Things Got Bad and Things Got Worse

It's Friday, October 31st, and things just got worse for Senator McCain.  In the major tracking polls, he has not been over 45% for three weeks, and over the last three days, while his assault on Senator Obama has intensified, he has not budged in the polls.  At a time when he needed a breakthrough, he has been mired in his own mud and stuck in place.

Mr. McCain goes into the campaign's final weekend a bigger underdog than any victorious candidate in a modern election.  And with the economic news consistently going against him, it doesn't look good.

A Bloomberg article frames the facts: "With four days until Election Day, national polls show his Democratic rival Barack Obama leading by an average of 6 percentage points, and battleground polls show Obama ahead in more than enough states to win the decisive 270 Electoral College votes.

'There will not be a comeback curmudgeon by the name of John McCain,'' Kenneth Duberstein, who served as a chief of staff for President Ronald Reagan, said on Bloomberg Television's ``Conversations with Judy Woodruff,'' which will air later today. ``I think it's going to be Barack Obama. And I think it is going to be somewhere between 320 and 350 electoral votes.' "

Polls have been wrong before, of course, but modern polling has consistently gotten better.  And with the advantage as high as it is for Mr. Obama, there appears to be little hope for the Senator from Arizona.

If the election goes as it looks, with not only Mr. Obama taking the Presidency, but also with expanded majorities in the House and Senate, then the new administration will at least begin next year with a mandate to make some major changes.  If there has been one theme in this election that has worked, it has been that of change.  Almost 90% of Americans believe the U.S. is on the wrong track, so they appear to be ready for a change.

My hope, if Mr. Obama wins, is that the change will get us back on track and allow America to recover its place as a world leader, not only in military might and economic strength, but in moral leadership as well.  I am not convinced that Americans have abandoned their commitments to democracy, equality and fairness--those qualities that have served as a beacon of hope to the rest of the world during my lifetime.  This leadership has been squandered over the last decade by corrupt and foolish political and business leaders.  It's asking a lot of a single election to correct this huge a problem, but my hope is that it will at least start to reverse the process that has gotten us into this mess.

3rd Quarter GDP Goes Negative

We now have confirmation that the U.S. is beginning a recession.  Reuters reports: >

The economy shrank at a 0.3 percent annual rate in the third quarter, its sharpest contraction in seven years as consumers cut spending and businesses reduced investment in the face of rising fears that recession was setting in.

The Commerce Department said the third-quarter contraction in gross domestic product was the steepest since the corresponding quarter in 2001 though it was slightly less than the 0.5 percent rate of reduction that Wall Street economists surveyed by Reuters had forecast.>

The culprit was what all of us expected: consumer spending, which has propped up GDP growth for the last few years, finally succumbed to higher oil prices, lower home prices, and the shut-off of the second mortgage spigot that had fueled the borrowing binge of the last few years.

>Consumer spending, which fuels two-thirds of economic growth, fell at a 3.1 percent rate in the third quarter — the first cut in quarterly spending since the closing quarter of 1991 and the biggest since the second quarter of 1980. Spending on nondurable goods — items like food and paper products — dropped at the sharpest rate since late 1950.

Continuing job losses coupled with declining gains from stocks and other investments have put consumers under severe stress. The report showed that disposable personal income dropped at an 8.7 percent rate in the third quarter — the steepest since quarterly records on this component were started in 1947 — after rising 11.9 percent in the second quarter when most of economic stimulus payments still were flowing.

Consumers cut spending on durable goods like cars and furniture at a 14.1 percent annual rate in the third quarter, the biggest cut in this category of spending since the beginning of 1987. Car dealers have said that sales have virtually stalled, in part because tight credit makes it hard for even creditworthy buyers to get loans.<

These are not good numbers, and point to a protracted downturn.  If there is some kind of symmetry in business cycles, then the seven years of credit boom would be followed by seven years of credit bust.  I hope it won't be that way, and there will certainly be efforts by our political establishment to crank out another stimulus package, soon.  There is already one on the table in Congress, and it is hard to see that it will not be passed.

The statistical evidence that stimulus works is quite high, so that is good news.  The economy desperately needs a shot in the arm.  But, whether it will be enough to turn things around and stay turned around, is another question.  It is unlikely to be large enough to make a miracle, and that is what is needed for now.  But it looks as if there could be several quarters of decline, putting the recovery at or beyond June of 2009.  And that's the best outlook. It may be even worse, but I think there will be a Herculean effort from our new president to shorten the cycle once he takes office in late January.

Effects of Another Stimulus Package

Looks like we're in for another round of fiscal stimulus. (Does stimulus come in rounds? Just asking...) Anyway, Menzie Chinn at the venerable Econobrowser blog revisits Mark Z.'s Congressional testimony from last summer, wherein he rated the relative oomph of various legislative stimuli. (Also available in this Dismal Scientist article .)

Chinn avers:

Onebig caveat to the argument for infrastructure spending is that it usually takes a long time to plan such projects. Hence, it is not clear when the spending for such projects would actually occur, and hence the stimulus to the economy (this is called an outside policy lag, in the jargon). The "one-year horizon" shown in the table is for the horizon of one year from beginning of spending, not the beginning of planning and appropriation.

I have two observations here. First, if the spending could be directed to the states which had construction about to start, but hindered by financing or state revenue issues, then the problem of timing could be partly mitigated. I admit that it is unlikely that there are a tremendous number of such projects (although I am happy to be corrected). That leads me to my second observation.

The CBO study Options for Responding to Short-Term Economic Weakness (January 2008) laid out three principles for effective stimulus, loosely characterized as "timely, targetted, and temporary". Spending on infrastructure is problematic on this first count if one believes the recession will be short. If one believes that it will be prolonged (in the now outdated lingo, "L-shaped" instead of "V-shaped"), then this drawback is not so significant.

Rise of Japanese Yen May Bring Retaliation

From the NY Times: <Currency market traders were keeping nervous watch for central bank intervention, after Group of 7 finance and monetary officials expressed concern about the recent excessive volatility in the yen’s exchange rates.

“We are concerned about the recent excessive volatility in the exchange rate of the yen and its possible adverse implications for economic and financial stability,” the G-7 statement said. “We continue to monitor markets closely and cooperate as appropriate.”>

If intervention were carried out, central bankers would likely sell yen for other currencies, driving down the yen and providing support to other currencies.

Although I am bullish on the yen over a long period, it does look as if its rise in value has been to fast for too long, so be prepared for a downturn of some duration.

<Shoichi Nakagawa, the Japanese finance minister, said he was watching the currency market with great interest. His comments were read in the market as a warning of possible intervention in the currency markets. The yen’s appreciation to alarming heights against other key currencies, to the detriment of exporters, who are seeing their international competitiveness eroded as a result. >

If this program is carried out, look for the exchange traded fund, UUP, to rise dramatically.  This ETF is long on the U.S. dollar and short on the yen and other developed market currencies.  A dramatic fall in the yen plays into this short position.

However, in a late development: French Finance Minister Christine Lagarde said the Group of Seven nations doesn't plan to intervene to sell the yen after warning today against the currency's ``excessive volatility.''

``The yen has over the past 48 hours seen brutal trading that reflects a great volatility that's linked to current market moves,'' Lagarde said in an interview with Bloomberg News in Montpellier, France. ``We wished to support this possible intervention of Japanese authorities knowing this would be about a purely Japanese intervention.''

Asked specifically if the G-7 would intervene to sell the yen, after it rose to its highest in almost 13 years against the dollar, Lagarde said ``no.''

Japan, however, will probably enter the market to keep the rise in check. This may be enough to satisfy the G7 members, and allow them to keep out of the market.

Opportunity in the Currency Market Turmoil

If you think that the American equities markets have been hit hard lately, take a look at some of the emerging markets. The graph below charts the last six months of the Dow Jones Industrial Average, the iShares ETF, EEM, which tracks emerging markets around the world, and EWY, the South Korean ETF from iShares. Many emerging markets have fallen 60% or more over this period. 

Their currencies have also taken a significant hit. The chart below shows the U.S. dollar as measured against developed market currencies over the same period, with EEM and JEM, a basket of emerging market currencies in Asia, Latin America, Europe, the Middle East and Africa.

While the currency hit has been only about a 25% loss, it is about a 45% difference with the U.S. dollar. Also shown are the Mexican peso (FXM) and the Brazilian real (BZF), to show how similar the currency drops have been for all emerging markets. However you look at it, it has been a grim picture.

There are a couple of driving forces that explain the reaction of investors. The first is that everyone is concerned that the slowdown in America and European economies will disproportional affect emerging markets, since the western nations buy much of all EM goods. During a downturn, demand for many of the goodies the EM countries produce will fall, and their export trade, which largely drives their economies, will falter.

A second reason is an extension of this phenomenon. Hedge Funds have been particularly large investors in the EM economies over the last decade. And, their investments have covered the complete range of securities: currency holdings, equities investments and their sovereign debt. But, now that the party is over, the Hedge funds are having to pony up on margin. This leads them to dump much, if not all, they bought. This is exacerbating the downturn, just when it is hurts the most. Isn’t that always how it goes?

During this huge sell-off, two currencies have become safe haven plays: the U.S. dollar and the Japanese yen. The number one and two economies in the world, regardless of how bad it looks, are still the safest places to put one’s confidence—or at least that is what the financial markets around the world are telling us.

This concentration of trends does, however, bring with it a potential upside.

• Given the serious decline in currency prices in the emerging markets, and
• Given that most all of them have financed much of their expansion of export production capacity with debt, and
•   Given that much of that debt is owed to the U.S., Japan and western Europe,
• Therefore, the banks and Treasuries of all the lending countries are getting antsy about being repaid.

Debt repayment by the EM countries is partially impaired by their falling economies. That is to be expected, because economic downturns are always expected after a period of rapid expansion. But, the problem is made much worse by the fact that their currencies are falling at the same time. Much of the debt they owe is denominated in dollars, so they now have a double whammy to face. Their revenues are falling because of their shrinking production, and their currencies are depreciating at the same time that the U.S. dollar and yen are increasing. Now, they have twice to three times as much problem in repaying their debt.

Lenders are quite upset. But, the lenders (large banks) have the ears of their respective governments, and no one in any government want more bad news to capture the headlines of the financial pages. They are working as hard as they can to contain the carnage that has already been unleashed. If they add defaults of some of the major EM countries to the list, it would set off a new round of tumbling confidence and stock prices.

Therefore, there is a move afoot to help the EM countries by a coordinated effort of the developed nations to enter the foreign exchange markets and buy EM currencies—helping prop them up, at least until things settle down a bit. If this rescue effort comes about, then look for EM currencies to have a good bump. ETNs such as JEM would benefit, as would individual currencies such as Brazil, Mexico, South Africa, Russia, etc..

This is far from a done deal, and any monies put into this type of speculation would be an usual risk. The deal may not come off, and their currencies could continue their decline. If there is intervention, then I would take a short term view of the improvements in currency prices, and have a strong idea of when to get out. For those with a strong risk appetite, this may be a good place to look.

I'm still bullish on the Dollar (UUP) and the Yen (FXY), and I consider these currency plays to be much less risky than betting on an intervention in the EM currencies.

Economic Outlook is Dismal

Housing Market

The number of homeowners ensnared in the foreclosure crisis grew by more than 70 percent in the third quarter of this year compared with the same period in 2007, according to data released Thursday.
Nationwide, nearly 766,000 homes received at least one foreclosure-related notice from July through September, up 71 percent from a year earlier, said foreclosure listing service RealtyTrac Inc.

By the end of the year, RealtyTrac expects more than a million bank-owned properties to have piled up on the market, representing around a third of all properties for sale in the U.S.

Six states — California, Florida, Arizona, Ohio, Michigan and Nevada — accounted for more than 60 percent of all foreclosure activity in the quarter, with California alone making up more than a quarter of all U.S. foreclosure filings.

Last month, foreclosure resales accounted for more than half of existing home sales in California last month, as home sales jumped 65 percent from a year ago, while the statewide median home price fell 34 percent to $283,000, according to MDA DataQuick.

Alan Greenspan's Testimony (From NY Times)

Alan Greenspan, the former Federal Reserve chairman, said Thursday that the current financial crisis had uncovered a flaw in how the free market system works that had shocked him.

Mr. Greenspan told the House Oversight Committee on Thursday that his belief that banks would be more prudent in their lending practices because of the need to protect their stockholders had proved to be wrong.

Mr. Greenspan said he had made a “mistake” in believing that banks operating in their self-interest would be enough to protect their shareholders and the equity in their institutions.

Mr. Greenspan said that he had found “a flaw in the model that I perceived is the critical functioning structure that defines how the world works.”

China's Growth in Question

BEIJING — For three decades, China has fueled its remarkable economic rise by becoming the world’s workshop and unleashing a flood of low-priced exports. But faced with a possible global recession and weakening demand for Chinese exports, the question now is whether the ruling Communist Party can prevent the financial crisis from derailing the country’s economic miracle.

This question is pressing not just for China but also for the rest of the world. American officials and many economists say continued Chinese growth is vital to the global economy as the United States and Europe face severe downturns.

Yet to navigate the crisis, many analysts say, China will need to recalibrate its economic model, stoke domestic investment with heavy government spending and promote policies to increase consumer demand in a nation known for high savings rates.

At the geopolitical level, China would seem well positioned to expand its influence. It sits on $1.9 trillion in foreign exchange reserves, accumulated from giant trade surpluses and heavy foreign investment in China, and it could acquire discounted stakes in Western banks and industrial companies.

But for now, most analysts say China’s top priority is protecting its own economy. Chinese leaders say the domestic financial system is largely insulated from the global crisis — China’s banks remain domestically focused and have relatively small exposure to toxic securities sold by American and European banks. But economic growth has fallen to the lowest level in five years, unemployment is a growing concern, and scores of factories are closing in the country’s export region. Domestic stock exchanges have lost 65 percent of their value, and real estate sales have plummeted.

China still seems likely to avoid an outright recession, but a significantly slower growth would pose a political challenge for the Communist Party, which derives much of its legitimacy from delivering jobs and increasing wealth. Conventional wisdom holds that China’s output must grow at a minimum of 8 percent for the economy to produce enough jobs to absorb increases in the working-age population, and many economists expect growth to drop below that level next year.

Housing Starts Hurting

Back and Forth on Housing Starts

Economic hard times inspire two contradictory responses. One is to simply to want it to stop hurting. The other is to want the system purged and cleansed, at whatever up-front cost. The two are not mutually exclusive; indeed it's quite common to wish for each in turn, or even simoultaneously. But they point in opposite directions, and underly pretty much all the debate we're hearing among economists, policymakers and talk-show guests—such as this one .

Sorting them out, however, is necessary before you can intepret news such as today's about U.S. homebuilding. From Aaron Smith:

Builders slashed housing starts and residential building permits in September to their lowest level since early 1991 as they worked to realign supply and demand. Housing starts dropped 6.3% to an annual rate of 817,000 units, and permits fell 8.3% to an annualized pace of 786,000 units. The rate of decline in homebuilding has clearly intensified: Housing starts over the past three months have contracted at a 68.3% annualized rate, the worst such reading since March 1980.

You can see this as disastrous, an economic train wreck. All those lost housing jobs, all that idle investment in land, lumber and equipment. The ripple effects—on employment, retail sales, overall growth—will be severe. Somebody—like maybe a presidential candidate?—should propose a plan to boost housing construction and save the economy.

Or not. As Aaron also writes:

Although significant progress has been made in lowering the supply of new homes to a level more consistent with the current low demand, we think further cutbacks in homebuilding will be forthcoming to more quickly draw down inventories.

Progress? Yes. Remember that what ails the economy—the financial side of it, at least—stems from the plunge in house prices that followed the end of the recent bubble. Rising defaults, underwater mortgages, frozen securities markets and the global banking crisis all began there. Any recovery, therefore, depends on house prices stabilizing. But house prices can't stabilize if builders keep pumping inventory into an already glutted market. Something's got to give. And the faster and deeper it gives, the sooner we can begin to climb out of this hole.

Let me amend that. The faster and deeper it gives, up to a certain point. That being the point at which all those lost construction jobs and all that idle investment is enough to sink demand for new houses, so that even as prices plummet and "affordability" rises in some technical sense, it still doesn't revive the economy.

At which point we abandon all talk about system-cleansing, and just hope someone can make it stop hurting.

Andrew Cassel in West Chester on October 17 at 11:45 AM 

Small Men in Big Jobs

October 11, 2008
I don’t know if the market turmoil of last week marks the end of the financial crisis. But I do know that the crisis has changed the very nature of financial markets for far into the future. All over the world, the “hands off” approach to financial markets is being abandoned as quickly as it was adopted decades ago. The hype and certainty of the “let the markets be markets” mentality is now recognized as silly and irresponsible, as the life savings of millions of innocent investors have been wiped out or severely reduced, and the world’s financial system teeters under threat of collapse. An orgy of irresponsible risk-taking by our financial and political leaders has shown them to be small men in big jobs.

We now find ourselves in a strange, upside down universe, where the lead role of socializing the financial system in America is being led by a President who just weeks ago was touting the benefits of deregulation and singing the praises of neglectful capitalism. All the followers of the Reagan Revolution, it seems, are now counter-revolutionaries, looking in every quadrant for targets of their finger pointing—everywhere but where it belongs—right at themselves.

Fortunately, the American people, while fooled then, aren’t now. We get it that our welfare is too important to abandon to the greedy gyrations of unfettered financial markets. We knew it in the 1930’s, but, after decades of successful regulation, we forgot what got us there.

We need to turn the corner, and, if the polls are correct, voters will set this straight in a few weeks. There will be pain ahead, but we will recover. Americans can rise to the occasion, and the occasion is now.

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