February 06, 2004


Today is Axel Rose's birthday. He's 42. Happy Birthday Axel. Also Happy Birthday to the Gipper, who at 93, ads a year to his record as the longest living U.S. President. We'll forgive Reagan today for marrying conservatives to deficit spending. We choose to remember for any number of quotes about limited government, including this one, "The kind of government that is strong enough to give you everything you need is also strong enough to take away everything that you have." I mention Axel, however, because a couple of young French acoustic guitar players were rocking out to an old Guns N' Roses song last night. I was enjoying a post-blogging beer last night when they belted it "Patience" (Said woman take it slow/ things will be just fine/ you and I'll just use a little patience). The Fed, for its part, got more reason to be patient today. The BLS released the January employment numbers today and although un-employment declined, it declined less than "expected." The bond market welcomed this news. It means the Fed will be "patient" in raising rates. In other words, if the Fed's waiting for employment to pick up before it raises rates, it's going to be waiting for awhile. Housing Update Fannie and Freddie--renegade credit creators and systemic risks to the financial economy--got two shots fired across their bow this week. First, the Office of Federal Housing Enterprise Oversight (OFHEO) imposed Freddie with the maximum capital surcharge available under law. The company has to hold 30% more capital than currently required. OFHEO is also requiring the company to get pre-approval for certain transactions until executives bring Freddie's financial statements up-to-date--or report them, for that matter. This is just the first step it getting the GSEs to slow down the pace at which they've been expanding their balance sheets. Congress, the Fed, OFHEO, the President...everyone in Washington is starting to realize what a monster Fannie and Freddie have become. They've issued trillion in bonds to buy up mortgages. But in reality, the asset side of their balance sheet is made up of millions of mortgages...which could easily go into default if rates rise. The GSEs are on the hook to bondholders...and their main source of income is in jeopardy in a rising rate environment. And today, the WSJ reported that: "The Fed plans to change the way Fannie, Freddie and their sister government-sponsored enterprises pay holders of their debt securities. The Fed acts as the GSEs' transfer agent for the payments. On days when the payments are due, the Fed makes the payments for the companies around 9:15 a.m., although the GSEs don't need to repay the Fed until around 6 p.m. Essentially the Fed has been giving the GSEs and a few other entities, such as the World Bank, interest-free loans for as long as nine hours on total bond payments of as much as $145 billion a day." Economically, it's not going to change things overnight. And in a strange way, it's encouraging that regulators are getting on the case...trying to prevent the systemic domino defaulting the OFHEO outlined in the report in produced last year (and which was the basis of MY report on housing). But this is shutting the proverbial barn door after the proverbial horse has left, proverbially. Non-proverbially, the slow-boiling rise in rates might allow the GSEs to prepare for a bigger shock down the road. And in the interim, that will probably take some pressure off Fannie Mae (FNM). However, the strange truth of the financial economy in America is that it's built on the backs of homeowners. It's built on debt. And more acutely, the ability of individual Americans to make a monthly mortgage payment is now a critical issue to the owners of trillions of Fannie and Freddie issued or guaranteed bonds.

Dollar Going No Bid?

Let's look at the dollar and debt in terms of supply and demand. First, to pay for its record deficit, the Federal government plans to borrow $177 billion in the first quarter by selling bonds. It will sell (assuming there are buyers) $24 billion of three-year notes, $16 billion of five-year notes and $16 billion of 10-year notes. From the LA Times..."It's unprecedented this much supply is coming into the market — obviously that's got to get placed somewhere," said Andrew Lombara, a trader at HSBC Securities in New York. Yes. It's got to get placed somewhere. But where? Surely there will be buyers. Even when the underlying currency is falling and U.S. yields are getting even punier compared to yields in Europe, the U.K., and Australia, right? Bloomberg reports that The dollar fell to $1.2601 against the euro at 7:05 a.m. in New York from $1.2535 late yesterday. The dollar, much to my euro-spending chagrin, fell 29% against the euro in the two years to Dec. 31. The Bloomberg article goes on, "We see plenty of reasons for continued dollar weakness,'' said Trevor Dinmore, a currency strategist at Deutsche Bank AG in London. ``Because of the event risk, you don't want to be adding'' dollars before the G-7 meeting, he said. About the only people in the world who seem to want to "add dollars" are the politicians in Washington, by spending more. But you can't keep adding supply, debasing the currency, and expect demand to remain robust. By the way, the BEDspread, my measure of the appetite for U.S. debt versus emerging market debt, stands at 4.65. The yield on a basket of Uncle Sam's debt (GVT) rose yesterday as bond prices fell. It stands at 4.49%. And even though emerging market bonds have fallen recently on a wave of profit taking, yields are hovering above 9%, with EMD, the Salomon Brothers Emerging Market Bond Index, yielding 9.14%. BEDspread watchers know by now what to look for...EMD yields under 9% and a sudden spike in GVT yields above 5%. For now, U.S. bonds are getting a bid at almost any price. And if stocks are weak (on labor news for example), bond yields may fall even more. Don't blink, though. The G-7 meeting is coming soon. And currency markets, as George Soros has said, are panic markets. They do not work in an orderly fashion. "Flexible" currency markets, the kind John Snow has been cheering for, reflect the strength of the underlying economy. If that's truly the case, the dollar's next "adjustment" could be swift and sudden.

Unknown Unknowns

Quote of the day, from Michael Kinsley. I think he means...you're better of deciding what you think...than you are trying to figure out what everybody else thinks. "The process the Democrats are putting themselves through resembles John Maynard Keynes' famous description of the stock market. The game isn't to figure out which stocks are most likely to do well, but to figure out which stocks other investors think are most likely to do well. And these other investors are thinking of other investors and so on. Keynes thought this helped to explain the volatility of stock price. Your judgment about other people's judgment, let alone other people's judgment about other people's judgment, is inherently less certain and more subject to breezes of false or true insight and information than your judgment about your own judgment.

February 05, 2004

Selling Dollars

Two important facts from taxfoundation.org regarding the FY 2005 budget....even non defense discretionary spending is on the rise under Bush...and two, the part of the non-discretionary part of the budget keeps getting larger as a percentage of total spending...making even a reduction in discretionary spending less helpful to reducing overall deficits. Conclusion: the government is blowing out the budget...and it has no intention of actually paying off this debt. When will the bond holders realize the danger to their dollars? Hint, they already have. They just dont want to spark a rush to the exits with panic selling. This from today's WSJ (emphasis added is mine): "A number of Asian central banks, among the biggest investors in U.S. government debt, are looking at alternative targets for their vast dollar holdings... "The percentage of U.S. government debt owned by foreigners stood at 37.3% last year, compared with 33.9% in 2002 and less than 4.7% in 1965. Foreign central banks hold more than $800 billion in Treasurys -- $1 of every $5 the U.S. government owes. "Asia's bigger central banks face a difficult task. They want to reduce dollar risk and shift reserves to better returns, but they have to trim dollar holdings without spooking the U.S. debt market or currency markets -- and potentially fueling the dollar's downward momentum. That in turn would undercut another goal of Asian governments: to slow the rise of their currencies against the dollar, which makes their exports more expensive and threatens Asian jobs. "Although Bush administration and Federal Reserve officials acknowledge that the rest of the world won't lend ever-increasing amounts of money to the U.S. forever, they insist they don't see any imminent threat of a crisis. "Reliance on borrowed funds may not be sustainable," Fed Chairman Alan Greenspan said in a speech last month, but then added that "there is, for the moment, little evidence of stress." The dollar's declining value is a sign of waning foreign appetite for dollar-denominated assets, he said, "yet inflation, the typical symptom of a weak currency, appears quiescent." And from the Tax Foundation (my emphasis added) Non-Defense Discretionary Spending: The administration proposes $466 billion for non-defense discretionary programs, an increase of $123 billion, or 36 percent, above President Clinton's final fiscal year. Despite the fact that the administration would effectively freeze discretionary spending in real terms in FY 2005, discretionary spending has grown by an average of 6.0 percent during the term. This is a faster rate of real growth in discretionary programs than at any period over the past 25 years. Entitlements (excluding net interest): Entitlement spending will top $1.3 trillion in FY 2005, an increase of $300 billion -- or 30 percent -- above President Clinton's final fiscal year. After adjusting for inflation, entitlement spending is set to grow by an average of 4.8 percent per year during this term, a growth rate only exceeded during the G.H.W. Bush administration. As a share of the budget, entitlement spending will top 57 of total federal spending. This means entitlements are consuming 11 percent more of the budget than they did during President Reagan's last fiscal year in 1989.

Quote of the Day

President Bush's inability to control the federal budget demonstrates yet again that democracy's inclination toward excessive spending is as powerful as a force of nature. The past two years' outrageous 8.2% annual increase in domestic discretionary spending is unfortunately only the latest example of excessive government spending. Since the beginning of the century, domestic federal spending has increased more than tenfold from less than 2% of Gross Domestic Product to close to 20% today. As the quantity of spending has increased, moreover, the quality has declined, with larger proportions going to transfers from one group of citizens to another rather than to public goods. From John O. McGinnis and Michael B. Rappaport in yesterday's WSJ.

Blodget Finds His Calling

Henry Blodget is telling stories again. But this time, instead of hawking internet stocks for Merrill Lynch, he's covering the Martha Stewart trial for slate.com. And he's doing a pretty good job of it. You can see why Merrill picked Blodget to spin Internet yarns for the public. He's a good story teller. And behind every bad stock there's a really good story. Here's a piece of Blodget's latest work. It's a description of the testimony of Douglas Faneuil, a Merrill Broker who allegedly told Martha Stewart that Sam Waksal was unloading his shares of ImClone stock a day before the FDA released a negative report on ImClone's cancer drug Erbitux. Faneuil is cooperating with the prosecution. You can find all Blodget's dispatches at http://slate.msn.com/id/2094441/entry/2094442/ The excerpt: "Douglas Faneuil, it turns out, is a beanpole. There was no wind in the courtroom, but if there had been, his suit would have flapped. While being sworn in, he hunched over the guard like a NBA player leaning over a coach. "My knees are long," he said, endearingly, to the judge, when explaining why he couldn't move the witness chair closer to the microphone. Between the defense and the media, Faneuil has been so trashed of late that expectations were low. He would have exceeded them even if they had been high. Faneuil was polite, deferential, entertaining, likable, and, dare I say it, credible (pre-cross-examination, of course). The interplay between him and Seymour, moreover, was masterful: Standing at the lectern, 15 feet in front of Faneuil, Seymour looked like a stern mother helping rehabilitate her formerly wayward son. Did there come a time at Merrill Lynch when you did something illegal? Karen Patton Seymour asked. "Yes," said Douglas Faneuil. What did you do? asked Seymour. "I told one client what another client was doing and then lied about it to cover it up," said Faneuil.

February 04, 2004

"Yes...We're Insolvent...But Not, You know...Really Insolvent"

Spent an hour today with Mr. Daily Reckoning, Bill Bonner, discussing the possibility of a default by the U.S. government. Does the dollar standard end with a bang or a whimper? With deflation or inflation? And if everyone wants to sell U.S. bonds, who's going to buy and at what price? Lots of people find it hard to believe the government could go bankrupt...become insolvent. They might be surprised to find out the government already IS insolvent. Of course, in defending its balance sheet, the government says appearances are deceiving. I haven't made any comment on the government's defense of its balance sheet. It speaks for itself. But I did highlight what I thought were some extraordinary statements...extraordinarily arrogant. If you want to see a PDF image of the balance sheet itself, fedbalancesheet.jpg From "Analytic Perspectives" on the FY 2005 Budget: Table 12-1 seems to imply that the Government is insolvent. Is it? No. Just as the Federal Government's responsibilities are of a different nature than those of a private business, so are its resources. Government solvency must be evaluated in different terms. What the table shows is that those Federal obligations that are most comparable to the liabilities of a business corporation exceed the estimated value of the assets actually owned by the Federal Government. The Government, however, has access to other resources through its sovereign powers. These powers, which include taxation, allow the Government to meet its present obligations and those that are anticipated from future operations even though the Government's current assets are less than its current liabilities. The financial markets clearly recognize this reality. The Federal Government's implicit credit rating is the best in the world; lenders are willing to lend it money at interest rates substantially below those charged to private borrowers. This would not be true if the Government were really insolvent or likely to become so. Where governments totter on the brink of insolvency, lenders are either unwilling to lend them money, or do so only in return for a substantial interest premium.

The Perpetual Debt Machine

Wanna know just how bad is? Do you? Really? You sure? Okay. Then don't pay attention to the fiscal year deficit as a percentage of GDP. It doesn't tell you anything useful--which is exactly why the government uses it. It minimizes what a scheme they're running. Below is a chart showing current government liabilities as a percentage of GDP. And below THAT is the text from the White House's "Analytical Perspectives" on the FY 2005 Budget. If you're a masochist, you can find the whole thing at http://www.whitehouse.gov/omb/budget/fy2005/pdf/spec.pdf. The figures below do NOT include social security. And please note the text I've bolded in the explanation from the Feds. Then tell me if you're comforted. And if you want to understand how government deficits and the making of war are inextricably linked throughout history, I recommend you take a look at Scott Trask's article at http://www.mises.org/fullarticle.asp?control=1419&id=65 . It's great. Money quote: "Since Prime Minister Robert Walpole's introduction of the funding system in England during the 1720s, the secret was out that government debt need never be repaid. Just create a regular and dependable source of revenue and use it to pay the annual interest and the principal of maturing bonds. Then for every retired bond, sell a new one. In this way, a national debt could be made perpetual." The government explanation for what a "liability" is. Table 12-1 includes Federal liabilities that would also be listed on a business balance sheet. All the various forms of publicly held Federal debt are counted, as are Federal pension and health insurance obligations to civilian and military retirees and the disability compensation that is owed the Nation's veterans. The estimated liabilities stemming from Federal insurance programs and loan guarantees are also shown. The benefits that are due and payable under various Federal programs are also included, but these are short-term obligations not long-term responsibilities. Other obligations, including future benefit payments that are likely to be made through Social Security and other Federal income transfer programs, are not shown in this table. These are not Federal liabilities in a legal or accounting sense. They are Federal responsibilities, and it is important to gauge their size, but they are not binding in the same way that a liability is.

Something Stirring in "The Two Americas"

Lord Rees Mogg has become quite engaged in the Democratic primaries. It's a good thing, too. I treat it with equal parts amusement and horror. But he's always a keen observer of politics, having spent his whole life in the business of calling elections and trends. It's hard to convey to you the extent to which Bush is disliked in official European circles and the press. The foreign press is dying to get behind the campaign of a dynamic Democrat. For now, they're settling with John Kerry's looks. LRM makes an astute observation the missive below. He points out that long after Howard Dean and Al Sharpton are gone, and John Kerry has the nomination, the rhetoric of John Edwards is going to be with us. And frankly, I'm not encouraged. Edwards has the only coherent campaign theme: two Americas...one America for the rich and the powerful with low taxes, great healthcare, quality education, and secure jobs. Another America where people scrape to make ends meet, can't eat right, stay healthy, or give their kids a better future. It's pretty awful class-centric Marxist pandering by a trial lawyer who knows how to cry crocodile tears. But that doesn't mean it won't work...and we won't be hearing a lot more of it in the coming years....(note, all the emphasis added is mine) Strategic Insider -- William Rees-Mogg -- 4 February 2004 The British follow American elections very closely. There are a number of reasons for this. American policy has a great impact on British life, so that the decisions made by an American President can often be more important than those made by a Prime Minister. The United States also influences British political attitudes, much of our political weather, and most of the economic weather comes from across the Atlantic. American politics come in the English language, which makes them more intelligible than the local politics of Europe, let alone those of Russia or China. Now we have the U.S. networks by cable or satellite. I followed the early primaries on Fox News, and saw Howard Dean's extraordinary speech live from Iowa. I am writing after the round of primaries which included the victory of Senator Edwards in South Carolina and of General Clark in Oklahoma. All the other states went to Senator Kerry. What has struck me more than anything else is the high level of interest in the Democratic primaries. Of course, there have been occasions of high interest before. I suppose the highest level of interest was in the Democrat primaries of 1968, which started with the revolt of Gene McCarthy against the Vietnam War, saw Lyndon Johnson's decision not to seek a second term, went on to the tragic murder of Robert Kennedy and ended in the nomination of Hubert Humphrey, who was eventually to be defeated by Richard Nixon. At the time, I thought that Robert Kennedy would have beaten Nixon if he had lived. There is nothing like 1968 about the primaries of 2004, though for a few weeks Howard Dean did seem to have started another students' crusade. Yet the turnout levels are quite exceptional. Something is stirring in the American political consciousness, and these movements usually come across the Atlantic to us before they have blown themselves out. I like the look of Senator Kerry, but then, as an Englishman, I would. He not only looks like a President, he looks like a Prime Minister, and of a classical type. Think of Gladstone, think of Asquith, serious and determined older men, with much of the statesman about them. There has always been a cultural link between New England and Old England, and Senator Kerry would carry England, not only in the primaries, but in a Presidential election. Nevertheless, it is Senator Edward's campaign that rings alarm bells. I think he has struck a theme which may be destined to play a large part in our economy as well as in the U.S. economy. I expect Senator Kerry to win the nomination, and people in England will welcome that if it happens. But I expect the social theme which Edwards has been expound skillfully to be at the forefront of the Presidential election and of our next General Election in May or June of 2005. We shall be hearing some Edwards' speeches from our political platforms. The theme is concern for the people who have not benefited from the prosperity of the late 1990s and the present recovery, those who have missed out. This is not primarily a question of jobs. By historic standards both the United States and Britain have a high level of employment. It is much more a matter of the quality of jobs, the quality of opportunity. The contraction of manufacturing has destroyed great numbers of well paid production line jobs, but it has also destroyed whole tiers of middle management. Middle management has been rapidly downscaled in financial and service industries. Yet the costs of establishing a professional life have escalated -- university fees, home purchases, health insurance, pension provision, have gone through the roof. That is the pattern of modern life, and, as always, the U.S. sees it first. Undoubtedly, there is a whole sector of society who feels that they will never reach their expectations, because the expectations have become more expensive and the opportunities have become fewer. When I first visited the United States, in the early 1950s, there was a book of popular sociology about "The Man in the Grey Flannel Suit". I am not sure that Brooks Brothers still sell grey flannel suits, though they do still sell the managerial button-down collar. But the debate in the primaries tells me that the man in the grey flannel suit is not happy. And he is a powerful voter. William Rees-Mogg 4 February 2004

Self Immolating Currencies

So much hinges on the dollar now. This isn't clear to most investors. It's not perceived as a threat, and probably won't be until it's too late. But the twin deficits are grinding the currency into a mush pulp. Check out the dive-bombing dollar below. The dollar matters a lot more to stock prices now than any single factor. That's why I'm spending so much time trying to make it clear that sometime this year, you're going to hear the dollar break, and it's going to start costing Americans in ways they can't imagine. Here's a quote from a Dallas Fed report on the risks to the economy in 2004. You can find the whole report at http://www.dallasfed.org/research/indepth/2004/id0401.html . The big risk is that the weak dollar leads to a sell-off in U.S. financial assets AND a powerful surge in inflation. Which means you'll wake up one day and find that your latte is 40% more expensive. "...a disorderly decline in the dollar could boost inflation fears and bond yields, thereby undoing some of the financial stimulus to housing, consumption, and investment. Currently, foreigners are lending an extra $1.5 billion a day to the U.S., much of which is in the form of central bank purchases of U.S. Treasuries." It's not just a fall in stock prices that a weak dollar prompts...but a rise wholesale and consumer prices. The study continues: The dollar could plunge if private investment sentiment shifted suddenly against investing in U.S. assets or if some foreign central banks buy less Treasury debt to keep their currencies from rising against the dollar. The dollar matters partly because a sudden decline could push up non-oil import prices (shown by the red line in Figure 12), which have an influence on core wholesale prices at the intermediate level (the blue line). The Fed report says the stage is set for a robust recovery, but that there are some remaining "headwinds." The dollar is the biggest one. What's interesting is how important business investing is to the tone of the report. And within business investing, the report mentions exactly the same subject I looked at yesterday, IT and software spending. "Looking within manufacturing, virtually all the increase in output has occurred in the high-tech sector, depicted by the blue line in Figure 5, with recent signs that output excluding high tech; the red line;has begun increasing. The revival in high tech reflects the combination of a rebound in business equipment investment and increased high-tech sales to consumers." Manufacturing output because business investment in IT is up. So shows the chart below. But it hasn't yet led to higher employment. And as I contended yesterday, it might not at all. Changes in the labor market don't take place within just the U.S. economy any more. They take place in a globalized workforce, where the division of labor is global. There's no guarantee that lost jobs in one domestic field will lead to new jobs in a new domestic field. My colleague James Boric summed up--with a lot more efficiency--the argument he saw me making: "What you are saying is...Sure, US companies may continue to invest in new equipmentnt. And in fact they might keep on coming up with the best new inventions -- that revolutionize the world. And yes, those will create new opportunitieses for workers. But it isn't likely that those jobs will be filled in the US. It would be cheaper for Intel, Microsoft and Cicso to farm out their work to Mexican or Chinese workers -- who will do the same job but for 40% less. As we become more and more technologically advanced, our machines will actually replace the need for manpower -- just like mechanized farming equipment did in the 1900s." Jamedisagreesss with me and sides with the chairman that the key issue is flexibility...and that even though we can't know what the next big thing will be that creates new jobs, there's always been one...from the railroads, to cars, to computers. Maybe. But maybe it's not a bad time to prepare yourself for a world in which all but the very best jobs migrate outside America to places where they can be done more cheaply. It's another great migration. But this time it's not to America, or even within America. It's the great migration of the world economy from the West to East...the services production capital of the world in India and the goods production capital of the world China. It's a great economic contest. And America does have some economic advantages, technology being one of them. But it's also a contest for basic natural resources. As a reviewer for a book I'm reading on China put it, "Can the Earth sustain yet another industrialized and consumption-based economy in a country with a population nearly four times that of the U.S.? Are Americans and other Westernized countries willing to relinquish some of the standard of living increases made in the past few decades to meet the growing resource demands of such international development?" You don't have to relinquish a high standard of living. You just have to prepare for the events coming. One way of doing that is to realize the gravity of the threat. Just doing that will make you much more realistic about what you have to do as an investor. And after that...you can pursue the path I've laid out in SI...profiting on the delcine of the financial economy (sometimes with leverage if you can afford the risk). Owning the assets of countries on the periphery of the Asian boom through exchange traded funds. And of course, in an age of self-immolating paper currencies, own gold.

Quote of the Day: Trade deficit originates in US extravagance

What does the communist Chinese People's Daily have to say about the U.S. trade deficit? Trade deficit originates in US extravagance: "Trade deficit is the result of the counting of balance of payments. According to the accounting principle of the balance between income and expenditure, a country must have the means of payment if what it buys in the world market surpasses what it sells. Historically, various countries usually make up this difference with gold or silver. But in today's world, the United States possesses a kind of privilege, which enables it to pay around US$400 billion worth of trade gap annually with US dollars it issued. But this kind of privilege is only a necessary condition allowing the incessant expansion of US trade deficit, its ample conditions lie in the aspect of demand, i.e., the unlimited pursuit of extravagance. "

February 03, 2004

No Remorse at $400

I'd intended on doing more stock market blogging today. But the work below on the labor market and business investment took most of my time. Market blogging tomorrow for sure. I did, however, run a quick chart on the continuous gold contract. Gold has dipped under $400 the last few days...and some of my techical partners in crime think $380 is in the near future. Today, the signals are mixed. AU, NEM, and ABX are all modestly down. But HMY and DROOY are modestly up. If the dollar keeps falling, the dollar price of gold is going to go up. I'll have more later this week on some internal dynamics in the gold market. But for now, $400 is a good remorse price. That is, in case you're not familiar with a term I first coined a few months go, the remorse price of gold is the price you'll regret not having bought at when gold goes up to over $1,000 an ounce...and higher.

Big Brother is...Scanning You

I can't decide whether this is good....or bad....from today's Washington Post Code Orange: Glowing Lawyer (washingtonpost.com): "Take, for example, an incident involving a Washington lawyer of a certain age who went to his doctor a few months ago for a routine heart checkup. (No, no, despite his profession, a heart was indeed located.) The exam included a stress test with injection of a radioactive isotope -- most likely technetium or thallium -- which helps illuminate the heart muscle during exercise. The doctor told him he passed. The elated lawyer says he left work several hours later and was driving along I Street NW between 16th and 17th when a police car with lights flashing zipped up behind him. An officer on a bicycle pulled alongside. What could this be? Couldn't be speeding, a red light or a stop sign. 'Sir,' the officer explained, 'you were not pulled over because of a traffic violation. You were pulled over because you are radioactive.' After about 15 harrowing minutes of some discussion, checking of license and ID"

Layoffs and Business Investment

The good news today is that even though corporate layoffs were up in January 26% to 117,556, that was 11% lower than January 2003's 132,222 and 53% lower than January 2002's 248,475. But does that mean the employment picture is improving because there are fewer layoffs? We'll have a better idea when Friday's numbers come out. But it's an important question for stock investors. Increased business hiring is crucial to a strong recovery. Business spending creates consumer incomes. And a consumer who makes money spends more money. An early sign of future business hiring is increased business investment. If businesses are investing, it traditionally means hiring will soon follow. But something may be different about this economic environment. We may see higher business investing WITHOUT the employment. That's because current business investment is in exactly those areas than tend to reduce jobs, not create them. Take the two charts below for example. The first shows business investment over the last four years. You can see it topped out right before the stock market in early 200. It's begun to recover since early 2002. And in the fourth quarter, it was again up a respectable 6.9%, surely an encouraging sign for employment right? Maybe not. The second chart shows investment in equipment and software as a percentage of business investment (as opposed to investment in structures.) In 2000, equipment and software investment ($918 billion) were 74% of total business investment more than twice business investment in "structures." In 2003, equipment and software grew to 79% of total investment. Business investment is recovering gradually... ...but does investment in equipment and software create jobs? It's obvious from these numbers that equipment and software investment makes up the bulk of business investment. It's been that way for some time. But what is included in the category "equipment and software?" The answer can be found in the National Income and Product Accounts (NIPA). And what you'll find is that a large percentage of American business investment is in information technology...and that this is almost certainly bad news for the labor market. The Bureau of Economic Analysis has put the data for GDP into a format that's searchable and exportable. (God bless Dr. Richebacher, who's been working off hard copies all these years.) That makes it easy for you to breakdown exactly where business investment is taking place and then try and correlate that with trends in the labor market. The NIPA numbers show four distinct categories of equipment and software investment. They are: information technology, industrial, transportation, and other. I've gone back over the last fifteen years and looked at the changes in the composition of the equipment and software numbers to see what they show us. First, a table showing what percentage each category is of total equipment and software investment in 1990 and then in 2000 % of Equipment and Software Investment 1990 2000 Info Tech. 41% 50% Industrial 21% 17% Transportation 16% 17% Other 19% 14% As you can see, IT spending was already the leading component of business investment in 1990. By 2000, it had grown another 10%, while investment in the "old economy" declined 4%. In terms of actual dollars...IT spending grew 163% between 1990 and 2000. "Old Economy" spending grew at less than half rate, 72%. And in third quarter of last year when total business investment grew at 12.8%, investment in equipment and software actually grew at 17.6%, making up for the actual decline in business structure investment. Within the equipment and software category, it was computers and software that accounted for the largest gain at 27%, while transportation investment actually shrunk, and investment in "old economy" industrial equipment grew at 1.5%. Machines Replace Men Greenspan likes to argue that business investment in IT makes us more productive, and that rising productivity is the hallmark of a growing economy with rising standards of living. He admits that it causes "dislocations." As businesses by labor saving devices, some workers get more productive. The rest get laid off. The Chairman, however, is not too concerned. Our economy is dynamic. I'll quote him at length from a recent speech delivered via satellite to the HM Treasury Enterprise Conference in London on January 26th. Emphasis added is mine. "...Starting in the 1970s, American Presidents, supported by bipartisan majorities in the Congress, deregulated large segments of the transportation, communications, energy, and financial services industries. The stated purpose was to enhance competition, which was increasingly seen as a spur to productivity growth and elevated standards of living...." "As a consequence, the United States, then widely seen as a once great economic power that had lost its way, gradually moved back to the forefront of what Joseph Schumpeter, the renowned Harvard professor, called "creative destruction," the continuous scrapping of old technologies to make way for the innovative. In that paradigm, standards of living rise because depreciation and other cash flows of industries employing older, increasingly obsolescent, technologies are marshaled, along with new savings, to finance the production of capital assets that almost always embody cutting-edge technologies. Workers, of necessity, migrate with the capital." So far so good. Old industries die out. New ones with newer technologies are born. And with them, new jobs. At least that's the theory. Greenspan is just heating up. He continues, "Through this process, wealth is created, incremental step by incremental step, as high levels of productivity associated with innovative technologies displace lesser productive capabilities. The model presupposes the continuous churning of a flexible economy in which the new displaces the old." That "displacement," of course, is the loss of jobs in old industries. It DOES create new wealth in the new industries where it creates new employment. However that wealth need not be created in America. American providers of IT goods and services will make a profit. But much of their labor may come from overseas. And of course, non-American companies selling IT goods and services will make a profit too. Greenspan does admit that this focus on IT investment creates what he calls a "structural" labor problem. We focus on what our workers have a comparative advantage in and are more productive in (technology) and invest less in areas where we're not as competitive. He says, "In recent years, competition from abroad has risen to a point at which developed countries' lowest skilled workers are being priced out of the global market place." That's Fed-speak for losing your job because it's cheaper to do overseas. All of which is fine. That's what happens in mostly free globalized markets. If you believe in free markets you have to take your medicine on this one. But it does raise the question of where the new jobs will come from, a question I've often asked here. Where will American enjoy a comparative advantage in the 21st century? It certainly promises to be bright if you're information and technology savy and provide a service that depends on personal experience and judgment. But even white collar jobs are becoming commodified. Not to worry, says the Chairman. "We can usually identify somewhat in advance which tasks are most vulnerable to being displaced by foreign or domestic competition. But in economies at the forefront of technology, most new jobs are the consequence of innovation, which by its nature is not easily predictable." That doesn't stop him from trying though, "What we in the United States do know is that, over the years, more than 94% of our workforce, on average, has been employed as markets matched idled workers seeking employment to new jobs. We can thus be confident that new jobs will displace old ones as they always have, but not without a high degree of pain for those caught in the job-losing segment of America's massive job turnover process." Trouble is, new jobs AREN'T replacing the old ones, Greenspan's assurances aside. And we can't really say in this brave new world if they will. Even the Fed's own researchers aren't sure. Here's a quotation from a January study in "The Regional Economist," a publication of the St. Louis Fed. "The second type of labor market turnover is more permanent, what economists call "structural" job losses or gains. Structural unemployment occurs, for example, when new technologies lead to new labor-saving production processes or lead to new types of goods and services that replace existing products. In manufacturing and agriculture, for instance, industries have continually taken advantage of technological innovations that have lessened their demand for labor. The result is that fewer workers are needed to produce the same amount of output, and the firms and workers who remain in these industries are more productive. "For example, from 1992 to 2002, the number of motor vehicles produced in the United States rose from 9.7 million to 12.5 million, while the number of production workers declined by about 5 percent to 222,000. "Big-box" retailers like Sam's, Costco and Best Buy have fueled dramatic changes in the distribution and warehousing of goods. The information technology revolution has played an important role in this retail revolution.2 Although structural changes tend not to be the cause of recessions, they may nonetheless be a contributing factor to a jobless recovery." What does a structural change to the job look like? Take a look at the chart below. You can find the whole report here. Greenspan could be right. Maybe the jobs will come. And if they do come, and if they are driven by technology, maybe we simply can't know what they are until they get here. After all, who would have guessed the people below would go on to create so much wealth for investors and productivity for business? Still, all the evidence points to an America with excellent technology and high-paying jobs. And I haven't explored how rising productivity helps the whole work force. But in the shorter-term, a lot more Americans are going to be "displaced" under globalization. They already don't' like it. They'll like it even less as the pace picks up. In fact, they may like it so little that their lackey politicians start clamoring for trade restrictions...oh wait...that's already happening. By the way, if you're a data junkie like me, you may be interested to know that the last year in which business investment in industrial goods exceeded IT investment was 1977.

Quote of the Day, Part Two

Looking forward politically by looking backward historically, from John Flynn's "As We Go Marching." "...Facism is a system of social organization which recognizes and proposes to protect the capitalist system and uses the device of public spending and debt as a means of creating national income to increase employment."

Quote of the Day, Part One

From my friend Paul Van Eeden, who has an excellent column up at http://www.kitco.com/weekly/paulvaneeden/jan302004.html. The good news is that large trade deficits can be eliminated. The bad news is that a large trade deficit is almost always followed by a recession, the magnitude of which is proportional to the trade deficit. Given the size of its trade deficit, it would be a pleasant surprise if the United States can eliminate its current trade deficit by a mere recession. The magnitude of the deficit suggests a depression is more likely.

February 02, 2004

Disposable Income Currently Indisposed

Topping the eco news today, disposable personal incomes grew at 0.1% in December. That was after the tax-cut and rebate boost of the third quarter when incomes grew at over 8%. In other words, there were no cash-bonuses under the Christmas tree for most Americans (or in the mailbox, for those who don't celebrate Christmas.) The big bombshell in the Q4 GDP report is that the total fourth quarter expansion in disposable income of $1.7 billion was 99% lower than the third quarter expansion of $160 billion. Hat tip to the always-reliable Greg Weldon for the legwork on this. This falls into line perfectly with our strategy laid out last week of being bond bulls and equity bears. It's probably bad news for durable goods manufacturers who were already reeling from the recent subpar report. That's what you get though, when you front load consumption through artificially low rates. Discretionary spending on non-big ticket items falls when consumer incomes tighten. Even if tax refund windfalls are large this year, a possibility, the weak labor conditions make it more likely that the savings rate (currently 1.3%) will go up, rather than consumer spending. Of course, I could be wrong and Americans may keep spending far more than they make, even as they make less. Other highlights (or lowlights as the case may be) from the report (and all this courtesy of my fried Greg Weldon): *the personal savings rate was down to a new low. It came in at 1.5%, down from 2.3% in the third quarter *Personal consumption was down too. Finals sales to domestic buyers were up 3.1%, but that was less than half the third quarter pace of 7.2%. More evidence that the stimulus is less stimulating. *Wages and salaries rose at 0.5% in the third quarter. This was half the rise of first quarter, and down from Q3's 0.7% rate. In summary: incomes are stagnant, disposable income is vanishing, the stock market is still priced for utopia.

Chart of the Day

Heavy research day...light on blogging. But I did come across this revealing chart. It's a different kind of productivity, but nonetheless impressive for the U.K. No wonder the BOE is raising rates to cool the economy down. Forget about the punch bowl and cut off the beer consumption!

Quote of the Day, FCC launches investigation into halftime show

I didn't see it...er...I did see pictures of it later, not live. But the controversy surrounding nipple-gate seems a bit misplaced. It's obviously in poor taste. But it's completely consistent with the sex-saturated programming on MTV. "I am outraged at what I saw during the halftime show of the Super Bowl. Like millions of Americans, my family and I gathered around the television for a celebration. Instead, that celebration was tainted by a classless, crass and deplorable stunt. Our nation's children, parents and citizens deserve better.'" Michael Powell, Chairman of the FCC Two points. One, if you don't like what you see on TV, do less celebrating around it. And two, if you think you deserve better than what you're watching, change the channel. Or better yet, don't watch at all! The last thing we need is to use something like this as an excuse for more regulation. T.V. IS regulated...by viewers who can switch off.

Deficits DO Matter

Just one last follow up to the topic broached less week about deficits. After sending the article below to my colleague, his question came back, "Can you prove that higher deficits slow down capital formation?" The answer...in the affirmative...below. If you measure government deficits as a measure of GDP, they seem smaller. But the key economic question, in terms of sustainability and capital formation, is government deficits as a percentage of gross saving. To what extent is government borrowing crowding out private investment and capital formation? First, some back ground from a 1994 Fed research paper titled “Fiscal Policies Aimed at Spurring Capital Formation: A Framework for Analsyis” (exciting title.) The authors, Robert Chirinko and Charles Morris had this to say about the negative impact of government deficits on capital formation: “Government deficits create a shortfall in private capital formation by reducing the pool of saving available for private sector borrowers, thus “crowding out” private capital formation. To the extent that deficits are not used for investment purposes {ed note: simple redistribution of income or debt service payments are not, in the economic sense, “investment”} total capital formation is reduced.” And to buttress the point that because its big bad Uncle Sam, and he can borrow at below-market rates and punish the rest of the market, the authors ad this: "An important feature of government borrowing is that it is insensitive to interest rates. That is, the government will borrow whatever it needs to finance its deficit no matter what the interest rate, because its budget deficits are always financed. As a result, deficits reduce the funds available for private capital formation.” It follows that larger government deficits reduce capital formation even more. But again, how do you measure the size of the deficit? At what size does it begin to matter? Auburn economist Dr. Roger Garrison published an article last summer on the very subject. Garrison said, in a nutshell, don’t look at GDP, look at gross private saving. The main purpose of GDP, as Senator Everett Dirksen once said, was to make everything else look small in comparison. Garrison says, “GDP makes for a politically attractive but economically irrelevant indicator. How much is government borrowing relative to the funds available for borrowing?” The Fed study authors tell us that in the 1970s, the federal deficit was 11% of private saving. Last summer, when Garrison ran his figures, the projected federal deficit of $304 billion was just under 20% of gross saving of $1.5 trillion. With a projected federal deficit of $521 billion, and gross savings in 2003 (excluding December) of $1.8 trillion, the federal deficit is nearly 30% of gross savings. Bingo. Rising deficits absorbing more of already meager private savings. The end result is what the Fed study’s authors tell us: “high (and growing) federal budget deficits increase competition for the scarce pool of private saving, raise interest rates, and crowd out private investment.” You might argue that foreign investment ads to the pool of available savings, reducing the negative impact of higher government borrowing. But foreign savings have also been going to finance government deficits, not towards investment and capital formation. Garrison says, “In recent years changes in international capital flows have been the primary consequence of increased deficits. This means that the US Treasury is going to to head with the U.S. export industry. Foreign funds flowing directly or indirectly into the Treasury are funds that are not spent on U.S.-produced goods ands services.” This LOOKS good in the short term, when all those foreign funds are keeping bond yields low and stock prices high. For one, it’s tenuous. The drop in the dollar has increased the cost of owning dollar-denominated assets. That means foreigner are a lot less likely to lend their savings to losing American financial investments. Ultimately, this points to the utter insustainability of budget deficits, at least at lower rates. Either the federal government begins to absorb even more of dwindling private savings, and pushes bond prices up (at the expense of stocks), OR the Fed’s raise rates to keep borrowing.