By Candy Zeng
SHENZHEN, China - Enough is enough, even in China's tearaway stock markets, at least for one pioneering fund manager who has liquidated his firm's mainland assets and claimed ignorance of what is happening in the market there.
Some peers of Zhao Danyang, founder and general manager of Pure Heart Asset Management, have praised his decision; others say the Chinese markets are still in bull mode and there is plenty profit still to be made.
Fund-managed assets in the mainland swelled to more than 3 trillion yuan (US$416.7 billion) last year as the Shanghai Composite Index soared to its record high of more than 6,000 point in October. A fall to below 5,000 was followed by a year-end rally that ran through to January before the index continued its decline to about 4,383 yesterday.
The average return of open-ended stock investment funds was more than 100% last year, their gains helping to inspire tens of millions of Chinese investors to put their money in various funds.
Many market analysts and fund managers remain optimistic about the outlook of yuan-denominated A-share market this year and confident that fund investment can have another "golden year", despite recent turbulence. Some private funds have become more cautious and conservative, with Zhao leading the way in pulling out of the market in fear of a continued downturn.
Zhao, whose Pure Heart was an influential officially approved "private fund" management firm, announced the termination of business to liquidate five mainland funds under its management on January 2, 2008.
Zhao established a private securities investment fund to invest in the A-share market in 2004; it is believed to have been the first "sunny", or officially approved private fund, in the mainland. He was praised as the "godfather" of China’s private funds for his vision and legendary success in fund management when the market at the time was dominated by bears.
So his decision to liquidate all of his firms’s five mainland private funds right after the New Year was like a stone thrown into a quiet lake.
"We would rather miss an opportunity than blindly take a reckless move under whatever [market] circumstances,'' Zhao wrote in a letter to his clients before the liquidation. "To survive in each investment decision is always our priority."
Zhao predicted in 2005 that the Shanghai Composite would bottom out from 1,000 to a high plateau of 3,000 to 5,000 points in three to five years. He was absolutely right about the trend but wrong on the pace.The index climbed to 5,000 in just about one year.
From April 2004 to June 2005, when the Shanghai index plunged from 1,700 to 1,000, Zhao’s Pure Heart Fund I of A shares made an investment return of 25%. In Hong Kong, the Pure Heart Fund that continues there had gains of 500% by mid-January since its inception in 2003.
Zhao was becoming cautious when the Shanghai Composite reached 3,000 in early 2007 although he did set up two new funds at the beginning of last year. Both had achieved relatively mild returns of some 20% at the time of the liquidation. Meanwhile, the Shanghai stock index soared by 93% and most public funds invested heavily in A shares had revenue growth of more than 50%.
"So far, the A-share and H-share markets are beyond our understanding.” Zhao wrote in his letter, with H-shares referring to Hong Kong-listed mainland-related stocks. "The bottom and peak of the indexes are always a riddle. Now, we can’t find any proper investment targets which meet our investment criteria and have enough margin of safety as well."
He became the first manager to terminate active "sunny private funds" when the market was still considered a bull. In the investment fund circle, in particular in the eyes of his peers in private funds, he was regarded as a moral leader for his early retreat.
Li Chunyu, general secretary of Shenzhen Financial Consultant Association, said the termination of Pure Heart funds of A shares was sudden but not unexpected. "It is normal for a private fund to terminate when opportunities of investment vanishes. It happens almost every day in overseas markets."
Li consoled Chinese investors who were used to witnessing the opening of new funds in the bull market in an article addressing the liquidation of Pure Heart funds.
He praised Zhao for his honesty. "To be faithful is the cornerstone for the survival and growth of private funds. Zhao is honest with his clients about his understanding of the market and returned the money to them. Not every private fund manager has his courage, which is also a challenge to the public funds."
Liu Mingda, manager of Shenzhen Mingda Capital Management, said Zhao is a responsible person because otherwise he could still rein in management fees even if he continued running the funds at a loss.
Though admiring his bravery and accountability, most private fund managers are not as pessimistic as the prudential Zhao. New private fund products were launched one after another from December last year through trust companies. Shenzhen International Trust and Investment Co Ltd (SITIC) helped establish 13 such private funds in December. In the first week of 2008, a total of seven new private funds were being promoted through trust companies.
"There is a common saying that China will experience Ten Golden Years [of bullish markets],'' said Lin Yuan, manager of Lin Yuan Investment Management Company in a private fund promotion meeting sponsored by SITIC on January 27. "I believe we will have 15 golden years. We have cheap labor and growth no country can surpass."
Lin, a doctor-turned private fund manager, is a legendary speculator and investor himself. He is reported to have started with an investment of 8,000 yuan in stocks in 1989, building this to 400 million yuan by the end of 2005. Lin set up his first "sunny private fund" through SITIC in February 2007 and another two in September. By the end of last year, his first first fund had a return of investment of 60% and the other two less than 4%.
Various security investment funds in China were big winners in last year’s bull market.
Fund-managed assets jumped to 3 trillion yuan from 856 billion yuan at the end of 2006. The number of investors' accounts in security investment funds boomed to 90 million last year from 14 million in 2006.
The sunny private funds were generally out-performed by public stock funds last year. A recent private fund rating showed that 10 out of 53 private funds recorded 100% returns while half of public stock funds doubled their income last year. The average growth of net assets value of private funds was less than 40% in the first half of last year and 20% in the second half; both were only half the growth of public stock funds.
"The high yields [of public funds] are abnormal," Liu Mingda said in defense of his private fund peers in the recent promotion meeting. "Even Warren Buffett couldn’t do that. His average rate of return is some 30%. Our core target is to seek value investment in the long run."
He also attributed the comparatively lower yield rate of private funds to their different mechanisms. "Public fund managers care about attracting more investment and winning the race with the stock index; we care about gains from our investment. So that’s why we are more conservative."
Generally speaking, private funds mainly live on their 20% share of investment returns while open-ended funds can pretty much survive on management fees given their large pool of investors.
Pan Jiang, a Franklin Templeton Sealand Fund Management analyst, said the termination of Pure Heart served as an education on risk to investors.
"Private funds can liquidate themselves but open-end funds leave the choice [to redeem] open to investors. Maybe soon there will be open-end funds liquidated' by the markets," Pan was quoted as saying by a Chinese business newspaper.
Candy Zeng is a freelance journalist based in Shenzhen, China.
Friday, February 1, 2008
World chokes on bad spell on Wall St
By David Dapice
The recent meltdown in global stock markets is the first truly global financial crisis since the word "globalization" became widely used. While Latin America and Asia suffered in the 1990s, this crisis marks a wider, possibly deeper set of problems underlining how vulnerable the integrated world economy has become to failures in one part of the globe. What began as worry over tremors in the US mortgage market has become a full-blown confidence crisis.
The fundamental problem is that financial innovation in the United States has outpaced the ability of either private managers or public officials to monitor what's going on with the financial industry slicing and dicing loans to create ever-newer instruments that few understood. That complexity has tied the financial world in knots as it seeks a way out of the mess.
Broadly speaking, each part of the US financial system became fee-oriented and ignored basic rules of fiduciary responsibility. Mortgage companies originated new home loans - sub-prime mortgages and others - for a fee and promptly sold them. Banks bought, bundled, and then sliced and diced these mortgages into different risk classes, selling them to hedge funds and even central banks.
How risky was each part? The ratings agencies, paid by the banks that originated these bundles, looked only at recent default experience. Since real-estate values had been rising, any borrower in trouble could sell the property or refinance, so defaults were low and the bundles seemed safe enough for AAA ratings.
The buyers of these mortgage fragments relied upon the ratings agencies. This debt was safe, but only until property prices began to drop. Then the lack of underwriting standards - not even checking the income declared in some cases - began to matter.
If the problem were confined to sub-prime mortgages, it would be a serious but not overwhelming problem. However, many adjustable-rate mortgages, home-equity loans, second mortgages, credit-card debts, and even "regular" mortgages are also threatened. As property values fall, many borrowers find their debt is worth more than the property. At that point, it often makes sense to walk away from the property and let the bank foreclose. One reason for the panic is that nobody really knows how many millions of foreclosures there will be, how much these will depress real-estate values and thus render additional classes of debt suspect. Some observers expect that commercial-property and regular bank loans will also suffer as this process proceeds.
Many banks, confident about the loans, ended up holding some of the debt they originated or promised to take back debt if the buyer wanted to sell. Banks now have less equity capital relative to their loans, as needed to remain within financial standards. Until that's repaired, banks will likely be conservative in making loans. This problem is not solved by low interest rates, though they might ease the problem over time. With inflation at 4% and a weak dollar, it's not clear if the Federal Reserve can lower interest rates much below 3% without running risks. As of Tuesday, the Fed lowered the overnight rate on interbank lending to 3%, and now has little room to maneuver.
Each part of the US financial system became fee-oriented and ignored basic rules of fiduciary responsibility.
Fiscal policy in the United States is similarly hobbled. The Iraq war was "paid for" with tax cuts, following the neo-conservative wisdom that government deficits don't matter. Because debt to GDP has grown so much, the feasible amount of tax cuts is small, only about 1% of GDP. As housing and stock prices fall, the net worth of families declines and consumption drops. Since several trillion dollars of wealth are likely to evaporate and consumption is likely to fall by several hundred billion dollars, there's little faith in the $150 billion fiscal-stimulus package announced by the Bush administration.
In short, there's an ongoing massive decrease in both housing and financial wealth, aggravated by reduced bank lending, and limited ability of monetary or fiscal policy to respond. This explains why US markets are weak and many Americans - and some Wall Street investment banks - think a recession is already here.
But what about decoupling? Wasn't the rise of emerging market economies and growing trade among them supposed to reduce the world's reliance on the stressed US consumer? Several points explain the simultaneous movements in stock markets: First, many banks around the world bought these "collateralized mortgage obligations" issued by US banks. Several European banks have suffered billions of dollars in losses and may face further difficulties as other loan losses rise in a soft economy. This makes them more conservative.
Indeed, the European Central Bank has actually pumped in more liquidity than the Federal Reserve into shaky credit markets. As the euro has strengthened - a logical step as global central banks diversify out of dollars for reserve holdings - exports have come under pressure and imports have grown. Finally, several EU nations also had overheated real estate that has begun to cool. Overall, Europe finds it has diminished prospects for growth.
Japan was already weak with a negative quarter of gross domestic product - a broad measure of the economy in 2007. Most of its growth came from exports, which are now uncertain. Japanese consumers seem reluctant to spend, and business investment is muted as exports slow and population declines.
Australia and Canada had strong currencies driven by the commodity boom, now looking tired. They might escape if the "BRIC" story had remained intact and the large emerging economies of Brazil Russia, India and China continued to grow. However, the Chinese and Indian economies face issues of stock-market and real-estate bubbles, inflation, social unrest, and too-rapid credit expansion. They, too, are more fragile, and when money began to seek safety, they no longer seemed a safe haven.
Like the sorcerer's apprentice, we have created things we do not understand and cannot easily control.
So where is the world economy now? The optimists say that the real problem is panic, not reality. Growth may slow, but is intact. Even if the United States suffers a recession - and many predict it will not - the other parts of the world will continue to grow and by the end of 2008 the worst should be over with. The pessimists cover a broader range of outcomes, but believe that the financial fallout from bad debts could feed upon itself and become worse. Given the limited ability of fiscal and monetary policy, they see a much larger chance of a prolonged slowdown or even severe recession.
Given the complicated financial links among nations, it's not just a question of projecting a modest decline in exports for fast-growing nations like China. Rather, it's a matter of understanding how the world's economies are bound together in various ways and avoiding a self-fulfilling decline in investment due to conservative banks and diminished growth expectations.
A witty economist once said that stock-market declines had predicted nine of the last four recessions. The message is that a decline in stock prices need not predict future economic difficulties.
In this case, the complexity of the debt instruments may prevent countermeasures from effectively preventing a recession. In the "old days" of the 1990s, a local bank might have negotiated with a homeowner, reducing the mortgage payments and avoiding foreclosure. Without new legislation, this is difficult as the mortgages are owned by many parties; the payment collector does not own the mortgage and cannot easily negotiate with homeowners.
Other debt instruments are similarly complex, and it just may be that like the sorcerer's apprentice, we have created things we do not understand and cannot easily control. If that is the case, the stock markets may be telling us something correctly this time.
David Dapice is associate professor of economics at Tufts University.
The recent meltdown in global stock markets is the first truly global financial crisis since the word "globalization" became widely used. While Latin America and Asia suffered in the 1990s, this crisis marks a wider, possibly deeper set of problems underlining how vulnerable the integrated world economy has become to failures in one part of the globe. What began as worry over tremors in the US mortgage market has become a full-blown confidence crisis.
The fundamental problem is that financial innovation in the United States has outpaced the ability of either private managers or public officials to monitor what's going on with the financial industry slicing and dicing loans to create ever-newer instruments that few understood. That complexity has tied the financial world in knots as it seeks a way out of the mess.
Broadly speaking, each part of the US financial system became fee-oriented and ignored basic rules of fiduciary responsibility. Mortgage companies originated new home loans - sub-prime mortgages and others - for a fee and promptly sold them. Banks bought, bundled, and then sliced and diced these mortgages into different risk classes, selling them to hedge funds and even central banks.
How risky was each part? The ratings agencies, paid by the banks that originated these bundles, looked only at recent default experience. Since real-estate values had been rising, any borrower in trouble could sell the property or refinance, so defaults were low and the bundles seemed safe enough for AAA ratings.
The buyers of these mortgage fragments relied upon the ratings agencies. This debt was safe, but only until property prices began to drop. Then the lack of underwriting standards - not even checking the income declared in some cases - began to matter.
If the problem were confined to sub-prime mortgages, it would be a serious but not overwhelming problem. However, many adjustable-rate mortgages, home-equity loans, second mortgages, credit-card debts, and even "regular" mortgages are also threatened. As property values fall, many borrowers find their debt is worth more than the property. At that point, it often makes sense to walk away from the property and let the bank foreclose. One reason for the panic is that nobody really knows how many millions of foreclosures there will be, how much these will depress real-estate values and thus render additional classes of debt suspect. Some observers expect that commercial-property and regular bank loans will also suffer as this process proceeds.
Many banks, confident about the loans, ended up holding some of the debt they originated or promised to take back debt if the buyer wanted to sell. Banks now have less equity capital relative to their loans, as needed to remain within financial standards. Until that's repaired, banks will likely be conservative in making loans. This problem is not solved by low interest rates, though they might ease the problem over time. With inflation at 4% and a weak dollar, it's not clear if the Federal Reserve can lower interest rates much below 3% without running risks. As of Tuesday, the Fed lowered the overnight rate on interbank lending to 3%, and now has little room to maneuver.
Each part of the US financial system became fee-oriented and ignored basic rules of fiduciary responsibility.
Fiscal policy in the United States is similarly hobbled. The Iraq war was "paid for" with tax cuts, following the neo-conservative wisdom that government deficits don't matter. Because debt to GDP has grown so much, the feasible amount of tax cuts is small, only about 1% of GDP. As housing and stock prices fall, the net worth of families declines and consumption drops. Since several trillion dollars of wealth are likely to evaporate and consumption is likely to fall by several hundred billion dollars, there's little faith in the $150 billion fiscal-stimulus package announced by the Bush administration.
In short, there's an ongoing massive decrease in both housing and financial wealth, aggravated by reduced bank lending, and limited ability of monetary or fiscal policy to respond. This explains why US markets are weak and many Americans - and some Wall Street investment banks - think a recession is already here.
But what about decoupling? Wasn't the rise of emerging market economies and growing trade among them supposed to reduce the world's reliance on the stressed US consumer? Several points explain the simultaneous movements in stock markets: First, many banks around the world bought these "collateralized mortgage obligations" issued by US banks. Several European banks have suffered billions of dollars in losses and may face further difficulties as other loan losses rise in a soft economy. This makes them more conservative.
Indeed, the European Central Bank has actually pumped in more liquidity than the Federal Reserve into shaky credit markets. As the euro has strengthened - a logical step as global central banks diversify out of dollars for reserve holdings - exports have come under pressure and imports have grown. Finally, several EU nations also had overheated real estate that has begun to cool. Overall, Europe finds it has diminished prospects for growth.
Japan was already weak with a negative quarter of gross domestic product - a broad measure of the economy in 2007. Most of its growth came from exports, which are now uncertain. Japanese consumers seem reluctant to spend, and business investment is muted as exports slow and population declines.
Australia and Canada had strong currencies driven by the commodity boom, now looking tired. They might escape if the "BRIC" story had remained intact and the large emerging economies of Brazil Russia, India and China continued to grow. However, the Chinese and Indian economies face issues of stock-market and real-estate bubbles, inflation, social unrest, and too-rapid credit expansion. They, too, are more fragile, and when money began to seek safety, they no longer seemed a safe haven.
Like the sorcerer's apprentice, we have created things we do not understand and cannot easily control.
So where is the world economy now? The optimists say that the real problem is panic, not reality. Growth may slow, but is intact. Even if the United States suffers a recession - and many predict it will not - the other parts of the world will continue to grow and by the end of 2008 the worst should be over with. The pessimists cover a broader range of outcomes, but believe that the financial fallout from bad debts could feed upon itself and become worse. Given the limited ability of fiscal and monetary policy, they see a much larger chance of a prolonged slowdown or even severe recession.
Given the complicated financial links among nations, it's not just a question of projecting a modest decline in exports for fast-growing nations like China. Rather, it's a matter of understanding how the world's economies are bound together in various ways and avoiding a self-fulfilling decline in investment due to conservative banks and diminished growth expectations.
A witty economist once said that stock-market declines had predicted nine of the last four recessions. The message is that a decline in stock prices need not predict future economic difficulties.
In this case, the complexity of the debt instruments may prevent countermeasures from effectively preventing a recession. In the "old days" of the 1990s, a local bank might have negotiated with a homeowner, reducing the mortgage payments and avoiding foreclosure. Without new legislation, this is difficult as the mortgages are owned by many parties; the payment collector does not own the mortgage and cannot easily negotiate with homeowners.
Other debt instruments are similarly complex, and it just may be that like the sorcerer's apprentice, we have created things we do not understand and cannot easily control. If that is the case, the stock markets may be telling us something correctly this time.
David Dapice is associate professor of economics at Tufts University.
Bernanke hits the joy button
By Julian Delasantellis
In the hospital with my fractured foot this month, I was introduced to the medical miracle called Patient Controlled Anesthesia (PCA). Basically, PCA describes a container of pain medication attached to the intravenous line, controlled by the patient himself through a thumb switch. The doctor would set an upper limit of analgesia I could self administer per given time period, after which, no matter how many times you pressed your joy button, nothing would come out. I do not believe that the creators of PCA should receive a nomination for the Nobel Prize in Medicine, for the Nobel Peace Prize seems much more appropriate.
And now we have US Federal Reserve chairman Ben Bernanke, whaling away at his joy button, rapidly approaching his upper limit.
For the sixth time since last August, and, more amazingly, for the second time in nine days, the US Federal Reserve has decreed another sharp cut in short-term interest rates, this time twin 50 point cuts of the Discount Rate, to 3.5%, and the Federal Funds Target Rate, to 3%. Less than one month into the new year, the Fed has already engineered a quantity of interest rate easings, 125 points, that only the most optimistic of Fed observers predicted for the whole year.
I remember that after the great equity market crash of 1987, a floor trader was asked about how long the selling could last. Well, he said, the market lost 22% of its value that day, so, at the maximum, this could only last a bit over three more days.
Just as stock prices can't move below zero, there is an implicit floor past which short-term interest rates can't be lowered, and the United States is currently falling towards that level like a piano thrown out of a skyscraper.
At the most basic level, interest rates are simply the price of money, the added remuneration a borrower must pay to someone else, the lender, to convince him that its worth his while to defer some consumption for the period of time which is the term of the loan.
As national macroeconomic managers have realized since at least the time of Hammurabi (and that was thousands of years ago), interest rate levels are key control tools for a national economy. Interest rates that are too high, like any high price, tend to depress and inhibit demand; in the case of investment, their high costs inhibit otherwise profitable investments that with lower rates would have been made.
Children at a toy store learn quickly about how unpleasant it is when things are priced too high, but, for an economy as a whole, it's just as bad or worse when things are priced too low.
Every once in a while, a radio station, say, Hot Oldies 97.5, will do a promo and have gasoline sold at 97.5 US cents for a few hours; the lines of cars around the block demonstrate the manner in which low prices stimulate demand.
In the case of money, its price, its interest rate, serves to interpret and implement a market economy's desires as to what projects will or will not receive investment. Too low interest rates, and investments get made that would not, and probably should not. As the manhunt for the perpetrators of the subprime crisis develops and intensifies, many are pointing fingers at former Federal Reserve chairman Alan Greenspan, for dropping and holding the Federal Funds Target Rate to 1% from mid-2003 to mid-2004.
By lowering the price of investment capital to near zero, this is said to have spurred the tremendous overinvestment in the US housing sector. The massive wave of condominium and single-family residence construction that followed defined the froth of the 2004-06 housing mania, and, as many of these projects now sit empty, boarded up and in foreclosure, their very presence signifies the waste of society's scarce capital that went to build them, not to mention the devastated fortunes and futures of those who owned or lent to them.
But what if the Fed lowers interest rates to the cellar, and still you don't get a spur in investment and economic growth? That has been the experience of Japan for coming on 15 years now. In September 1995, in response to the collapse of the "bubble economy", the massive overinvestment in Japanese stocks and real estate, (that sounds familiar, doesn't it?) the Bank of Japan lowered its discount rate to under 1%, where it has been ever since. (It sat at an unbelievably low 0.1% from late 2001 until last year.)
Still, the response, in terms of Japanese economic growth during this period, has been, at the most, lackluster. This has been due to capital flight and the fact that low interest rates may be a very ineffective policy implement in dealing with economic slowdowns arising out of crises from an over-leveraged financial sector.
That, too, sounds familiar, doesn't it?
One danger of rapid Federal Reserve easings down towards 1% that doesn't get as much attention as it should is the psychological effect.
An economy in crisis is like a building afire. If it's your building, nothing sounds more reassuring than the wails of the fire engines as they wind their way through the streets to you. Likewise, as the economic news grows ever-more grim (as illustrated by the shockingly low 0.6% growth rate, barely above that which signifies the onset of recession, for the US economy reported Wednesday on morning) business and investors will expect, and receive hope from, more help from the Fed in the future.
If the Fed continues to cut at a rate of 125 points a month, all possible help will be exhausted before spring; a little slower rate of easings does essentially the same by mid-summer.
It is a near certainty that there will still be more grim economic news (such as the bad news with the bond insurers that pricked the brief bubble of the stock market rally that followed on the Fed decision) hitting the markets by the time the simple mathematical fact that you can't cut interest rates beyond zero completes the Fed's actions.
Far from providing soothing and immediate relief, central bank interest rate moves act with a substantial delay, a time lag, as they work their way through the economy. This time lag can be at least six months to sometimes as much as two years. Thus, as the Fed commenced the current easing rate cycle during last August's financial crises, the economy was still feeling the contractionary effects of the interest rate hike cycle that finished in June, 2006. It will probably not be until early to mid-2009 that America will see any positive effects from this current wave of easings - assuming that the economy does not settle into a Japan-style contraction seemingly impervious to monetary management.
A common complaint regarding US monetary policy over the past two decades or so is that, with the wisdom of 20-20 hindsight, the last move of any interest rate change cycle is always a mistake.
Greenspan's Fed was cutting rates (to support the flagging re-election prospects of George H W Bush, perhaps?) almost right up to the election of 1992; later it would be discovered that the economy was in full recovery almost a year earlier. Greenspan was also still raising rates well into 2000, as the economy was starting to deflate from the popping of the dot-com stock bubble. More recently, Greenspan's last cut of 2003 stoked the housing bubble, which Bernanke's final hike of 2006 definitively killed off.
So, if Bernanke drives rates to 1% or lower, will it be seen by the beginning of the next decade as the chief contributing factor to the development of another ultimately destructive boom-bust cycle in the economy? With the current doleful experience with real estate and the subprimes still a very malodorous sensation in the nostrils of high finance, the next bubble will likely not be in housing; in this month Harper's, Eric Janszen suggests that loans to the renewable energy equipment and infrastructure sector might be the next financial crises that will be the inevitable result of a free market uber alles government ethic that regulates personal pet ownership more stringently than it does its financial markets.
Greenspan dealt with the time lag problem of monetary policy with the slow and steady approach; most of his rate moves were no greater than 25 basis points at a time. In that way, even if the Fed was doing what later would come to be seen as damage by cutting or raising one too many times, at least the damage might be contained.
Bernanke seems to have eschewed this approach; of his now six interest rate easings, four, the August 17 discount rate cut, the twin September 18 discount and Federal Funds rates cuts, and both of this month's cuts, have been 50 points or greater. This is the case even with many still potentially troubling indicators of future rising prices. These include a falling US dollar, and both high energy prices and sharply rising import prices presenting a very real argument that inflation continues to be a real threat to the US economy.
But like a young man who vows to be not like his father but soon finds out that the vicissitudes of adulthood have him making the exact same life choices as his progenitor, in one way Bernanke now finds himself walking in pere Greenspan's shoes.
As I explained in October (Reaping what is sown, Asia Times Online, October 6, 2007), in a review of Greenspan's autobiography The Age of Turbulence, Greenspan was always quick to cut short-term interest rates in times of crisis or panic in the financial markets; eventually, it came to be seen that his Fed was reacting to the markets, rather than the other way around.
With the current cut cycle commenced last autumn, Bernanke seemed to be going out of his way to impress on the markets his desire that his Federal Reserve would follow a new course, that it would not be led around by the markets. I explained last November (Bernanke: Don't take me for granted, boys, Asia Times Online, November 2, 2007, and Playing 'chicken' with the markets, Asia Times Online, November 17, 2007) I explained how he seemed to be indicating to the markets that, in the future, interest rate hikes, and especially cuts, would now be more closely aligned to changes in standard macroeconomic variables, such as the outlook for inflation or unemployment. Markets may rise or fall as may be, but it's not really a proper concern for a central bank.
Then came the stock market declines of November and the past few weeks. Suddenly, there Bernanke is, a chip off the old block, taking after his old da, cutting rates in reaction to market panic. The first line in the explanatory statement that followed the announcement of these cuts was: "Financial markets remain under considerable stress, and credit has tightened further for some businesses and households."
But not only is the current Fed cutting in the face of the financial market's "considerable stress", they're turbo-cutting, cutting fast, frequently, substantially, even, as in both last August and last week, in between meetings.
In a little-noticed speech from January 11, Federal Reserve governor and believed Bernanke Fed board ally Frederic S Mishkin described the new, pedal to the metal Fed-cutting paradigm.
Policymakers should be prepared for decisive action in response to financial disruptions. In such circumstances, the most likely outcome - referred to as the modal forecast - for the economy may be fairly benign, but there may be a significant risk of more severe adverse outcomes. In such circumstances, the central bank may prefer to take out insurance by easing the stance of policy further than if the distribution of probable outcomes were perceived as fairly symmetric around the modal forecast.
In English, this ain't your father's Federal Reserve anymore. We're gonna cut and cut (as illustrated by new market predictions of further interest rate cuts for next month and beyond), and the monetary policy time lag be dammed; if we overshoot and a new boom-bust cycle develops, well ...
As in the old Chinese proverb and curse goes - may you live in interesting times.
Why does the Fed do it - why do they keep cutting rates on the markets' command instead of waiting for the time lag to cut in? As I wrote last summer as the cries for Fed easings began to mount, the current structure of the socio-political and socio-economic power nexuses of America reacts with absolute outrage to falling stock prices.
Poor children can snack on lead paint chips in schools redolent of overflowing sewerage, and through the night ambulances can crisscross the streets of America's great metropolises looking for emergency rooms that will accept a patient in cardiac arrest without health insurance, but if stocks go down, the panic buttons really get pushed, especially with a newsmedia so longing to report the stories that the critical upper-income demographic finds interesting and appealing.
But as the quick selloff that followed the latest rate easing proved, the path of least resistance in US, and most likely global, stocks still is down, and, at this rate, there soon will be little or nothing that the Bernanke Fed can do about it.
A common scenario of US television advertisements features an adult son turning to his father for advice; if Bernanke is soon forced to turn to Papa Greenspan for such wisdom, the scene should also probably include the mobs of rampaging upper-income stock investors, perhaps armed with pricey pitchforks freshly purchased from that oh so chic Restoration Hardware, all baying for his blood.
Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.
In the hospital with my fractured foot this month, I was introduced to the medical miracle called Patient Controlled Anesthesia (PCA). Basically, PCA describes a container of pain medication attached to the intravenous line, controlled by the patient himself through a thumb switch. The doctor would set an upper limit of analgesia I could self administer per given time period, after which, no matter how many times you pressed your joy button, nothing would come out. I do not believe that the creators of PCA should receive a nomination for the Nobel Prize in Medicine, for the Nobel Peace Prize seems much more appropriate.
And now we have US Federal Reserve chairman Ben Bernanke, whaling away at his joy button, rapidly approaching his upper limit.
For the sixth time since last August, and, more amazingly, for the second time in nine days, the US Federal Reserve has decreed another sharp cut in short-term interest rates, this time twin 50 point cuts of the Discount Rate, to 3.5%, and the Federal Funds Target Rate, to 3%. Less than one month into the new year, the Fed has already engineered a quantity of interest rate easings, 125 points, that only the most optimistic of Fed observers predicted for the whole year.
I remember that after the great equity market crash of 1987, a floor trader was asked about how long the selling could last. Well, he said, the market lost 22% of its value that day, so, at the maximum, this could only last a bit over three more days.
Just as stock prices can't move below zero, there is an implicit floor past which short-term interest rates can't be lowered, and the United States is currently falling towards that level like a piano thrown out of a skyscraper.
At the most basic level, interest rates are simply the price of money, the added remuneration a borrower must pay to someone else, the lender, to convince him that its worth his while to defer some consumption for the period of time which is the term of the loan.
As national macroeconomic managers have realized since at least the time of Hammurabi (and that was thousands of years ago), interest rate levels are key control tools for a national economy. Interest rates that are too high, like any high price, tend to depress and inhibit demand; in the case of investment, their high costs inhibit otherwise profitable investments that with lower rates would have been made.
Children at a toy store learn quickly about how unpleasant it is when things are priced too high, but, for an economy as a whole, it's just as bad or worse when things are priced too low.
Every once in a while, a radio station, say, Hot Oldies 97.5, will do a promo and have gasoline sold at 97.5 US cents for a few hours; the lines of cars around the block demonstrate the manner in which low prices stimulate demand.
In the case of money, its price, its interest rate, serves to interpret and implement a market economy's desires as to what projects will or will not receive investment. Too low interest rates, and investments get made that would not, and probably should not. As the manhunt for the perpetrators of the subprime crisis develops and intensifies, many are pointing fingers at former Federal Reserve chairman Alan Greenspan, for dropping and holding the Federal Funds Target Rate to 1% from mid-2003 to mid-2004.
By lowering the price of investment capital to near zero, this is said to have spurred the tremendous overinvestment in the US housing sector. The massive wave of condominium and single-family residence construction that followed defined the froth of the 2004-06 housing mania, and, as many of these projects now sit empty, boarded up and in foreclosure, their very presence signifies the waste of society's scarce capital that went to build them, not to mention the devastated fortunes and futures of those who owned or lent to them.
But what if the Fed lowers interest rates to the cellar, and still you don't get a spur in investment and economic growth? That has been the experience of Japan for coming on 15 years now. In September 1995, in response to the collapse of the "bubble economy", the massive overinvestment in Japanese stocks and real estate, (that sounds familiar, doesn't it?) the Bank of Japan lowered its discount rate to under 1%, where it has been ever since. (It sat at an unbelievably low 0.1% from late 2001 until last year.)
Still, the response, in terms of Japanese economic growth during this period, has been, at the most, lackluster. This has been due to capital flight and the fact that low interest rates may be a very ineffective policy implement in dealing with economic slowdowns arising out of crises from an over-leveraged financial sector.
That, too, sounds familiar, doesn't it?
One danger of rapid Federal Reserve easings down towards 1% that doesn't get as much attention as it should is the psychological effect.
An economy in crisis is like a building afire. If it's your building, nothing sounds more reassuring than the wails of the fire engines as they wind their way through the streets to you. Likewise, as the economic news grows ever-more grim (as illustrated by the shockingly low 0.6% growth rate, barely above that which signifies the onset of recession, for the US economy reported Wednesday on morning) business and investors will expect, and receive hope from, more help from the Fed in the future.
If the Fed continues to cut at a rate of 125 points a month, all possible help will be exhausted before spring; a little slower rate of easings does essentially the same by mid-summer.
It is a near certainty that there will still be more grim economic news (such as the bad news with the bond insurers that pricked the brief bubble of the stock market rally that followed on the Fed decision) hitting the markets by the time the simple mathematical fact that you can't cut interest rates beyond zero completes the Fed's actions.
Far from providing soothing and immediate relief, central bank interest rate moves act with a substantial delay, a time lag, as they work their way through the economy. This time lag can be at least six months to sometimes as much as two years. Thus, as the Fed commenced the current easing rate cycle during last August's financial crises, the economy was still feeling the contractionary effects of the interest rate hike cycle that finished in June, 2006. It will probably not be until early to mid-2009 that America will see any positive effects from this current wave of easings - assuming that the economy does not settle into a Japan-style contraction seemingly impervious to monetary management.
A common complaint regarding US monetary policy over the past two decades or so is that, with the wisdom of 20-20 hindsight, the last move of any interest rate change cycle is always a mistake.
Greenspan's Fed was cutting rates (to support the flagging re-election prospects of George H W Bush, perhaps?) almost right up to the election of 1992; later it would be discovered that the economy was in full recovery almost a year earlier. Greenspan was also still raising rates well into 2000, as the economy was starting to deflate from the popping of the dot-com stock bubble. More recently, Greenspan's last cut of 2003 stoked the housing bubble, which Bernanke's final hike of 2006 definitively killed off.
So, if Bernanke drives rates to 1% or lower, will it be seen by the beginning of the next decade as the chief contributing factor to the development of another ultimately destructive boom-bust cycle in the economy? With the current doleful experience with real estate and the subprimes still a very malodorous sensation in the nostrils of high finance, the next bubble will likely not be in housing; in this month Harper's, Eric Janszen suggests that loans to the renewable energy equipment and infrastructure sector might be the next financial crises that will be the inevitable result of a free market uber alles government ethic that regulates personal pet ownership more stringently than it does its financial markets.
Greenspan dealt with the time lag problem of monetary policy with the slow and steady approach; most of his rate moves were no greater than 25 basis points at a time. In that way, even if the Fed was doing what later would come to be seen as damage by cutting or raising one too many times, at least the damage might be contained.
Bernanke seems to have eschewed this approach; of his now six interest rate easings, four, the August 17 discount rate cut, the twin September 18 discount and Federal Funds rates cuts, and both of this month's cuts, have been 50 points or greater. This is the case even with many still potentially troubling indicators of future rising prices. These include a falling US dollar, and both high energy prices and sharply rising import prices presenting a very real argument that inflation continues to be a real threat to the US economy.
But like a young man who vows to be not like his father but soon finds out that the vicissitudes of adulthood have him making the exact same life choices as his progenitor, in one way Bernanke now finds himself walking in pere Greenspan's shoes.
As I explained in October (Reaping what is sown, Asia Times Online, October 6, 2007), in a review of Greenspan's autobiography The Age of Turbulence, Greenspan was always quick to cut short-term interest rates in times of crisis or panic in the financial markets; eventually, it came to be seen that his Fed was reacting to the markets, rather than the other way around.
With the current cut cycle commenced last autumn, Bernanke seemed to be going out of his way to impress on the markets his desire that his Federal Reserve would follow a new course, that it would not be led around by the markets. I explained last November (Bernanke: Don't take me for granted, boys, Asia Times Online, November 2, 2007, and Playing 'chicken' with the markets, Asia Times Online, November 17, 2007) I explained how he seemed to be indicating to the markets that, in the future, interest rate hikes, and especially cuts, would now be more closely aligned to changes in standard macroeconomic variables, such as the outlook for inflation or unemployment. Markets may rise or fall as may be, but it's not really a proper concern for a central bank.
Then came the stock market declines of November and the past few weeks. Suddenly, there Bernanke is, a chip off the old block, taking after his old da, cutting rates in reaction to market panic. The first line in the explanatory statement that followed the announcement of these cuts was: "Financial markets remain under considerable stress, and credit has tightened further for some businesses and households."
But not only is the current Fed cutting in the face of the financial market's "considerable stress", they're turbo-cutting, cutting fast, frequently, substantially, even, as in both last August and last week, in between meetings.
In a little-noticed speech from January 11, Federal Reserve governor and believed Bernanke Fed board ally Frederic S Mishkin described the new, pedal to the metal Fed-cutting paradigm.
Policymakers should be prepared for decisive action in response to financial disruptions. In such circumstances, the most likely outcome - referred to as the modal forecast - for the economy may be fairly benign, but there may be a significant risk of more severe adverse outcomes. In such circumstances, the central bank may prefer to take out insurance by easing the stance of policy further than if the distribution of probable outcomes were perceived as fairly symmetric around the modal forecast.
In English, this ain't your father's Federal Reserve anymore. We're gonna cut and cut (as illustrated by new market predictions of further interest rate cuts for next month and beyond), and the monetary policy time lag be dammed; if we overshoot and a new boom-bust cycle develops, well ...
As in the old Chinese proverb and curse goes - may you live in interesting times.
Why does the Fed do it - why do they keep cutting rates on the markets' command instead of waiting for the time lag to cut in? As I wrote last summer as the cries for Fed easings began to mount, the current structure of the socio-political and socio-economic power nexuses of America reacts with absolute outrage to falling stock prices.
Poor children can snack on lead paint chips in schools redolent of overflowing sewerage, and through the night ambulances can crisscross the streets of America's great metropolises looking for emergency rooms that will accept a patient in cardiac arrest without health insurance, but if stocks go down, the panic buttons really get pushed, especially with a newsmedia so longing to report the stories that the critical upper-income demographic finds interesting and appealing.
But as the quick selloff that followed the latest rate easing proved, the path of least resistance in US, and most likely global, stocks still is down, and, at this rate, there soon will be little or nothing that the Bernanke Fed can do about it.
A common scenario of US television advertisements features an adult son turning to his father for advice; if Bernanke is soon forced to turn to Papa Greenspan for such wisdom, the scene should also probably include the mobs of rampaging upper-income stock investors, perhaps armed with pricey pitchforks freshly purchased from that oh so chic Restoration Hardware, all baying for his blood.
Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.
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