratio is off the scale both in terms of size and endurance.” His investment group has been the top rated global strategy analyst for the last seven consecutive years.

This year, it is quite possible that China sees annual growth of less than 10%. While this is by no means a recession, if their economy slows down 4-6% it will have a global impact. Based on their holdings and consumption patterns we could see declines, in order of magnitude, precious metals, oil, mid level luxury brands and global interest rates. The continued development of the Chinese middle class will continue to support food and agricultural prices as well as textiles. In the U.S. investors, “don’t fight the Fed.” The globalization of the economy suggests, “don’t fight the central banks.”

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

A Model for Economic Recovery

I’m re- posting an article I read this week. It’s so easy to focus on the problems and argue about the details. I had completely forgotten the magnitude of Canada’s economic turnaround. This is a great example of focusing on the solution.
All rights go to John Mauldin and David Hay.

O Canada!

“Debt and deficits are not inventions of ideology. They are facts of arithmetic.”

– Paul Martin, Canada’s finance minister at the start of the country’s “Redemptive Decade”

Arrivaderci, Italia; Yo, Canada

It’s ok—you can be honest with me. Many of you on the receiving end of this newsletter were probably wondering if I had developed some kind of Italian infatuation, sort of like the young cyclist in that fun movie from the late 1970s, Breaking Away. You can rest easy. Although I readily concede it is a breathtakingly beautiful country (save for Naples, which we discovered is the Tijuana of Italy), my wife and I were thrilled to be back in the US of A, where the first thing I did was order a cheeseburger.

Certainly, the Italian locals were consistently friendly and extremely gracious even as we mangled their lovely language. However, as they opened up to us, it became clear how fearful they are about their country’s economic future. Like so many southern European nations, Italy’s debt levels have soared to grotesque levels, even compared to our own current state of fiscal debauchery. Therefore, it was somewhat ironic that one of the two books I read while over there was about Canada and, specifically, the extraordinary financial turnaround that country has made over the last 15 years. Remarkably, if you were to roll the clock back to 1995, Canada was actually deeper in debt than Italy. In those days, the Canadian dollar was derisively known as either the Loonie (after the bird on Canada’s $1 coins) or the Northern Peso. The situation was so dire that the Wall Street Journal ran what turned out to be a pivotal article in which the authors asserted that Canada had become “an honorary member of the Third World in the unmanageability of its debt problem.”

This editorial set off shock waves around the world and, of course, within Canada itself. To its credit, Canada’s political establishment got fiscal responsibility religion in a hurry; it was almost like they went from being atheists to Southern Baptists overnight. And, get this: for the most part, it was Canada’s equivalent our Democratic Party that assumed the yoke of pulling the country back toward the high ground of financial solvency. Do you think that perchance we could learn a thing or two from Canada’s experience?

Canada High and Dry

It’s been a consistent theme of mine for a year or more that Americans are not going to passively accept the disastrous fiscal path on which our brilliant political parties have put us. It has also been my belief that politicians from both sides of the aisle would get the message. At this time last year, there weren’t many who agreed with me (in fact, when I put forth this theory to the CEO of a huge financial firm 13 months ago, he looked at me like I was suggesting the Mariners’ front office knew how to run a baseball team). But the public backlash against unsafe and insane fiscal policies is now unmistakable, and it’s very much a bipartisan movement. Politicians, being the generally feckless creatures they are, have scrupulously (or should that be un-) avoided putting forth much in the way of tangible solutions prior to the critical mid-term elections, now just a month away. Yes, I know, the GOP came up with the Pledge to America, and it’s a start—of sorts—but it strikes me as woefully unequal to the massive task. A far more rational way to approach the problem (I realize that rationality and politicians rarely converge) would be to make the book I just finished—The Canadian Century, Moving Out of America’s Shadow—required reading for all incoming members of Congress. It would be nice to demand this from incumbents as well, but let’s face it: most of them don’t even bother to read the legislation they put into law.

Many of you also know that I’ve brought up the remarkable Canadian renaissance more than a few times. Thus, I was truly excited to read the aforementioned book after seeing a review of it earlier this year. Though I was aware of the happy outcome, I really had no idea how Canada pulled off moving from “basket case to world beater,” in the writers’ own words. And there’s no exaggeration in that statement; Canada then was in far worse shape than even we are now in our headlong rush to fiscal perdition. For example, in the mid-1990s, one-third of all government revenues were being devoured by interest costs on Canada’s rapidly escalating debt. To illustrate how bad that was, in the US today interest expenses consume just 10% of tax revenues, excluding the non-cash interest accrual on Treasury debt held by the Social Security trust fund (more on that later).

By the 1990s, Canada had also become one of the developed world’s most socialized economies, with the government accounting for 53% of the country’s GDP. Economic growth was stagnating, while debt levels were inexorably and dangerously mounting. At its scariest zenith, Canadian federal and provincial government debt amounted to 120% of GDP, with roughly 70% at the national level and an outrageously bloated 50% owed by the provinces. Again, to put that in perspective, despite our debt binge over the last decade, US government debt is around 60% of GDP, while state debt is nearly 17% of GDP, or 77% overall (this is based on net, not gross, debt and excludes the Social Security trust fund holdings as well as intergovernmental liabilities). Moreover, unlike in our present situation, Canada’s interest rates were rising due to worries about the nation’s solvency. Its coveted AAA credit rating was yanked, and the market was treating it as an increasingly unreliable borrower. In other words, it was much like the situation a number of European countries find themselves in today—except that Canada didn’t have Germany to bail it out. As you can readily see, there’s simply no question that Canada was in some very deep doo-doo. Which begs the multitrillion-dollar question: How the heck did it get out of that jam?

Northern Composure

As I’ve given various speeches over the last year, it has become clear to me that very few Americans are aware of the extraordinary recovery Canada has achieved since the mid-1990s. When I bring it up, most people seem surprised that Canada could have gone from a laughing stock to the envy of the developed world in just a decade. But, actually, 10 years wasn’t the true recovery period. And that was my big surprise from reading The Canadian Century. The reality is that Canada achieved stunning progress in a mere three years. Further, this time frame was consistent at both the federal and provincial levels. In case you think I’m exaggerating the speed and magnitude of the rehabilitation, let me provide some specificity:

• Paul Martin, the finance minister for the national Liberal Party, unveiled a budget in early 1995 that shocked all the cynics accustomed to smoke-and-mirrors accounting. It reduced program spending by 8.8% over two years (and our politicos quiver over a mere hint of spending freezes).

• As part of this radical spending rationalization, federal government employment was reduced by 14%.

• Federal grants to the provinces were reduced by 14% as well, but the trade-off was that they were allowed to control how the money was spent. Provincial governments also needed to provide half of all funding (i.e., put skin in the game).

• While some taxes were raised (and, according to the authors, these worked against the recovery), spending cuts were 4 ½ times tax hikes.

• Canada’s welfare system was dramatically modified. Rather than just providing a blank check to the provinces (which administered the welfare programs), Ottawa incentivized them to put the funds to better use. Benefits were cut for single, employable individuals and aggressive efforts were made to get them back in the work force.

• Despite accusations from the far left that the poor would suffer due to these changes, the percentage of welfare recipients fell in just a few short years from 10.7% of the population to 6.8% by 2000. From 1997 to 2007, the percentage of Canadians classified as low-income plunged by over 30%.

• The tax structure was dramatically redesigned. Corporate tax rates were cut by nearly a third, taxes on corporate capital were abolished, and personal income and capital gains taxes were reduced.

• The General Services Tax (basically a consumption tax or VAT) was instituted to pay for the tax cuts described above. While initially very unpopular, it was a key part of the rehab plan.

• The Canada Pension Plan (CPP), the country’s version of Social Security, also underwent major surgery. Instead of payroll taxes gradually rising to 14%, the increases were pulled forward but capped at under 10%. This produced immediate surpluses that were invested in higher-returning corporate securities. (As noted in past EVAs, this is a huge defect with our Social Security system; its many trillions are tied up in low-yielding US government bonds that simply add to our overall national indebtedness.) The CPP today is well-funded and actuarially sound.

• As a result of these actions, and many others I’ve left out, the federal budget was balanced within three years.

After achieving this remarkable feat, Canada went on to produce 11 straight budget surpluses. This allowed our northern neighbors to reduce their federal debt from 80% of GDP to 45%. Further demonstrating how quickly good policy can turn things around, the provinces enacted similar measures. Most of them also moved to balanced budgets or surpluses within just three years, though in the case of Ontario it took five years. However, that was still one year ahead of schedule (pronounced “shh-edule”, of course). By contrast, even Congressman Paul Ryan’s allegedly bold goal to balance the US budget will take decades to attain.

One of the recurring themes from The Canadian Century is the concept that not all taxes are created equal. Some have a much more negative impact on economic activity than others. This totally resonates with me and it’s why I believe estate taxes should be our version of the VAT. However, I would concede that possibly a combination of the two might be necessary and desirable.

Most of all, I have tremendous respect for what has worked in the real world and within a country so similar to our own. By the way, in case you think that Canadians universally supported these rational reforms as they were first enacted, consider how similar our northern friends are to us. They are every bit as fractious as we are. There was a cacophonous chorus of extreme Keynesians (those who believe government spending should never be cut) who predicted Canada’s grand experiment would be an abject failure. Yet, despite all those who were sure that downsizing government would do the same to their growth rate, Canada’s economy grew at 3.3% per year versus the developed-world average of 2.7%. Notwithstanding Canada’s undeniable success, should we decide to follow in its footsteps, be prepared for folks like NY Times columnist Paul Krugman to wax apocalyptic. Come to think of it, given his forecasting track record, that would be a good thing.

Quite an amazing story, eh? Unquestionably; and it’s interesting that today, most of Europe is essentially following the same game plan (without giving Canada credit—probably due to its legendary pride, bordering on arrogance). Yet there is one immensely important difference.

The Crucial Currency Tailwind

The aforementioned Wall Street Journal article from early 1995 that strongly suggested Canada was careening toward bankruptcy not only served as a national wake-up call, it also tanked the Canadian currency. While this collapse was highly embarrassing to its citizenry, it sowed powerful seeds of recovery. Canadian goods became very inexpensive on world markets, thereby stoking demand. And Canada’s real estate became irresistibly attractive to both American and Asian investors, drawing in massive amounts of hard currency. As mentioned in numerous past EVAs, this is the vital missing link for countries like Italy. The stunning rise in the euro from the depths early this summer is the worst thing that could be happening to the Continent, especially for the weaker countries—almost all of them except Germany.

Fortunately for us, our situation is much more like Canada’s was in the 1990s. The buck is once again seriously undervalued, not only against the euro but versus the yen as well (the dollar recently touched 15-year lows against Japan’s currency). This will greatly aid our exporters, who are already prospering.

Perhaps I’ve missed it, but I haven’t heard a single representative from either party bring up the notion of emulating Canada. Both parties seem to be infected with, among other maladies, an acute case of Not Invented Here-itis. Maybe it’s time for all of us who are deeply concerned about our country’s financial future to harness the power of the internet to influence the many fresh faces that will soon be moving to the other Washington. The good news is that this incoming class promises to be far less indoctrinated by their respective parties’ failed ideologies and much more open to innovative concepts. If they are, it’s not a stretch to believe that our finances can begin to track the Canadian path, as illustrated below.

Role reversal time? The Canadian Century was clearly written for domestic consumption. As such, there is a fair amount of chest-puffing over Canada’s accomplishments, as well as some thinly veiled savoring of our own current predicament (the Germans have a perfect word for this: schadenfreude). Yet the authors also concede a few chinks in Canada’s armor. For one thing, they note that there is some serious backsliding going on when it comes to adhering to the fiscal reformation creed. A certain amount of this is attributable to combating the ravages of the Great Recession, even though Canada was not nearly as hard-hit as the US. But beyond this, the authors are seeing clear evidence that the resolve to restrain spending seems to be waning. Alas, this does seem to be the natural cycle of democracies: Governments spend recklessly until the situation is so bleak there is no choice but to drastically cut back. Once financial health is restored, there then seems to ensue a long, almost imperceptible erosion of fortitude until a crisis hits and debt levels rise so terrifyingly that corrective action becomes unavoidable. Often, as in Canada, it’s the more putatively liberal party that administers the tough but necessary medicine.

The book is also quite candid in its admission that Canada’s healthcare system is largely as dysfunctional as our own. The authors point out the immense challenge that lies ahead for both countries in bringing the wealth-devouring beast of healthcare under control. It’s hard to disagree with their belief that both the US and Canadian healthcare systems need a healthy injection of incentive-based economics, competition, and behavioral modification. Thus far, neither country has made much progress in that regard.

For me, though, the key message of this book is that the future does not have to be a depressing choice between accepting sub-par growth or committing fiscal suicide. Canada’s experience emphatically demonstrates that replacing bad policies with good ones leads to dramatic and rapid improvement, with the shift to financial soundness restoring confidence and actually boosting long-term growth. Some forty years ago, then US President Richard Nixon famously remarked, “We’re all Keynesians now.” To fully channel his inner Keynes, Nixon needed to take us off the gold standard, which he did in 1971. The keys to the perpetual printing press had been found. Soon thereafter a new economic term was coined: stagflation. These days, at least when it comes to fiscal policy, a far wiser statement would be: “We’re all Canadians now.” If we want to right our nation’s financial ship, we might be well-advised to swallow our pride and follow the lead of a country that has long been in our shadow. This is likely to be far more effective than further pursuing failed economic policies from our distant past. Page 6 Evergreen Virtual Advisor (EVA) October 8, 2010

David Hay | Chief Investment Officer | Evergreen Capital Management, LLC

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Perhaps We’ve Gotten Ahead of Ourselves

Commodity Prices have been on a tear. No question about it. Gold has traded over $1,300 per ounce and silver is over $21 an ounce. The grain markets have seen huge gains in corn, beans, rice and oats. Even markets like coffee, orange juice and cotton have participated in the broad commodity rally. Does this mean it’s a good time to put more money in commodities? Not necessarily. This is where our philosophy diverges from stockbrokers. We don’t generate revenues for the firm based on equity under management. Therefore, our best business practice is to provide our individual traders with information that will help them be successful over the long term.

The commodity markets as a whole, have built this rally on the economically sound principals of inflation, which include a declining dollar and low interest rates. However, according to the data that I’ve been watching, it’s quite possible that we’ve gotten a bit ahead of ourselves in the economic cycle. At this point, the anticipation may be greater than the event.

Starting with the big picture. There is a third component to inflation that hasn’t gotten much press over the last year and that is, velocity. Velocity in economics is how quickly money is changing hands. The higher the velocity of a dollar and the more it circulates, the more action there is in the economy and the closer we are to potential inflation. What we’ve seen since the economic crisis began and the housing bubble collapsed is that the Federal Reserve Board has flooded the economic system with Dollars.

The adjusted monetary base of the United States has increased nearly 25% since September of 2008. Broadly speaking, this means there are 25% more dollars in our pockets and in our checking, savings and cd accounts at the bank. However, as I wrote last week, Americans are finally starting to save their money. This is why the velocity of money has declined by more than 17% since the economic crisis began in 2008. This is in spite of the Federal Reserve Boards attempts to stimulate spending.

The United States is the financial trading center of the world. We have the most mature stock and commodity exchanges. They are the most highly regulated and also the most liquid. Therefore, we are the hub of the global financial network. The commodity markets here in the U.S. service 40% of all traded commodities. Therefore, the prices of commodities traded here in the U.S. actually reflect a global view of fair value. The decline in the U.S. Dollar has made trading prices in the U.S. seem like the latest sale at Kroger, just bring in your Treasury coupon for double points.

Finally, in the weekly Commitments of Traders Reports, we have seen a very large build up of large speculator and commodity index trader long positions with the commercial traders increasing their short positions as the markets have climbed. The fact that many of these markets are significantly below their pre financial market collapse highs of early 2008 is a telltale sign that the current market rallies may be over extended. It’s important to note that the two groups supporting the commodity markets have no ties to fundamental value. The large traders are simply trend followers. They are willing to be long or short any market at any time. The commodity index traders are only allowed to purchase commodity contracts to keep their portfolios properly weighted. They will add positions as the market climbs and offset positions as needed on a market decline.

Commercial traders are the producers or, end line consumers of the actual commodities themselves. They are keyed into the entire production mechanism and have a keen understanding of the issues affecting their markets. The general theme I see building is that they believe many of these markets are substantially overbought and inflation is further away than we think. While they do believe there is inflation coming down the pipeline, they believe it is further off than the commodity markets are making it look. They have bought up large positions in short term Treasuries while taking a decidedly more bearish tone towards the long end of the yield curve. In fact, the commercial trader net position in the 30 year bond is the most bearish it’s been since 2005, prompting me to consider taking profits in our bond trade from several weeks ago.

The combination of an economy flooded with cash led many investors to anticipate inflation down the road, which makes commodities a very sensible place to put money. However, given America’s newfound desire to save, the flood of cash hasn’t quite had the textbook multiplier effect that was expected to increase GDP 50% for every dollar spent by the government. Given the over extended state of some markets combined with fundamental data supporting declining velocity, it may be a good time to adjust risk in the commodity markets.  Velocity will increase and repurchasing commodities on a pullback could be an effective strategy once the actual race finally gets going.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures.

Pandora’s Grecian Riddle

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures.


Pandora’s Grecian Riddle

Here’s a riddle for you. What could make the U.S. Dollar and Gold rally while keeping short term interest rates exceptionally low, in the face of a bleak domestic economy?

The answer: bigger troubles overseas finally finding their way into the light.

I have said for the last 6 months that there is big trouble brewingin Old Europe and the Mediterranean. Many of you who absorb information fromsources other than CNBC and Fox Business channel are already aware that Greeceis on the verge of catastrophe. Members of the EU met in Brussels yesterday,February 15th for the primary purpose of discussing what to do withGreece’s inability to bring their budget in line with national their nationaldebt expenditures, currently totaling about 300 million Euros. They will alsoneed to secure financing of more than 50 million Euros to maintain operationsthrough the end of this year. Currently, their deficit represents about 12.7%of GDP. Jean- Claude Trichet and the rest of the EU policymakers want thisnumber to be brought down to 4% for 2010. It is my understanding that there isa tacit agreement among members of the EU that deficit financing cannot accountfor more than 3% of GDP for EU members.

To put this in perspective, our debt levels here in the U.S. arerunning at approximately the same percentages as Greece. This would be theequivalent of the U.S. cutting its budget deficit, currently around $1.3trillion by more than $550 billion both this year and next. Can you imagine thecivil unrest this would create or, what it would mean to Medicare, welfare orsocial security? How about schools, police forces and the postal service? Thisis what the approximate proposal by the EU would cause in Greece.

Obviously, the next thought is, “its Greece. So what? How badcould it be?” Remember that we’re talking approximately 300 billion Euros.According to John Mauldin, this represents 2.7% of European GDP. Remember BearStearns? They held less than 2% of U.S. banking assets. The issue here is thatthe other members of the European Union would not have the collectivecoordination to operate swiftly and decisively in the event of contagion.Russia in 1998 had a very clear operating system. Decisions were made anddirectives were carried out. Argentina in 2002 was also able to implement thedefault, restructure, revalue and grow procedure within less than a year.However, according to yesterday’s meeting, as reported in both “The Guardian”and the “Telegraph,” there is virtually no consensus among what should be done.The mandate to cut debt was issued but, what enforcement power is there tocarry it out? How long will the other nations allow the European Union as awhole to be seen as impotent in the world financial markets?

Of course, Greece has choices. Most plausibly, they agree to EU concessions and implement them fractionally – like the teenage child that whose completion of the chore list is underwhelming, to say the least. Secondly, they could default on their debt. This would throw the country into a depression.However, unlike Russia and Argentina, who both had a wealth of natural resources to fall back on, over 75% of Greece’s GDP comes from the service sector and less than 4% comes from natural resources, which consist mainly ofagriculture. Therefore, they will not be able export their way to economic recovery the way the Russia and Argentina have. Finally, they could vote to remove themselves from the European Union. The benefits would include a devaluation of their debt and an instant competitive edge in labor pricing.Unfortunately, any savings – monetary or land (mark-to-market), left in Greece would be devalued immediately and it would leave them unable to securefinancing on the open market for quite some time.

Going back to where we started, I asked the question, “What would make the Dollar and Gold rally while keeping short term U.S. interest rates low?” As of this morning, (2/16/10), European Union leaders have broken offtalks with Greece over what to do. A Grecian default would place a huge strain on Germany, Switzerland and France, the three primary holders of Grecian debt(Mauldin). Great Britain and Spain are stuck dealing with their own problemsand the Swiss won’t get involved. If the EU were to bail out Greece, what wouldIreland say? Here in the U.S. we arbitrarily chose to save some firms and letothers fall by the wayside. Think Bear Stearns versus Goldman. The fallout was substantial. I can’t imagine the political chess game that involves picking which country to save and allowing which one to fail. From a tradingperspective, and this is about trading – not political rhetoric, this eventwill create uncertainty in the financial markets. Holders of Euros will diversify. Whether they buy U.S. Dollars directly or, simply move money out ofthe Euro and into other currencies, this action will devalue the Euro. Furthermore,this uncertainty will attract more money to Gold. Finally, uncertainty in theEuro Currency will reassert the U.S. debt markets as king, thus keeping short term rates low for the foreseeable future.

Any questions, please call.Andy Waldock866-990-0777

The Coming Double Dip

This blog is published by Andy Waldock. Andy Waldock is a commodity futures trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures.

This morning’s (10/29/09) GDP headline on MSNBC reads, “GDP Grows at Best Pace in Two Years.” Bloomberg says, “Economy Expands for First Time in a Year.” Lastly, CNN said, “Economy Finally back in gear.

Statistically, speaking, this morning’s GDP numbers showed growth of 3.5% for the third quarter. This breaks a four quarter string of steadily shrinking numbers. By definition, this uptick brings us out of, “recession.”  This morning’s report looks great in the headlines, sounds good on the evening news and provides warm fuzzy water cooler conversation. However, I believe this is exactly the setup for the Double Dip Recession we’ve been talking about for quite some time.

Let me paraphrase the economic definition of “recession. “ A recession occurs when an economy has two consecutive quarters of declining GDP. We had experienced four straight quarters of declining GDP prior to this morning’s report.  In a free market economy, I would join the water cooler conversation and breathe a collective sigh of relief. However, our economy over the last year, can hardly be called a, “free market economy,” and therefore, I will continue to hold my breath and face the realities of what I believe will be a SIGNIFICANT downturn in our country’s economic stability.

Over the last quarter, the economic effect of the government’s cash for clunkers and housing stimulus packages has been substantial. Unfortunately, the temporary stimulus has done nothing to fix the underpinnings of our country’s global ability to compete into the future. These programs were far more akin to giving a man a fish, rather than teaching a man to fish. Had we allowed the markets to work themselves out, we would have saved billions of taxpayer money that went to bail out worthless financial corporations. Had some of this money been spent on our country’s infrastructure instead, we would have created new jobs by updating the electrical grid and allowing new green energy to be transferred from where it’s created to where it’s needed. The highway system, bridges and railways haven’t been significantly updated since their creation in the 1950’s and are in dire need of repair. As I write this, I see that the Golden Gate Bridge is closed because a cable snapped! Finally, high speed internet needs to be rolled out to everyone, just like the phone companies did so many years ago. These INVESTMENTS in our country’s future would do far more to ensure long term growth than the corporate BAILOUTS we are paying for to make us feel good now.

Due to the programs that have been implemented, we have ended the recession. Hurray for us – NOT. What we have done is placed whip cream and cherries on a pile of cow dung. Let me blow the froth off and show you how much it smells underneath the rhetoric. Deflation is still our major economic concern. Deflationary economies have no chance of sustaining growth. Many of you will argue that because of the falling Dollar and our government’s position of Quantitative Easing, that inflation should be our primary concern. I don’t think that’s the case.

First of all, we still have rising unemployment. According to the last unemployment report, we are at 9.8% unemployed. There are also another 7% underemployed and another 3-4% who’ve simply quit looking for work. According to John Mauldin, “A few years ago, 1 in 16 Americans were unemployed or underemployed. Today, that number is 1 in 5.” Obviously, this means no wage inflation. This is also why I think national infrastructure retooling would’ve been more beneficial. Secondly, between the housing collapse and the bear market in equities, we have seen significant wealth destruction. People are increasing their rate of savings as their net worth declines. Haven’t we all tightened our collective belts a bit? Again, lack of spending equals deflation not, inflation. Finally, the Federal Reserve Board has dropped interest rates to near 0%. Typically, this would be extremely stimulative and very inflationary. However, the money the Fed is printing is not making it to out to home buyers, entrepreneurs or, small businesses. The money is being used to shore up the balance sheets of the many troubled lending institutions at the corporate and private levels. Therefore, the velocity of money is still very low in spite of the amount of money the Fed has been printing and money velocity is positively correlated with inflation. Low velocity means low inflation.

This morning’s GDP numbers need to be taken in context. The dip was halted but, it’s just a breather before the next section of the slide. Watch the Commitment of Traders Reports for the next selling opportunity.


Reasons for U.S. Dollar’s Strength


This blog is published by Andy
Waldock. Andy Waldock is a trader, analyst, broker and asset manager.
Therefore, Andy Waldock may have positions for himself, his family, or, his
clients in any market discussed. The blog is meant for educational purposes and
to develop a dialogue among those with an interest in the commodity markets.
The commodity markets employ a high degree of leverage and may not be suitable
for all investors. There is substantial risk in investing in futures.

It has been noted that the U.S. Dollar makes a high or a low for the year in January approximately 2/3 of the time. Some prominent market mavens are attributing the Dollar’s strength to “strong cyclical forces at play” while others believe that the Dollar’s time as the currency of last resort is nigh. Both positions appear, to me, to be based on more on rhetoric and black magic than on sound fundamental analysis. Those of you who’ve asked me about the Dollar have gotten the same response from me since the commodity futures market’s bottom in December. I don’t understand the Dollar’s strength. I can advise on technical levels and pattern recognition but, I don’t have a fundamental thesis to frame my trading in this market at this time. The following article by John Mauldin of www.frontlinethoughts.com has provided me with a framework I can wrap my head around. I hope it helps you as much as it has myself.Andy.

The Risk in Europe

I mentioned last
week that European banks are at significant risk. I want to follow up on that
point, as it is very important. Eastern Europe has borrowed an estimated $1.7
trillion, primarily from Western European banks. And much of Eastern Europe is
already in a deep recession bordering on depression. A great deal of that $1.7
trillion is at risk, especially the portion that is in Swiss francs. It is a
story that could easily be as big as the US subprime problem.

In Poland, as an
example, 60% of mortgages are in Swiss francs. When times are good and
currencies are stable, it is nice to have a low-interest Swiss mortgage. And as
a requirement for joining the euro currency union, Poland has been required to
keep its currency stable against the euro. This gave borrowers comfort that they
could borrow at low interest in francs or euros, rather than at much higher
local rates.

But in an echo of
teaser-rate subprimes here in the US, there is a problem. Along came the
synchronized global recession and large Polish current-account trade deficits,
which were three times those of the US in terms of GDP, just to give us some
perspective. Of course, if you are not a reserve currency this is going to
bring some pressure to bear. And it did. The Polish zloty has basically dropped
in half compared to the Swiss franc. That means if you are a mortgage holder,
your house payment just doubled. That same story is repeated all over the
Baltics and Eastern Europe.

Austrian banks
have lent $289 billion (230 billion euros) to Eastern Europe. That is 70% of Austrian
GDP. Much of it is in Swiss francs they borrowed from Swiss banks. Even a 10%
impairment (highly optimistic) would bankrupt the Austrian financial system,
says the Austrian finance minister, Joseph Proll. In the US we speak of banks
that are too big to be allowed to fail. But the reality is that we could
nationalize them if we needed to do so. (And for the record, I favor
nationalization and swift privatization. We cannot afford a repeat of Japan’s
zombie banks.)

The problem is
that in Europe there are many banks that are simply too big to save. The size
of the banks in terms of the GDP of the country in which they are domiciled is
all out of proportion. For my American readers, it would be as if the bank
bailout package were in excess of $14 trillion (give or take a few trillion).
In essence, there are small countries which have very large banks (relatively
speaking) that have gone outside their own borders to make loans and have done
so at levels of leverage which are far in excess of the most leveraged US
banks. The ability of the “host” countries to nationalize their banks
is simply not there. They are going to have to have help from larger countries.
But as we will see below, that help is problematical.

Western European
banks have been very aggressive in lending to emerging market countries
worldwide. Almost 75% of an estimated $4.9 trillion of loans outstanding are to
countries that are in deep recessions. Plus, according to the IMF, they are 50%
more leveraged than US banks.

Today the euro
rallied back to $1.26 based upon statements from German authorities that were
interpreted as a potential willingness to help out non-German (in particular,
Austrian) banks.

However, this
more sobering note from Strategic Energy was sent to me by a reader. It nicely
sums up my concerns:

“It is East
Europe that is blowing up right now. Erik Berglof, EBRD’s chief economist, told
me the region may need €400bn in help to cover loans and prop up the credit
system. Europe’s governments are making matters worse. Some are pressuring
their banks to pull back, undercutting subsidiaries in East Europe. Athens has
ordered Greek banks to pull out of the Balkans.

“The sums
needed are beyond the limits of the IMF, which has already bailed out Hungary,
Ukraine, Latvia, Belarus, Iceland, and Pakistan — and Turkey next — and is
fast exhausting its own $200bn (€155bn) reserve. We are nearing the point where
the IMF may have to print money for the world, using arcane powers to issue
Special Drawing Rights. Its $16bn rescue of Ukraine has unravelled. The country
— facing a 12% contraction in GDP after the collapse of steel prices — is
hurtling towards default, leaving Unicredit, Raffeisen and ING in the lurch.
Pakistan wants another $7.6bn. Latvia’s central bank governor has declared his
economy “clinically dead” after it shrank 10.5% in the fourth
quarter. Protesters have smashed the treasury and stormed parliament.

“‘This is
much worse than the East Asia crisis in the 1990s,’ said Lars Christensen, at
Danske Bank. ‘There are accidents waiting to happen across the region, but the
EU institutions don’t have any framework for dealing with this. The day they
decide not to save one of these one countries will be the trigger for a massive
crisis with contagion spreading into the EU.’ Europe is already in deeper
trouble than the ECB or EU leaders ever expected. Germany contracted at an
annual rate of 8.4% in the fourth quarter. If Deutsche Bank is correct, the
economy will have shrunk by nearly 9% before the end of this year. This is the sort
of level that stokes popular revolt.

implications are obvious. Berlin is not going to rescue Ireland, Spain, Greece
and Portugal as the collapse of their credit bubbles leads to rising defaults,
or rescue Italy by accepting plans for EU “union bonds” should the
debt markets take fright at the rocketing trajectory of Italy’s public debt
(hitting 112pc of GDP next year, just revised up from 101pc — big change), or
rescue Austria from its Habsburg adventurism. So we watch and wait as the lethal
brush fires move closer. If one spark jumps across the eurozone line, we will
have global systemic crisis within days. Are the firemen ready?”

While Rome Burns

I hope the writer
is wrong. But the ECB is dithering while Rome burns. (Or at least their banking
system is — Italy’s banks have large exposure to Eastern Europe through
Austrian subsidiaries.) They need to bring rates down and figure out how to
move into quantitative easing. Europe is at far greater risk than the US.

Great Britain and
Europe as a whole are down about 6% in GDP on an annualized basis. The Bank
Credit Analyst sent the next graph out to their public list, and I reproduce it
here. (www.bcaresearch.com)
In another longer report, they note that the UK, Ireland, Denmark, and
Switzerland have the greatest risk of widespread bank nationalization (outside
of Iceland). The full report is quite sobering. The countries on the bottom of
the list are also in danger of having their credit ratings downgraded.

Aggregate Sovereign Credit Risk

This has the
potential to be a real crisis, far worse than in the US. Without concerted
action on the part of the ECB and the European countries that are relatively
strong, much of Europe could fall further into what would feel like a
depression. There is a problem, though. Imagine being a politician in Germany,
for instance. Your GDP is down by 8% last quarter. Unemployment is rising.
Budgets are under pressure, as tax collections are down. And you are going to
be asked to vote in favor of bailing out (pick a small country)? What will the
voters who put you into office think?

We are going to
find out this year whether the European Union is like the Three Musketeers. Are
they “all for one and one for all?” or is it every country for
itself? My bet (or hope) is that it is the former. Dissolution at this point
would be devastating for all concerned, and for the world economy at large.
Many of us in the US don’t think much about Europe or the rest of the world,
but without a healthy Europe, much of our world trade would vanish.

However, getting
all the parties to agree on what to do will take some serious leadership, which
does not seem to be in evidence at this point. The US almost waited too long to
respond to our crisis, but we had the “luxury” of only needing to get
a few people to agree as to the nature of the problems (whether they were wrong
or right is beside the point). And we have a central bank that could act

As I understand
the European agreement, that situation does not exist in Europe. For the ECB to
print money as the US and the UK (and much of the non-EU developed world) will
do, takes agreement from all the member countries, and right now it appears the
German and Dutch governments are resisting such an idea.

As I write this
(on a plane on my way to Orlando) German finance minister Peer Steinbruck has
said it would be intolerable to let fellow EMU members fall victim to the
global financial crisis. “We have a number of countries in the eurozone
that are clearly getting into trouble on their payments,” he said.
“Ireland is in a very difficult situation.

euro-region treaties don’t foresee any help for insolvent states, but in
reality the others would have to rescue those running into difficulty.”

That is a hopeful
sign. Ireland is indeed in dire straits, and is particularly vulnerable as it
is going to have to spend a serious percentage of its GDP on bailing out its

It is not clear
how it will all play out. But there is real risk of Europe dragging the world
into a longer, darker night. Their banks not only have exposure to our US
foibles, much of which has already been written off, but now many banks will
have to contend with massive losses from emerging-market loans, which could be
even larger than the losses stemming from US problems. Plus, they are more
leveraged. (This was definitely a topic of “Conversation” this
morning when I chatted with Nouriel Roubini. See more below.)

The Euro Back to Parity? Really?

I wrote over six
years ago, when the euro was below $1, that I thought the euro would rise to
over $1.50 (it went even higher) and then back to parity in the middle of the
next decade. I thought the decline would be due to large European government
deficits brought about by pension and health care promises to retirees, and those
problems do still loom.

It may be that
the current problems will push the euro to parity much sooner, possibly this
year. While that will be nice if you want to vacation in Europe, it will have
serious side effects on international trade. It clearly makes European
exporters more competitive with the rest of the world, and especially the US.
It also means that goods coming from Asia will cost more in Europe, unless
Asian countries decide to devalue their currencies to maintain an ability to
sell into Europe, which of course will bring howls from the US about currency
manipulation. It is going to put pressure on governments to enact some form of
trade protectionism, which would be devastating to the world economy.

Large and swift currency
swings are inherently disruptive. We are seeing volatility in the currency
markets unlike anything I have witnessed. I hope we do not see a precipitous
fall in value of the euro. It will be good for no one. It is a strange world
indeed when the US is having such a deep series of problems, the Fed and
Treasury are talking about printing a few trillion here and a few trillion
there, and at the very same time we see the dollar AND gold rising in value.

Politicizing the Stabilization Plan

The Political Nature of the Economic Crisis

September 30, 2008 | 2115 GMT


By George Friedman

Classical economists like Adam Smith and David Ricardo referred to their
discipline as “political economy.” Smith’s great work, “The Wealth of Nations,”
was written by the man who held the chair in moral philosophy at the University
of Glasgow. This did not seem odd at the time and is not odd now. Economics is
not a freestanding discipline, regardless of how it is regarded today. It is a
discipline that can only be understood when linked to politics, since the wealth
of a nation rests on both these foundations, and it can best be understood by
someone who approaches it from a moral standpoint, since economics makes
significant assumptions about both human nature and proper behavior.

The modern penchant to regard economics as a discrete science parallels the
belief that economics is a distinct sphere of existence — at its best when it is
divorced from political and even moral considerations. Our view has always been
that the economy can only be understood and forecast in the context of politics,
and that the desire to separate the two derives from a moral teaching that Smith
would not embrace. Smith understood that the word “economy” without the
adjective “political” did not describe reality. We need to bear Smith in mind
when we try to understand the current crisis.

Societies have two sorts of financial crises. The first sort is so large it
overwhelms a society’s ability to overcome it, and the society sinks deeper into
dysfunction and poverty. In the second sort, the society has the resources to
manage the situation — albeit at a collective price. Societies that can manage
the crisis have two broad strategies. The first strategy is to allow the market
to solve the problem over time. The second strategy is to have the state
organize the resources of society to speed up the resolution. The market
solution is more efficient over time, producing better outcomes and disciplining
financial decision-making in the long run. But the market solution can create
massive collateral damage, such as high unemployment, on the way to the superior
resolution. The state-organized resolution creates inequities by not
sufficiently punishing poor economic decisions, and creates long-term
inefficiencies that are costly. But it has the virtue of being quicker and
mitigating collateral damage.

Three Views of the Financial Crisis

There is a first group that argues the current financial crisis already has outstripped available
social resources, so that there is no market or state solution. This group
asserts that the imbalances created in the financial markets are so vast that
the market solution must consist of an extended period of depression. Any
attempt by the state to appropriate social resources to solve the financial
imbalance not only will be ineffective, it will prolong the crisis even further,
although perhaps buying some minor alleviation up front. The thinking goes that
the financial crisis has been building for years and the economy can no longer
be protected from it, and that therefore an extended period of discipline and
austerity — beginning with severe economic dislocations — is inevitable. This is
not a majority view, but it is widespread; it opposes government action on the
grounds that the government will make a terrible situation worse.

A second group argues that the financial crisis has not outstripped the
ability of society — organized by the state — to manage, but that it has
outstripped the market’s ability to manage it. The financial markets have been
the problem, according to this view, and have created a massive liquidity
crisis. The economy — as distinct from the financial markets — is relatively
sound, but if the liquidity crisis is left unsolved, it will begin to affect the
economy as a whole. Since the financial markets are unable to solve the problem
in a time frame that will not dramatically affect the economy, the state must
mobilize resources to impose a solution on the financial markets, introducing
liquidity as the preface to any further solutions. This group believes, like the
first group, that the financial crisis could have profound economic
ramifications. But the second group also believes it is possible to contain the
consequences. This is the view of the Bush administration, the congressional leadership, the Federal Reserve Board and
most economic leaders.

There is a third group that argues that the state mobilization of resources to save the financial
is in fact an attempt to save financial institutions, including many
of those whose imprudence and avarice caused the current crisis. This group
divides in two. The first subgroup agrees the current financial crisis could
have profound economic consequences, but believes a solution exists that would
bring liquidity to the financial markets without rescuing the culpable. The
second subgroup argues that the threat to the economic system is overblown, and
that the financial crisis will correct itself without major state intervention
but with some limited implementation of new regulations.

The first group thus views the situation as beyond salvation, and certainly
rejects any political solution as incapable of addressing the issues from the
standpoint of magnitude or competence. This group is out of the political game
by its own rules, since for it the situation is beyond the ability of politics
to make a difference — except perhaps to make the situation worse.

The second group represents the establishment consensus, which is that the
markets cannot solve the problem but the federal government can — provided it
acts quickly and decisively enough.

The third group spoke Sept. 29, when a coalition of Democrats
and Republicans defeated the establishment proposal. For a myriad of reasons,
some contradictory, this group opposed the bailout. The reasons ranged from
moral outrage at protecting the interests of the perpetrators of this crisis to
distrust of a plan implemented by this presidential administration, from
distrust of the amount of power ceded the Treasury Department of any
administration to a feeling the problem could be managed. It was a diverse group
that focused on one premise — namely, that delay would not lead to economic catastrophe.

From Economic to Political Problem

The problem ceased to be an economic problem months ago. More precisely, the economic problem has transformed into a political problem.
Ever since the collapse of Bear Stearns, the primary actor in the drama
has been the federal government and the Federal Reserve, with its powers
increasing as the nature of potential market outcomes became more and more
unsettling. At a certain point, the size of the problem outstripped the
legislated resources of the Treasury and the Fed, so they went to Congress for
more power and money. This time, they were blocked.

It is useful to reflect on the nature of the crisis. It is a tale that can be
as complicated as you wish to make it, but it is in essence simple and elegant.
As interest rates declined in recent years, investors — particularly
conservative ones — sought to increase their return without giving up safety and
liquidity. They wanted something for nothing, and the market obliged. They were
given instruments ultimately based on mortgages on private homes. They therefore
had a very real asset base — a house — and therefore had collateral. The value
of homes historically had risen, and therefore the value of the assets appeared
secured. Financial instruments of increasing complexity eventually were devised,
which were bought by conservative investors. In due course, these instruments
were bought by less conservative investors, who used them as collateral for
borrowing money. They used this money to buy other instruments in a pyramiding
scheme that rested on one premise: the existence of houses whose value remained
stable or grew.

Unfortunately, housing prices declined. A period of uncertainty about the
value of the paper based on home mortgages followed. People claimed to be
confused as to what the real value of the paper was. In fact, they were not so
much confused as deceptive. They didn’t want to reveal that the value of the
paper had declined dramatically. At a certain point, the facts could no longer
be hidden, and vast amounts of value evaporated — taking with them not only the
vast pyramids of those who first created the instruments and then borrowed
heavily against them, but also the more conservative investors trying to put
their money in a secure space while squeezing out a few extra points of
interest. The decline in housing prices triggered massive losses of money in the
financial markets, as well as reluctance to lend based on uncertainty of values.
The result was a liquidity crisis, which simply meant that a lot of people had
gone broke and that those who still had money weren’t lending it — certainly not
to financial institutions.

The S&L Precedent

Such financial meltdowns based on shifts in real estate prices are not new.
In the 1970s, regulations on savings and loans (S&Ls) had changed.
Previously, S&Ls had been limited to lending in the consumer market,
primarily in mortgages for homes. But the regulations shifted, and they became
allowed to invest more broadly. The assets of these small banks, of which there
were thousands, were attractive in that they were a pool of cash available for
investment. The S&Ls subsequently went into commercial real estate,
sometimes with their old management, sometimes with new management who had
bought them, as their depositors no longer held them.

The infusion of money from the S&Ls drove up the price of commercial real
estate, which the institutions regarded as stable and conservative investments,
not unlike private homes. They did not take into account that their presence in
the market was driving up the price of commercial real estate irrationally,
however, or that commercial real estate prices fluctuate dramatically. As
commercial real estate values started to fall, the assets of the S&Ls
contracted until most failed. An entire sector of the financial system simply
imploded, crushing shareholders and threatening a massive liquidity crisis. By
the late 1980s, the entire sector had melted down, and in 1989 the federal
government intervened.

The federal government intervened in that crisis as it had in several crises
large and small since 1929. Using the resources at its disposal, the federal
government took over failed S&Ls and their real estate investments, creating
the Resolution Trust Corp. (RTC). The amount of assets acquired was about $394
billion dollars in 1989 — or 6.7 percent of gross domestic product (GDP) —
making it larger than the $700 billion dollars — or 5 percent of GDP — being
discussed now. Rather than flooding the markets with foreclosed commercial
property, creating havoc in the market and further destroying assets, the RTC
held the commercial properties off the market, maintaining their price
artificially. They then sold off the foreclosed properties in a multiyear
sequence that recovered much of what had been spent acquiring the properties.
More important, it prevented the decline in commercial real estate from
accelerating and creating liquidity crises throughout the entire economy.

Many of those involved in S&Ls were ruined. Others managed to use the RTC
system to recover real estate and to profit. Still others came in from the
outside and used the RTC system to build fortunes. The RTC is not something to
use as moral lesson for your children. But the RTC managed to prevent the
transformation of a financial crisis into an economic meltdown. It disrupted
market operations by introducing large amounts of federal money to bring
liquidity to the system, then used the ability of the federal government — not
shared by individuals — to hold on to properties. The disruption of the market’s
normal operations was designed to avoid a market outcome. By holding on to the
assets, the federal government was able to create an artificial market in real
estate, one in which supply was constrained by the government to manage the
value of commercial real estate. It did not work perfectly — far from it. But it
managed to avoid the most feared outcome, which was a depression.

There have been many other federal interventions in the markets, such as the
bailout of Chrysler in the 1970s or the intervention into failed Third World
bonds in the 1980s. Political interventions in the American (or global)
are hardly novel. They are used to control the consequences of
bad decisions in the marketplace. Though they introduce inefficiencies and
frequently reward foolish decisions, they achieve a single end: limiting the
economic consequences of these decisions on the economy as a whole. Good idea or
not, these interventions are institutionalized in American economic life and
culture. The ability of Americans to be shocked at the thought of bailouts is
interesting, since they are not all that rare, as judged historically.

The RTC showed the ability of federal resources — using taxpayer dollars — to control financial processes. In the end, the S&L story
was simply one of bad decisions resulting in a shortage of dollars. On top of a
vast economy, the U.S. government can mobilize large amounts of dollars as
needed. It therefore can redefine the market for money. It did so in 1989 during
the S&L crisis, and there was a general acceptance it would do so again
Sept. 29.

The RTC Model and the Road Ahead

As discussed above, the first group argues the current crisis is so large
that it is beyond the federal government’s ability to redefine. More precisely,
it would argue that the attempt at intervention would unleash other consequences
— such as weakening dollars and inflation — meaning the cure would be
worse than the disease. That may be the case this time, but it is difficult to
see why the consequences of this bailout would be profoundly different from the
RTC bailout — namely, a normal recession that would probably happen anyway.

The debate between the political leadership and those opposing its plan is
more interesting. The fundamental difference between the RTC and the current
bailout was institutional. Congress created a semi-independent agency operating
under guidelines to administer the S&L bailout. The proposal that was
defeated Sept. 29 would have given the secretary of the Treasury extraordinary
personal powers to dispense the money. Some also argued that the return on the
federal investment was unclear, whereas in the RTC case it was fairly clear. In
the end, all of this turned on the question of urgency. The establishment group
argued that time was running out and the financial crisis was about to morph
into an economic crisis. Those voting against the proposal argued there was
enough time to have a more defined solution.

There was obviously a more direct political dimension to all this. Elections
are just more than a month a way, and the seat of every U.S. representative is
in contest. The public is deeply distrustful of the establishment, and
particularly of the idea that the people who caused the crisis might benefit
from the bailout. The congressional opponents of the plan needed to demonstrate
sensitivity to public opinion. Having done so, if they force a redefinition of
the bailout plan, an additional 13 votes can likely be found to pass the

But the key issue is this: Are the resources of the United States sufficient
to redefine financial markets in such a way as to manage the outcome of this
crisis, or has the crisis become so large that even the resources of a $14
trillion economy mobilized by the state can’t do the job? If the latter is true,
then all other discussions are irrelevant. Events will take their course, and
nothing can be done. But if that is not true, that means that politics defines
the crisis, as it has other crisis. In that case, the federal government can
marshal the resources needed to redefine the markets and the key decision-makers
are not on Wall Street, but in Washington. Thus, when the chips are down, the
state trumps the markets.

All of this may not be desirable, efficient or wise, but as an empirical
fact, it is the way American society works and has worked for a long time. We
are seeing a case study in it — including the possibility the state will refuse
to act, creating an interesting and profound situation. This would allow the
market alone to define the outcome of the crisis. This has not been allowed in
extreme crises in 75 years, and we suspect this tradition of intervention will
not be broken now. The federal government will act in due course, and an
institutional resolution taking power from the Treasury and placing it in the equivalent of the RTC will emerge. The question is how
much time remains before massive damage is done to the economy.

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