Monday, December 17, 2007


This should be good in an election year:

Dec. 17 (Bloomberg) -- The world economy is facing the risk of both recession and faster inflation.

Global growth this quarter and next may be the slowest in four years, while inflation might be the fastest in a decade, say economists at JPMorgan Chase & Co.


``What lies ahead is a period of stagflation -- slow or no growth combined with rising inflation -- in the advanced economies,'' says Joachim Fels, co-chief global economist at Morgan Stanley in London.

So far, economists say this will just be a "mild case" of stagflation compared to what we endured in the 70's and early 80's.

Funny thing though: many people don't remember the stagflation of the 70's and 80's because they aren't old enough (or even born yet.)

I wonder how people who weren't around for gas station lines, 19% interest rates and WIN buttons will react to even "a mild case" of stagflation?

Monday, December 03, 2007

The "R" Word

Four articles this morning would lead one to believe the country is either in a recession or headed for one - and it's going to be a doozy.

First, Bloomberg News reports that corporate profits for the third quarter are already in recession:

Dec. 3 (Bloomberg) -- U.S. corporate profits are in a recession, and the entire economy may not be far behind.

Slower sales and higher energy and labor costs are forcing companies from Bear Stearns Cos. to Pitney Bowes Inc. to reduce spending and hiring. Their efforts to keep earnings from eroding even further raise the risk that the economy, already weakened by the steepest housing slide since 1991, may shrink sometime next year.

``The earnings recession has already arrived,'' says David Rosenberg, North America economist for Merrill Lynch & Co. in New York. ``We are going to see an economic recession in '08.''

Next, Bloomberg News reports that Secretary of the Treasury Hank Paulson is desperately working behind the scenes to bash out a sub-prime mortgage accord with lenders and investors in order to stave off a second Bush recession:

The Treasury is negotiating with lenders to fix interest rates on some mortgages to prevent a surge in defaults as borrowing costs on 2006 loans rise from initially low rates. Paulson speaks at a conference in Washington at 10:30 a.m.

Paulson and Federal Reserve Chairman Ben S. Bernanke are concerned that falling home values will throttle consumer spending, which has driven much of the six-year expansion. By heading off further deterioration in the $11.5 trillion mortgage market, officials are also aiming to stem losses on securities backed by subprime loans.

Paulson and Bernanke kept playing down concerns about sub-prime mortgage problems until very recently, so there's no reason to think they actually have a handle on just how big the problem really is or how bad it's going to get now. Many analysts also believe it will be difficult to set up a large-scale program to realistically address the burgeoning foreclosure problem across the nation because so many of these mortgages are no longer held by the original lenders. And if the foreclosure problem can not be solved, the credit problem cannot be solved - at least not until all the bad debt gets cleared out of the system.

Paul Krugman notes in the NY Times that many in the financial world now realize that they don't really understand what they themselves have created:

The financial crisis that began late last summer, then took a brief vacation in September and October, is back with a vengeance.

How bad is it? Well, I’ve never seen financial insiders this spooked — not even during the Asian crisis of 1997-98, when economic dominoes seemed to be falling all around the world.

This time, market players seem truly horrified — because they’ve suddenly realized that they don’t understand the complex financial system they created.


“What we are witnessing,” says Bill Gross of the bond manager Pimco, “is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August.”

The freezing up of the financial markets will, if it goes on much longer, lead to a severe reduction in overall lending, causing business investment to go the way of home construction — and that will mean a recession, possibly a nasty one.

Behind the disappearance of liquidity lies a collapse of trust: market players don’t want to lend to each other, because they’re not sure they’ll be repaid.

In a direct sense, this collapse of trust has been caused by the bursting of the housing bubble. The run-up of home prices made even less sense than the dot-com bubble — I mean, there wasn’t even a glamorous new technology to justify claims that old rules no longer applied — but somehow financial markets accepted crazy home prices as the new normal. And when the bubble burst, a lot of investments that were labeled AAA turned out to be junk.

Thus, “super-senior” claims against subprime mortgages — that is, investments that have first dibs on whatever mortgage payments borrowers make, and were therefore supposed to pay off in full even if a sizable fraction of these borrowers defaulted on their debts — have lost a third of their market value since July.

But what has really undermined trust is the fact that nobody knows where the financial toxic waste is buried. Citigroup wasn’t supposed to have tens of billions of dollars in subprime exposure; it did. Florida’s Local Government Investment Pool, which acts as a bank for the state’s school districts, was supposed to be risk-free; it wasn’t (and now schools don’t have the money to pay teachers).

How did things get so opaque? The answer is “financial innovation” — two words that should, from now on, strike fear into investors’ hearts.

O.K., to be fair, some kinds of financial innovation are good. I don’t want to go back to the days when checking accounts didn’t pay interest and you couldn’t withdraw cash on weekends.

But the innovations of recent years — the alphabet soup of C.D.O.’s and S.I.V.’s, R.M.B.S. and A.B.C.P. — were sold on false pretenses. They were promoted as ways to spread risk, making investment safer. What they did instead — aside from making their creators a lot of money, which they didn’t have to repay when it all went bust — was to spread confusion, luring investors into taking on more risk than they realized.

Why was this allowed to happen? At a deep level, I believe that the problem was ideological: policy makers, committed to the view that the market is always right, simply ignored the warning signs. We know, in particular, that Alan Greenspan brushed aside warnings from Edward Gramlich, who was a member of the Federal Reserve Board, about a potential subprime crisis.

And free-market orthodoxy dies hard. Just a few weeks ago Henry Paulson, the Treasury secretary, admitted to Fortune magazine that financial innovation got ahead of regulation — but added, “I don’t think we’d want it the other way around.” Is that your final answer, Mr. Secretary?

Now, Mr. Paulson’s new proposal to help borrowers renegotiate their mortgage payments and avoid foreclosure sounds in principle like a good idea (although we have yet to hear any details). Realistically, however, it won’t make more than a small dent in the subprime problem.

The bottom line is that policy makers left the financial industry free to innovate — and what it did was to innovate itself, and the rest of us, into a big, nasty mess.

Finally, the AP reports that the U.S. adds $1 million dollars of debt a minute - or $1.4 billion dollars a day. If interest rates start to rise - as is expected to happen by the middle of next year, no matter how many interest rate cuts Uncle Ben gives this year - the interest on the national debt will really hammer an already overstrapped U.S. which has been fighting two foreign wars on borrowed money.

An overstrapped government, overstrapped consumers and a country that no longer manufactures anything and has made all its money recently by borrowing money from overseas and buying and selling assets and equities.

Scary stuff - and probably an even scarier recession coming down the road.

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