Friday, February 29, 2008

New Numbers Confirm Inflationary Recession (Stagflation)

Recently, just about every number have all confirmed the stagflation scenario I have predicted. This includes jobless claims, the producer price index, durable goods orders, new and existing home sales. Not to mention of course the market movements with a rapid decline in the dollar combined with soaring commodity prices

Yesterday's GDP report indicated that the headline volume growth number stayed unchanged at +0.6%, and the terms of trade adjusted real growth number also stayed unchanged at -0.6%. Domestic demand was revised down but so was the trade deficit, leaving production unrevised.

However,other revisions were clearly bearish. Inflation was revised up with both the GDP deflator and the domestic demand deflator being revised up with 0.1% point each while the Personal Consumption Expenditure deflator was upwardly revised by 0.2%:points. Meanwhile, disposable income was revised down even in nominal terms and much more so in real terms.

Today we got the monthly breakdown on that downward revision, with most of it coming in November and December. Real disposable income rose slightly in January, but this was entirely a result of temporary factors such as expired options and other bonuses. Despite these factors, real disposable income remains 0.2% below the September peak, confirming the beginning of a recession during the fourth quarter of 2007. This is likely to become even clearer after these numbers have gone through the annual revision in late July. These revisions always result in a downward revision of real growth and an upward revision of inflation. For example, the real growth rate for 2004 was initially reported as 4.4% while the GDP deflator was reported to rise 2.1%. After the 2007 annual revision it was said that growth was only 3.6% while the GDP deflator is said to have risen 2.9%.

With consumer price inflation soaring and nominal income growth likely remaining slow, this implies that real income will likely fall faster in coming month (also in February, the removal of the temporary factors that boosted the January number will also contribute to a deeper monthly decline. And with the savings rate being negative and asset prices falling, this will also imply a decline in personal consumption which in turn will contibute to faster declines in terms of trade adjusted real GDP.

Wednesday, February 27, 2008

Euro Rises Above US$1.50

While most professional forecasters have called for the dollar to rise, I have argued the opposite and called for the dollar to continue its decline, and more specifically fall against the euro so that one euro will cost more than $1.50.

Well, today the euro did indeed rise above the key $1.50 level.

The background for this is that U.S. dollar fundamentals are simply terrible. Helicopter Bernanke and his colleagues are debasing the value of the dollar at a very rapid pace in order to bail out a few failed Wall Street bankers. Meanehile the real economy is rapidly deteriorating, interest rates are lower than elsewhere even as America remains a large capital importer. There's something very wrong and unsound when a capital importer provides lower return on capital than elsewhere.

Yet, the currency market have for weeks been in denial about this, dreaming up fantasies about ECB rate cuts unlikely to occur (Inflation is rising in the euro area and is well above the ECB target. And while the ECB is inflationist they aren't fully as crazy as the Fed) and even in the unlikely event that they did occur would anyway be much lower than Fed rate cuts. Some analysts have even taken the failure of the dollar to fall significantly after the Fed rate cuts in late January as a bullish sign for the dollar. I would argue that it is a case of denial about fundamentals. But while markets are driven by sentiment in the short-term, fundamentals tend to catch up eventually. This is what has begun to happen in recent days, and which will continue during coming months. The euro will therefore likely rise to at least $1.55.

Tuesday, February 26, 2008

The Cloud Cuckoo Land Of Donald Kohn

Report after report are now confirming the arrival of what I've been predicting during the latest year, namely a recession in America combined with higher price inflation i.e. stagflation.

Stagflation is of course mainly the result of Fed policy. Fed policy have caused too much of productive resources to be devoted to malinvestments, particularly in the housing sector, which have caused a negative supply shock as more and more productive capacity is no longer demanded. Moreover, the gradual decline in the savings rate in America has also caused productive capacity to decline also creating negative supply effects. And last but not least, as the Fed again tries to revive the economy by more inflation it finds that this have only a limited effect on asset prices -which is to day, while it have probably limited the drop in house and stock prices,it haven't been able to induce them to actually rise, unlike the development in 2001 when they managed to get house prices to rise rapidly- and instead it have mainly had the effect of boosting commodity prices, which is now causing even the distorted government price indexes to accelerate in their rate of increase.

So how do Fed vice chairman Donald Kohn respond to this development? Well, in short by asserting the absurd. He asserts that the Fed, the institution that pushed America into recession and is now causing price inflation to surge will:

"do what is needed to help growth and keep consumer prices stable"

And just how will you do that, vice Chairman Kohn? I know how you created the opposite development that we are now seeing -see above-, but just what do you plan to do to promote sound growth? Do you plan on abolishing your institution, or at the very least stop inflating?

Similarly, he later dismiss the notion of stagflation by saying it won't happen because

"The situation in the 1970s was much more difficult than anything we are facing now.It was more difficult because in large measure there was a buildup of inflation over a long period, since the mid-'60s on,''

In retrospect, everybody who studied this period agrees that if this process had been cut off earlier it would have been a lot less painful than it was. That is a lesson that everybody on the Federal Open Market Committee understands."

As if Greenspan hadn't been building up inflation for a long time...
But what is clear given the current response of aggresive interest rate cuts in a period of stagflation is that the current FOMC certainly haven't learned the lesson to limit the damage at an early stage. Instead, while maybe reducing the severity of the downturn in the coming months it will certainly create an even greater and much more painful downturn later on.

Monday, February 25, 2008

South African Electricity Regulation-Another Cause Of High Gold Prices

The main reason of the dramatic recent surge in the price of gold and other commodities is the one I mentioned in the previous post-namely the inflationary policies of the Fed.

There are however other factors at work here. In the case of gold that means regulation of the price of electricity in one of the biggest producers of gold-South Africa. Compared to the nightmare of Zimbabwe, South Africa is relatively well-run. However, that says a lot more about Zimbabwe than about South Africa. The South African government has pursued many disastrous policies, including an inability to deal with the extremely high violent crime rate, affirmative action policies and price regulations in many areas-including electricity.

The South African government regulates the price of electricity and holds it down at very low levels compared to most other countries. As tends to be the case in all price ceilings, this have deterred or disabled both private investors and the government-owned power company Eskom from expanding capacity, something which is now causing massive shortages.

This massive electricity shortage in South Africa is now forcing many gold mining companies to reduce their output. This will help raise the gold price for as long as this power crisis continues. If and when it goes away, this temporary effect will go away, but it will during 2008 provide further support for the price of gold.

Saturday, February 23, 2008

Cause And Effect

It is hard to believe that it was only 22 days ago that I reported that the commodity price index called the CRB Futures index for the first time ever rose above the key 500-level. Yesterday it closed at 546.32, up 9% in just 22 days. The CRB spot index has also risen sharply, up 6.3% to 466.69.

And The Economist's commodity price index is up 8.5% during these 3 weeks, to 252.2.

What has caused this amazing commodity price bull market? In part, it reflects the structural commodity shortage that Jim Rogers discussed in his book Hot Commodities. But as I pointed out in my review of that book, it is also a result of the Fed's inflationary policies. If you look at money supply data for the last few weeks, you can see that MZM and even M2 have sharply accelerated in growth during the last four weeks. During the last few weeks of 2007, growth in these monetary aggregates had slowed down considerably from the rapid pace of August-September, but the Fed's dramatic rate cuts of January 22 and 30 have helped kick-start them again.

M2 is up 1.87% during the latest 4 weeks, while MZM (which is M2 minus time deposits and plus institutional money funds) is up 3.37% in the latest 4 weeks. It is not a coincidence that the sharp acceleration of the commodity price boom of the last few weeks was preceded by a sharp acceleration of money supply growth.

Wednesday, February 20, 2008

Yuan Rise Above 14 U.S. Cents

Sometimes when I talk about currency changes, it may seem confusing. For example when I talk about how the yuan rises in value and specifically says it rose from say 7.37 to 7.22 to the U.S. dollar, which may seem confusing as the number stated is falling while I write the value is rising. The explanation is of course that the number I refer to is how many yuan it takes to buy a U.S. dollar on the foreign exchange market, and so if the yuan rises in value it means it should take a lower number of yuan to buy a U.S. dollar. Even so, I can see how it may seem confusing to some.

One way to make it clearer would be to quote the inverted exchange rate, i.e. how many dollars -or more correctly cents- it takes to buy a yuan. Then the rise in the yuan's value would be more obvious, as for example the above mentioned increase in the yuan's value from 7.37 yuan per dollar to 7.22 yuan per dollar would be expressed as an increase in the value of the yuan from 13.57 cents to 13.85 cents.

If one were to express the yuan's value that way,then today it rose through a key psychological threshold. For the first in recent years, a yuan is worth more than 14 cents, or to put it another way 100 yuan is for the first time in recent years worth more than 14 dollars. In the normal way of expressing this exchange rate, this means that the exchange rate rose from 7.1485 yuan per dollar yesterday to 7.1425 yuan per dollar.

As I reported a month ago, the Chinese central bank has clearly increased the rate of appreciation in recent months. At that time, I reported it had risen 2.1% in a month, since then only slightly more than a month has passed and the yuan is up an additional 1.15%.

The reason for this is that the Chinese leaders are increasingly realizing the madness of subsidizing exports at the cost of a inflationary spiral at home, which is increasingly clear after the Fed's agressive rate cuts. What the threats from Senator Schumer and the arm twisting of Hank Paulsson couldn't achive in terms of getting the Chinese to accelerate the rate of yuan appreciation, Bernanke now seems to have achieved by pursuing a monetary policy so inflationary that the quasi-peg that the Chinese had have become unsustainable. That the Chinese are accelerating the pace of yuan appreciation is good for the Chinese economy-but not so good for the American economy (at least not in the short-term).

Only Shocking To Those Who Listen To Bad Economists

Financial markets are shocked over the new numbers showing inflation is getting worse in America. The consumer price index have increased 1.7% in three months, translating into an annual rate of 7%. I mean, didn't the Fed and all the Keynesian economists (plus Shostak-Austrians like Mike Shedlock and the "libertarian" Cato Institute's Fed fan club) all tell them that inflation would fall? Yes, they did, and they were all wrong. I, on the other hand, along with a handful others, including Jim Rogers, Peter Schiff and Antony Mueller have been predicting that inflation would get worse, and we have been proven right.

Now these same Keynesians who thought inflation would be falling by now, are again assuring us that inflation will fall back again. But I can tell you right now what is going to happen. Inflation won't fall, it's going to get even worse. The latest numbers that spooked the markets only reflect to a very small extent the effects of the recent commodity price surge for three reasons that I elaborated on here. But at least one and likely two of these factors will soon disappear, causing particularly food prices to rise at a much faster pace. And with oil prices again reaching $100 per barrel and with the price of Chinese imports rising faster and faster, energy price- and "core" price inflation will also accelerate.

Tuesday, February 19, 2008

Odd Interpretation Of Swedish Inflation Report

The Swedish inflation report showed lower inflation than analysts and the Riksbank had expected, which now causes bank economists to say the Riksbank won't raise rates anymore.

But didn't these bank economists read the actual report, and especially the fine print of it? Had they bothered to that they would have seen that the entire deviation of 0.3 percentage points and in fact an additional 0.2 percentage points from the forecasts was caused by a technical factor, namely that the Swedish statistical bureau had revised the weights of the bundle of goods and services used to calculate consumer price inflation. Excluding that , inflation was in fact 0.2% higher than the forecasts. One would have thought that people hired as economists by major commercial banks would bother to actually read the report they comment on, but apparently not.

Whether or not the Riksbank will raise interest rates again is uncertain. But it can't be ruled out with inflationary pressures growing and commodity prices going through the roof. And it is certainly a lot more likely than the rate cut these bank economists forecast.

Jim Rogers Kicks Ass

So what's new, you might ask. Jim Rogers has been kicking ass and taking names for decades. Well, there's nothing new about it, but it is still worthwhile to enjoy each additional time he does it. Here he does in this interview. I recommend you to read the entire interview, but I will here quote one of the things he said about Bernanke.

"We know now he doesn’t even know about economics. I mean, he’s got a PhD in economics and he was a professor of economics, but he doesn’t have a clue about economics.

I will quote you – I hate to quote you, but one more time - I was watching him testify before congress and I almost fell out of my chair. He said under oath, so we presume he wasn’t lying, that he was just a fool, he said if an American only buys American products, it does not matter to him if the value of the U.S. dollar goes down. He will not be affected. I was looking at the man to see if he was lying, giving government propaganda, but then I could see he didn’t even really understand.

He didn’t understand if, you know, even if say I’m an American, Lindsay, and I only buy American tires. Well if the price of foreign tires goes up, obviously the price of American tires are going to go up too. Plus, if the dollar goes down, the price of rubber’s going to go higher, etcetera, etcetera, etcetera.

So the man doesn’t even understand economics. He’s going to print money. He’s going to throw money out the window. The dollar’s going to go down further and further and further. Inflation’s going to get worse and worse and worse throughout the world – the world, not just America - and we’re going to have a worse recession in the end."

Sunday, February 17, 2008

Krugman Doesn't Quite Get It

This blog post by Paul Krugman starts of fairly good, by illustrating one of the imbalances of the U.S. economy by comparing the share of GDP going to various forms of demand in 2007 and the average for 1980 to 2000. Even last year, when residential investment was plunging it was actually still above the 1980 to 2000 average, illustrating just how massive the bubble really was. By contrast business investment, although increasing compared to 2006 was smaller than the 1980 to 2000 average.

But the big difference lies in how consumer spending had a much higher share of GDP, while net exports had deteriorated sharply. From this Krugman concludes that America needs to reduce consumption and increase net exports, but he seems unable to come up with any idea of how this is to be achieved in any way different from the current fiscal and monetary policies.

But what he fails to grasp is that the current policies aim at preventing this adjustment. Both the fiscal stimulus and the aggressive Fed rate cuts is intended to boost consumer spending and thus prevent the necessary adjustment. While the falling dollar will indeed help bring about this, this is more than offset by the demand boosting effects of the rate cuts and the fiscal stimulus. And in any case, the falling dollar will help achieve this correction of imbalances by reducing the purchasing power of American consumers.

What Krugman doesn't realize -or doesn't want to realize- is that it is simply not possible to keep consumer spending and business investments going and at the same time dramatically reduce the trade deficit. In order to eliminate the imbalances you're going to have to accept a recession. A deep recession in this case. No pain, no gain, in other words. Krugman the Keynesian may not like that, but it is nevertheless an objective fact.

Saturday, February 16, 2008

Two Interesting Economist Articles

This week offered not just one, but two interesting Economist-articles. One is about how the growth of domestic demand is accelarating in China, which is very good for China, and which also increases its chance of successfully "decoupling" from the U.S. recession and instead re-structure its production to satisfying domestic rather than American demand.

The other is yet another demonstration of the insanity and irrationality of EU farm policy. The production caps that it imposes on milk production now means that the EU will lose market share as demand for dairy products increases from China and elsewhere, while EU consumers at the same time will have to pay a lot more for milk, cheese and other dairy products. A lose-lose policy in all aspects, in other words. EU seem to be an organization solely devoted to impoverishing the vast majority of Europeans.

The Ugly Choice Facing America

Now that the presidential race in America has in effect been narrowed down to Hillary Clinton, Barack Hussein Obama and John McCain this means that whoever wins, the world loses. More or less a Kang vs. Kodos election. If you haven't read it already do read Ilana Mercer's excellent column The Hillary, Hussein, McCain Axis of Evil.

Do also read Larry Kudlow's column about the enourmous expansion of the state planned by Obama. Although some of this can be financed by withdrawing from Iraq -If he really keeps that promise-, that is nowhere near enough. And with the Democrats likely increasing their congressional majority these proposals are likely to pass, which means higher taxes and higher deficits. And Hillary is likely no better than Obama. McCain is much better on domestic spending, but that will largely be negated by the fact that he wants to keep the troops in Iraq indefinetly and also provide a "Marshall plan" for Iraq, and also extend the neoconservative democracy crusade mission to even more places.

Friday, February 15, 2008

How Asia Could Actually Benefit From U.S. Recession

The popular view is that the economies of China and the rest of Asia is dependent on exporting to America, and so they will suffer greatly from a American recession. But the truth is that there is no basis for that view. Apart from some short-term adjustment costs, there is no basis for believing that Asians would suffer from shifting their economy from exports to domestic demand. Indeed, there is every reason to believe they would benefit from it, as they and not the Americans would enjoy the fruits of their hard work.

As it is now, the Asians are basically getting screwed by the Americans. America get their goods and services and Asians get useless government bonds in return, bonds who have negative real returns, meaning that America in effect gets away with not paying much of the bill. I have previously written extensively about how much China loses by in effect subsidizing exports by holding down the value of the yuan.

I re-read an old Peter Schiff column about the subject which I have actually linked to before. It provides an excellent analogy of why Asia would actually benefit from falling exports to America by pointing to how America benefited from the end of World War II despite the fact that the U.S. economy in 1944 were seemingly completely dependent on military spending. But this overlooked first of all how resources could be shifted to producing consumer goods rather than weapons and secondly that military spending isn't a positive good for people (At best, it is something which helps a country avoid something even worse). Similarly, Asian countries could and should shift their production to domestic purposes and similarly exports do not provide any direct benefits for them. At best it helps them earn future benefits, but even that is to a large extent dubious considering how America inflates/devalues away much of the value of their debt. So, just like America benefited from the ending its "dependence" on military spending so would Asia benefit from ending its "dependence" on exports to America.

"During the Second World War, America’s industrial might was concentrated on supplying the war effort. We had ten million men under arms spread across three continents, our ships patrolled the Atlantic and Pacific and our bombers blackened the skies. Factories that had previously produced passenger cars, sewing machines, and farm equipment had been retooled to make fighter planes, jeeps, tanks, rifles, bullets, artillery shells, destroyers, aircraft carriers, submarines, uniforms, helmets, boots, mess kits, and military radios.

At the time we were a very busy nation. Our factories were in operation 24/7, and more people than ever before were working, including legions of women previously absent from the workforce.

Given this full-throttled activity, economists of that time period may have argued that America should never have stormed the beaches at Normandy or Iwo Jima. After all, if the War ended, a disaster would befall America’s wartime economy. Millions of soldiers and factory workers would lose their jobs and corporate profits would collapse as there would have been no more demand for all the weapons and military equipment they were producing. As victory abroad would surely bring recession at home, the war needed to be waged indefinitely.

As ridiculous as this argument sounds, it is exactly what most believe the Chinese should do today, as in reality their export driven economy is basically no different from America’s wartime economy in 1944.

During the War, American consumers did not receive any direct economic benefit from their hard work and economic activity. In fact, they sacrificed greatly. Because factories were producing military goods, consumer goods were in short supply. In addition, scores of common staples, such as butter, nylons and gasoline, had to be rationed, so that they or the resources needed to produce them, would be readily available for the military. Similarly, Chinese citizens now produce export goods from which they themselves derive no direct economic benefit. In effect, consumer goods are rationed in China so as to make them readably available in America.

However, when World War II ended, American factories didn’t shut down, they merely retuned to consumer goods production. Soldiers didn’t lose their jobs; they merely put their labor to more productive uses. Instead of being wasted on a war (which unfortunately had to be fought), resources were applied to civilian purposes, leading to a post-war economic boom.

The same would apply in China today. As Americans once sacrificed to defeat the Nazis and Imperial Japan, the Chinese now sacrifice merely to support the purchasing power of Americans. If China allowed the dollar to decline against the yuan, American purchasing power would by definition be transferred to the Chinese. In China, factors of production would therefore be reallocated as they were during post-war America. Factories would retool and labor would seek more productive employment. Instead of wasting scarce resources producing goods to export, China would instead produce goods for domestic consumption.

The time has come for China, and the rest of Asia for that matter, to redirect its vast resources to raising the standard of living of its own people rather than to propping up the living standards of Americans. As soon as the Chinese stop producing goods for Americans they can finally begin producing more for themselves.

It’s time for China to declare peace. Unfortunately, as Americans are the principal profiteers in China’s war, we stand to lose the most when it ends. So while peace means China’s days of sacrifice, rationing, and under-consumption will soon end, it means America’s are about to begin."

Thursday, February 14, 2008

European Growth Holds Up Fairly Well

Eurostat today published preliminary figures for economic growth that were stronger than most analysts had expected. The euro area saw a quarterly growth of 0.4%, or 1.6% in the American way of expressing growth (quarterly change at an annualized rate). Both Germany and France saw a significant deceleration in growth, but this was to some extent counteracted by stronger growth in Holland and Spain. The EU as a whole saw even faster growth, at 0.5% thanks to 0.6% growth in the U.K. and a whopping 3.1% growth in Slovakia (which would translate into an annual rate of 13%). This is of course related to Slovakia's 19% flat tax policy.

So far, there is thus no real evidence of a "recoupling", where the European economy is dragged down into a recession by the American recession. Yes, the service sector purchasing manager index was weak in January, but while this statistic is not meaningless, it certainly isn't conclusive considering how it does no weighting for the size of the firms and how big the changes in activity is. And since most other indicators still indicate moderate but still positive growth in Europe, decoupling remains the most likely scenario. Europe's dependence on the U.S. economy is in fact very small, so there is simply no way that the scenario popular in the media, where falling European exports to America will cause a European recession can come true. Some parts of Europe with overheated housing markets, meaning the U.K., Ireland, the Baltics and Spain will likely face some domestic problems and the widespread fear factor in financial markets over the effects on Europe of the U.S. recession could create a self-fulfilling prophecy to that extent. But in most of Europe, the fundamentals are in fact improving, meaning that Europe should be able to decouple from the U.S. recession.

Wednesday, February 13, 2008

The Riksbank's Rate Hike-Unexpected But Justified

I must admit to being as surprised by the Riksbank's interest rate hike today as was all other analysts. While one member of the Riksbank board, Lars Nyberg, had warned that the market's expectations of future interest rates was too low, it seemed unlikely to imply a rate hike because it seemed that this statement was meant to refer to the expectations of interest rate cuts later this year.

However, unlike most other analysts I think the decision was basically justified. Money supply growth remains high and consumer price inflation have steadily risen and seemed certain to rise above the Riksbank's target of 2%, even excluding the effects of previous rate hikes and increased consumption taxes (on tobacco and diesel/gasoline) in view of the high money supply growth, the high union wage deals and the global commodity price boom. Moreover, there are strong indications that this have caused inflationary expectations to rise, as Riksbank chairman Stefan Ingves points out.

To do as the ECB, to hold interest rates unchanged or as the Federal Reserve cut them dramatic would have been highly irresponsible and would have meant that they would have violated their task of holding consumer price inflation at 2%. The current Riksbank board thus appear to be a lot more hawkish than not only the ECB and the Fed, but also a lot more hawkish than the board led by former Riksbank chairman Lars Heikensten, whose decision to lower interest rates to 1.5% in June 2005is a root cause of the current high inflationary pressures and the excess debt creation and house price increases of the last few years.

Munkhammar Finally Expresses Semi-Austrian Ideas

The great problem facing the cause of the free market is that most free market economist either ignores the great insight of Austrian economics about the negative effects of central bank inflation, or even worse, actively defends the central bank, as is for example the case of Cato Institute senior fellow Alan Reynolds and columnist and CNBC host Larry Kudlow.

As a result of how the negative consequences of Fed policy have been ignored or defended by most free market economists, the left will be able to get away with describing the deep problems of the U.S. economy as a result of "American capitalism", which will give them the credibility in economic issues. As Peter Schiff puts it:

"Unfortunately, most of the criticism of our phony economic expansion has come from the left. The mindless cheerleading of the right will leave them devoid of any credibility on economic issues. Ron Paul is the only Republican who can say “I told you so.” If, as a result of right wing rhetoric, voters blame capitalism for our problems, this nation will take a giant turn to the left. While many on the left have criticized the economy, they have mainly done so for the wrong reasons and their “solutions” will only make the situation worse."

It is therefore good that Johnny Munkhammar, formerly of Timbro now with his own firm Munkhammar Advisory, after having been silent about the issue in the past has now published a semi-Austrian analysis of the U.S. economy. Better late than never is certainly the case here. Reading the entire article requires registration, but Munkhammar has published some relevant excerpts on his blog:

"The idea that the state could and should run the business cycle seems almost unquestioned these days. But the stagflation of the 1970s demonstrated how very hard it is to predict exactly how economies develop, and that it is even more difficult to influence them. ...

Even if governments could know when, how, and how much to stimulate, the positive effects of stimulation - if there are any - in an open economy will to a large extent be exported. Economic research also shows that any residual positive effects will be offset by the need to raise taxes in the future to pay off the debts. ...

The current financial turbulence started in the US housing market, specifically the subprime sector. Very loose monetary policies certainly contributed to a housing bubble and very high lending in the US ? and in other countries. ...

Financial problems as a consequence of too much cheap money will not be solved by policies that provide even more cheap money and the European Central Bank would be well-advised to keep cool. ..."

Tuesday, February 12, 2008

Attention: Oil Is Fungible

I believe that the oil price will soon increase as the market's fear of the effects on oil demand of the U.S. recession will turn out to be exaggerated (as it overlooks the continued strong demand in China and elsewhere), and so do not really think that the oil price increase of the last few days is unjustified per se, I do think that one of the cited reasons is nonsensical. It seems that all too many people fail to grasp the concept of fungible.

There is currently a battle between Venezuela's infamous ruler Hugo Chavez and the company of Exxon. Chavez has nationalized Exxon's assets in Venezuela, which prompted Exxon to retaliate by seeking court orders freezing Venezuelan assets in other countries. Chavez is so upset by this response from Exxon that he has now threatened to cut of oil exports to the United States, a threat which is now causing the market to bid up the price of oil.

What Chavez fail to grasp is that the only way this is going to have any affect at all on the U.S. is if he refrains from selling the oil he now sells to the U.S. to anyone, which is to say if he sharply reduces overall exports and production of oil.
And even then he will hurt himself a lot more than he hurts the U.S. as his socialist state is dependant for its survival on oil revenues while the U.S. would only be slightly damaged by this (And they would really be no more damaged than other oil importers such as the EU, Japan and China). If on the other hand (as seems likely) he starts selling that oil to someone else, all this will mean is that some other oil importer will buy less from other oil exporters. These other oil exporters will then sell their oil to the U.S., causing no net change at all in the U.S. access to oil.

It is perhaps not surprising that someone like Chavez doesn't understand such basic economic principle. Slightly more surprising is the fact that market participants does not seem to understand it.

Monday, February 11, 2008

Financial Journalists Who Don't Understand Finance

Dagens Nyheter has a story where journalists Patricia Hedelius and Dan Lucas "reveal" how the Swedish government would lose hundreds of millions of Swedish kronor in tax revenues if it privatized alcohol wholesale company and producer Vin & Sprit (whose most famous brand is Absolut Vodka).

The reason is supposedly that today Vin & Sprit does not use a loophole in the Swedish corporate income tax law which would have allowed them to reduce their tax payments by hundreds of millions of Swedish kronor. If however the company were privatized then it would most likely use that loophole, thereby allegedly depriving the Swedish government of all these money.

It is appalling but not surprising (given my past experience of them) that financial journalists does not seem to understand basic principles of finance or business administration. Namely in this case that the value of a company is related to the present value of its future net profits and that it therefore is irrelevant for the Swedish government whether companies it sell can use a well-known and predicted tax loophole.

The reason why Vin & Sprit today does not use that loophole is most likely that it would be meaningless for them to do it. A company is supposed to act in the interest of its owner, in this case the government. And it would really be pointless for them to try to use tax planning since the money is going to the government anyway-whether in the form of taxes or dividends. For a private company the situation is different of course and in their case it is basically the duty of the corporate management to use tax planning to minimize the tax cost. This is probably what these journalists focus on. However, what they neglect is the basic fact the price the government will receive in its privatization is related to the expected future net profits. And because this loophole exists, investors will be willing to pay a lot more for the company than they would have done if the possibility to use this loophole hadn't existed. How much more? Well, basically equal to the present value of the tax reduction, meaning that what the government loses in tax revenues they gain fully in a higher sales price for the company.

These incompetent journalists apparently haven't thought about how much investors would have paid for the company if a 100% tax rate -without any loopholes- had been applied. The answer is of course zero (At least if you set aside possible perceived benefits of gaining operational control of the company). And the same principle applies to any taxation of companies that will be privatized. Because of the fundamental principle of finance that the value of a company is equal to the present value of its future profits, expected future taxation of these companies have the same financial effect on the government as taxation of government owned companies. That is, none at all.

In a rational world, financial journalists would be required to understand that. But apparently they aren't, at least not at Dagens Nyheter.

Saturday, February 09, 2008

Inflation Getting Worse

Contrary to the repeated predictions of most economists, there is no sign that inflation is somehow slowing from their current high levels. Although oil is still, despite Friday's rally, below its January peak of $100 per barrel, most other commodities continue to soar in value. The CRB commodity price indexes reached yet new all time highs on Friday. The Economist's commodity price index is published only weekly, but the latest value showed a new all time high for that too, at 239.1, up 30.7% in the latest year. And do please note that this is not a base effect because the rate of increase is in fact accelerating. The increase for the latest 6 months is 17%, or 37% at an annual rate. The increase for the latest 3 months is 10.1%, or 47.1% at an annual rate. The increase for the latest month is 5.3%, or 85.8% at an annual rate.

Food commodities have increased particularly much, being up 8% (an annual rate if increase of 151.8%) in the latest month, 22.8% (an annualized rate of increase of 127.4%) in the latest 3 months and up 55.3% in the latest year. Investors who have followed the advice of me and Jim Rogers to invest in commodities in general and food commodities in particular have in other words earned very high returns.

So far, the price of finished food products has increased a lot less than that for three reasons: 1) Finished food products reflect the cost of other things than food commodities, and these costs have increased a lot less. This is especially true for food served at restaurants 2) Retailers and wholesalers have reduced their margins 3)There is an inevitable time between movements on the commodity prices and the prices of finished food products as the price of food sold now reflect market prices a few months or so earlier.

Factor 1 will continue to ensure that the price increase of finished food products will increase slower than the price of food commodities. However, factor number 2 will be difficult to sustain and will probably eventually disappear and factor number 3 will certainly disappear in a few months or so. This implies that food prices will increase a lot more in 2008 than in 2007, when it for example increased a mere 4.8% in America at the retail level.

That sharply higher food prices is on the way is also evident in the producer price indexes. Finished consumer food products at the wholesale level were up 7.4% in the 12 months to December 2007, a lot less than the 4.8% reported in the CPI. Intermediate food products were up 17.5% and crude food products were up 25.2%. And remember, in December the increase in commodity prices were a lot lower than now. Because of factor 1, not all of this will translate into higher retail food prices and in the short term factor 2 and 3 will probably also have a mitigating effect. But later in 2008, factor 3 and probably also factor 2 will gradually disappear as a factor, which implies a sharp acceleration of food price inflation.

And as "core" inflation have recently begun to rise again and as I expect the oil price to start rising again soon, it seems safe to say that consumer price inflation will remain at their current high level of above 4% in America and above 3% in the euro area (It might briefly fall below those levels during the spring due to base effects, but even if that happens, it will only be temporary). Not that this will stop the Fed from cutting interest rates as they will continue to claim that inflation will fall, like they did before the recent surge of inflation to more than 4%. Because of this and the underlying trends discussed in Jim Rogers book Hot Commodities, commodities remain an attractive investment object while bonds remain very unappealing considering how they provide low -in the euro area- or negative -in America- real yields. While brief corrections are likely to come, the underlying fundamentals for commodities remain strong so the upward trend will remain.

Thursday, February 07, 2008

U.S. Budget Deficit Increasing Sharply

Even before the implementation of the coming "stimulus package", the U.S. budget deficit is again increasing fast. Yesterday's Congressional Budget Office's monthly budget estimate, strangely ignored by the financial media showed a significant increase in the budget deficit for the first 4 months of fiscal year 2008 (fiscal years start 3 months before the calendar year, so fiscal 2008 is October 2007 to September 2008).

January is normally a surplus month, because a disproportional share of tax payments is supposed to be paid in January. However, the surplus was only $15 billion this year, down from $38 billion in January 2007. Some of this reflected calendar effects, but it also reflects a genuine sharp deceleration in the growth of tax revenues. Tax revenues are up only 3.3% so far this fiscal year in nominal terms, meaning that they are falling in real terms. And it would have been even worse hadn't it been for the significant increase in nonwithheld income tax receipts. Such receipts largely reflect payments for income earned some time ago, meaning they do not reflect current economic conditions very well. Interestingly, corporate income tax receipts fell by 10%, clearly reflecting a significant decline in corporate profits.

Spending on the other hand continues to increase as fast as ever, with a calendar adjusted increase of 8.2%. The spending post increasing the fastest is interest payments. This mainly reflects higher interest payments for TIPS because of the high rate of inflation, so in one sense one can say this increase is illusory. And given the sharp decline in bond yields recently, one can expect interest payments to decline as the government refinances its debt, despite the continued increase in the level of government debt. On the other hand, net medicare spending was temporarily held down as overpayments of benefits in 2006 were received. As this is only a temporary factor, this means that net spending will rise a lot faster later in the budget year. So overall spending might just continue to rise by about 8% or so for the rest of the budget year, much faster than the 5% increase in nominal GDP the latest year.

Because of the deceleration of revenue growth and the acceleration of spending growth, the deficit for the first 4 months of the fiscal year rose from $42 billion in fiscal 2007 to $90 billion in fiscal 2008. Or in other words, the monthly deficit is up on average $12 billion, which would imply an annual increase of $144 billion. Considering how some tax payments lag economic activity and considering the so-called "stimulus package", the deficit will however increase a lot more than just $144 billion (which would have been bad enough).

Wednesday, February 06, 2008

U.S. Government Demands That Others Copy Its Keynesianism

As is illustrated by the combination of the aggressive Fed rate cuts in combination with the massive fiscal stimulus package, the U.S. government is arguably the most Keynesian of all governments (at least among relatively rich countries).

I now see not just one, but two interesting articles in The Financial Times discussing this. The first one is a column by the economics editor Martin Wolf who points out that these policies can only "work" to the extent it worsens the imbalances that caused the recession (or more correctly, are associated with the real root cause, namely excessive money creation) in the first place, namely America's high level of inflation and massive current account deficit.

To the extent it causes the dollar to fall, it will worsen price inflation. To the extent the dollar doesn't fall, it will aggravate America's external deficits.

The second article is about how the U.S. government calls on the EU and Japan to undertake similar Keynesian measures to increase demand there. These calls were immediately rejected, but had they been implemented it would have a similar effect on America as a falling dollar. It will reduce America's external deficits but increase price inflation. As bad as America's unilateral Keynesianism is, it would only make the state of the world economy worse if other countries copied the policies that are the root cause of America's economic problems.

Monday, February 04, 2008

Fed Policy Makes U.S. Stock Markets Overvalued

Bloomberg news reports that the U.S. stock market have actually performed better than most other stock markets during the recent stock market decline. This may appear puzzling and strange considering the fact that the reason for the sell-off is the U.S. recession, and despite globalization, U.S. companies are still more likely to suffer from it than other stock markets.

The explanation for this lies in the fact that while the Fed has cut interest rates dramatically, other central banks have only cut them slightly (as in the cases of Bank of Canada and Bank of England), kept them on hold (as in the case of the ECB and the Bank of Japan) or even raised them (as in the case of the Swiss National Bank or the Swedish Riksbank). This have also caused market interest rates to fall sharply in the U.S. (particularly for shorter maturities) while they have remained relatively unchanged elsewhere. This in turn means that in the U.S. the alternative of bonds appear far less attractive than in the past, while such a shift haven't happened elsewhere. And because of that, equity valuations have risen sharply in the U.S. compared to other countries. Or in other words, not only do U.S. bonds appear far less attractive than elsewhere, but U.S. stocks also appear less attractive than stocks in other countries. One can discuss to what extent this reflects absolute overvaluation of U.S. stocks or absolute undervaluation of non-American stocks, but in any case, U.S. stocks are certainly overvalued in relative terms.

Sunday, February 03, 2008

China Exports Inflation

Interesting New York Times article about how the combination of rising domestic inflation in China, reduced export subsidies and the rising yuan will contibute to rising prices of Chinese imports and so raise inflation in America. This will be felt particularly much for goods that are dominated by the Chinese, such as toys and apparel. And even setting aside the direct effect of the higher prices of Chinese imports, this will also enable manufacturers in other countries to raise prices as they no longer need to fear Chinese competition as much.

If you look at U.S. import price statistics, you can see that between December 2003 and December 2006, the price of imports from China fell by 2.7%. But in the 12 months between December 2006 and December 2007, they rose 2.4%. And considering that both domestic inflation and the rate of yuan appreciation have accelerated (The combined effect of which is a rising real exchange rate), it seems clear that they will rise a lot more than that in 2008.

The rapid increase in the real exchange rate in China will of course also help provide continued support for the commodity price boom, which will also create upward pressure on inflation in America and elsewhere.

Peter Schiff On Fed Rate Cuts And Stimulus Package

Ron Paul economic advisor Peter Schiff's weekly columns are virtually always good, so if I was going to blog everytime it is good I'd have to do it nearly all weeks. Instead I just do it when it is unusually good and/or makes an entirely new point.

This week was one example of this, when he analysises the Keynesian policies pursued by the Federal Reserve and the Bush administration in cooperation with the Democratic Congress, in the form of dramatic interest rate cuts combined with a so-called stimulus package. You can read the whole column here, some excerpts follow below:

"A common definition of insanity is the act of repeating the same activity while expecting a different result. Bernanke is now repeating the same mistakes made by Greenspan, yet he and almost everyone on Wall Street expect a different result. The stock market bubble of the 1990s resulted from interest rates being too low, which sent false signals to businesses, causing them to over-invest in information technology, telecom, and dot coms. When that bubble burst, rather than allowing the corrective recession to run its course, the Fed responded by slashing interest rates. The result was an even larger bubble in real estate; causing consumers too borrow far too much money to buy houses and other goodies.

Now that the housing bubble has burst, the Fed is once again slashing interest rates to postpone the pain. However, in order to correct for years of extravagant borrowing and spending, the country is in desperate need of a period of saving and economizing. But by rewarding debtors and punishing savers, lower interest rates actually encourage the opposite behavior. Given how much harm this strategy has already done in the past why should we assume it will work any better now?

Consider a real world example. Suppose your spendthrift neighbor, maxed out on credit card and home equity debt, no savings in the bank, struggling to make ends meet and one paycheck away from foreclosure and personal bankruptcy, comes to you for financial advice regarding what to do with the $1,200 he received in the Federal Stimulus Lottery? Would your advice be to "go out and buy yourself a brand new plasma T.V."? My guess is that you would suggest he pay down his debts. If you were a good friend you might help him devise a budget to put his financial house back in order. Such a plan might include trading in his Mercedes SUV for a more fuel efficient Honda, brown bag lunches instead of expensive restaurants, tearing up department store charge cards, cancelling vacations, cutting back premium cable channels, etc. When you are neck deep in debt, the solution is to economize, ratchet down your lifestyle and repair your personal balance sheet. In other words, you go though your own personal recession.

Would your advice be any different if it was not just one neighbor asking but 300 million? If it's wrong for an overly-indebted individual to blow a windfall, it's just as wrong if millions of us do it collectively. If our economy is already suffering from too much debt, think of how much worse off we will be after we blow thought these rebate checks."

Friday, February 01, 2008

Commodity Price Indexes Reach New Highs

The Reuters-CRB Index of commodity prices, aka the CRB futures index, rose above the key level of 500 for the first time ever yesterday (although it touched it on Tuesday as well) and ended at 503.27, up 27% from a year ago.

The other CRB commodity price index, the CRB spot index, also reached a new all time high yesterday of 439.03 . This index have risen "only" 20% the latest year.

The Economist's commodity price index also reached a new all time high, at 232.4. It is up 25.7% the latest year.

This means that the commodity price boom continues to be strong, just as Jim Rogers and I have repeatedly predicted. It also implies continued strong price inflation, contrary to the views of "deflationists" (in the sense of predicting the future, not advocating it) like Nouriel Roubini and Mike Shedlock.