Thursday, April 17, 2014

The Shrinking Deficit: a Plus for the Market

The federal deficit is projected by the Congressional Budget Office to be just under $500 billion this fiscal year (the year ending Sept. 30, 2014). (See That's a lot of money, but only one-third the deficit of five years ago.  In other words, the deficit is lower by a trillion dollars, compared to half a decade ago.  That's a whopping huge drop, which leaves this year's deficit at 2.8% of GDP, below its historical norm of 3%.

When deficits fall, the government competes less in the credit markets against private sector borrowers.  This makes it easier for private interests to secure investment capital, a key predicate to economic growth.

Stocks tend to rise during periods of falling federal deficits.  The late 1940s and the 1950s are one example.  The 1990s are another.  The fact that stocks have risen steadily from their 2009 lows indicates that we are in another period of falling deficits and rising stocks. 

The future direction of the deficit is unclear.  The CBO predicts that it will fall a bit more next year and then begin to rise.  However, five years ago CBO didn't come close to predicting the deficit reduction we now have.  The weird, dysfunctional cognitive dissonance that is today's federal governance somehow managed to produce this beneficial result.  Who knows whether it might stumble its way to more good outcomes.  If the deficit stays moderate (near 3%), the markets will probably benefit.  While there are many other factors fueling volatility today, the federal deficit, improbably, isn't one of them.

Thursday, April 10, 2014

When the Market Will Go Down Next

With the stock market having more than doubled since its 2009 low, the question on the table--just about every investor's table--is when will the market turn down?  Recent trading days give us a likely answer.

For the past three trading days, the market dropped sharply as momentum stocks had bad momentum days.  Today, the market rallied briskly when the Federal Reserve released notes of its most recent open market committee meeting, indicating that central bank accommodation is alive and well.  Sweeter words could not have fallen on the market's ears, and stocks rejoiced.

As long as the market has confidence in central banks, there won't be a major downturn.  If the market senses that central banks are losing control, watch out.  Corporate earnings matter for individual stocks.  But central banking is the key to the overall direction of the market. 

Monday, March 24, 2014

The Limits of Globalization

Russia's seizure of Crimea reminds us that globalization isn't all it's cracked up to be.  The fall of the Soviet Union led to self-satisfied proclamations in the West about the triumph of capitalism and history ending in a glowing halo of liberal democracies.  Economic globalization would supposedly lead to worldwide reallocation of capital and resources to ever more efficient applications, with the result that economic tides would rise everywhere and prosperity would simmer in every pot. Nations and peoples worldwide would become increasingly interdependent and interlinked, making mutual tolerance in everyone's pecuniary interest.  Pots would melt around the world, diversity would be embraced, and preschoolers everywhere would learn the lyrics of Kumbaya.

Russia is interlinked with the rest of the world today:  economically in the energy markets and the financial markets, and securitywise with America and Western Europe in terms of dealing with Islamic radicals.  But none of that made a difference when Ukraine moved toward closer links with the West.  The centuries old Russian imperial imperative--that the Eurasian heartland be controlled from Moscow--howled.  Russia endeavored to maintain strategic geographic advantage by snatching control of Crimea's ports and naval bases, securing military and trade access to warm water.  Political machinations inside Ukraine have increased, in an effort to impede its Westward shift.  Russian troops in large numbers coincidentally gather for exercises within spitting distance of Ukraine's borders.  The economic sanctions imposed and threatened by the West have had no discernible impact on Russian policy. 

Globalization was an illusion fancied by people who fancied themselves elites.  This fancy illusion could be maintained as long as one cultivated ignorance of history.  But globalization is nothing new.  Europe in 1913 had extensive cross-border economic and financial relationships.  The European elites of the day were multilingual, cosmopolitan and cultured.  Somehow, none of that prevented the ignition of World War I over . . . well, nothing.  The most ridiculous war ever fought, World War I resulted in 20 million dead and peace terms imposed on Germany that were so harsh they practically guaranteed another war.  And that war--the Second World War--would require only 21 years before exploding in a frenzy of land grabs disturbing similar to what Vladimir Putin is doing now.  Whatever economic, financial, cultural and other ties are fostered by globalization, they don't trump the tribalism that characterizes almost all peoples in Europe, Asia and Africa.

Tribalism is difficult for Americans to grasp.  Having built a remarkably successful, diverse nation, Americans struggle with the idea that narrow concepts of group, based on cultural and historical ties, could somehow be so important as to justify conquering and killing.  Surrounded by the enormous economic benefits of the Melting Pot, Americans don't understand why other peoples can't embrace tolerance when tolerance will allow them bigger shopping sprees at the mall. But history tells us that you have to understand and deal with other peoples' irrationalities.  War, after all, is essentially always irrational.  But there are plenty of wars, all the time.  A smart foreign policy incorporates the need to consider and address other peoples' motivations, whatever they may be.

Economic sanctions have a role in America's and Europe's response to Russia.  But it would be a mistake to think they will be enough.  The sheer exertion of power will also have a place.  This doesn't mean triggers need to be pulled.  Strengthening NATO would get through to Putin, whose attention you get only if you exert power.  A pragmatic alliance with China should be sought (recall that Russia and China fought brief shooting wars in 1929, 1934, 1937 and 1969, so the Chinese have no illusions about Russian intentions).  The Japanese, who fought two wars with Russia in the 20th Century, should get a fist bump and more.  Unavoidably, America's Cold War coalition will have to be rebuilt.  And that's okay.  What's not okay is to believe that reason, plus maybe a few trade deals, will bring Putin around.

Sunday, March 16, 2014

How Putin Makes America Look Good

Not long ago, America was having a lot of bad hair days in foreign affairs.  The war in Iraq ended without stirring speeches or victory parades.  The war in Afghanistan is winding down, but won't have a prettier conclusion.  America led from behind in Libya and messed up in Benghazi.  Then, America led from even farther behind in Syria and, not surprisingly, got an aviary flip from the Assad regime when President Obama objected to the use of poisonous gas.  To avoid being totally blown off by a two-bit tin pot dictator, the Obama Administration had to work with Vladimir Putin's autocracy for a face-saving compromise that still isn't near full implementation.  America's grand strategy of pivoting toward Asia has floundered as extremism of numerous varieties keeps provoking eruptions in the Middle East and Europe.

Now comes Vladimir Putin--let's call him Vlad the Invader--who puts the shine on the United States.  Using the most transparently farcical of pretexts, Putin seized Crimea from Ukraine.  Okay, so there was a referendum in Crimea as to whether or not to "validate" the Russian land grab.  But with thousands of Russian troops "guarding" the polls to ensure "integrity" to the voting process, we knew how the vote would turn out before the polls opened.  There is nothing America can do to prevent Russia's annexation of Crimea, just as there was nothing America could do to stop Putin's 2008 land kleptomania in Georgia.

But America can and will react.  The EU will talk a lot--and then talk some more.  It will issue a few condemnations and maybe even an excoriation.  But sanctions?  Well, let's talk some more. 

America's sanctions will be primarily economic.  And Russia will respond in kind.  America's economic interests will suffer.  But Russia's economic interests will suffer more.  Not necessarily in terms measured by dollars (or rubles), but in terms of relative pain.  Russia has a much smaller and weaker economy than America.  And Russia's economy is growing slower, with continued prospects for slow growth.  Crimea requires significant subsidies, which will further drain Russia's resources, along with the added cost of all the military "exercises" the Russian Army is staging with walking distance of the Ukrainian border.  From a strategic standpoint, Russia's nuclear arsenal is a match for America's.  But Russia's economic arsenal is far weaker.  And Russia's energy customers and trade partners will look elsewhere for supplies and opportunities, not wanting to give leverage to a bully with a powerful military.

The Cold War was primarily an economic struggle.  America and the Soviet Union engaged in a 50-year competition to build to the most advanced and powerful military.  Arsenals cost money, and America's vastly greater wealth left the Soviet Union moribund, unable to deliver prosperity or even anything approaching a First World standard of living for its citizens.

As America and Russia swap sanctions, it is important to keep in mind that, realistically, the goal isn't to force Russia out of Crimea.  That won't happen.  The goal is to turn the crisis into an opportunity to make America once again the world's shining beacon of freedom and democracy.  America's sanctions, although likely to be ineffectual in terms of sending Russian troops back to the barracks, will contrast sharply with the EU's decrepitude, and the near silence from the Asia.  As an ironic consequence, America's influence around the world, and especially in the periphery of Russia's borders with many former members of the Soviet Union and former Soviet satellite states, will likely grow.  After all, no one likes a bully.  The bottom line is Putin has made America stronger.

The outcome of the looming war of sanctions is difficult to predict with precision.  But the advantage lies with America and its great economic strength.  Germany and Japan won the early rounds of World War II.  The Soviet Union won most of the early rounds of the Cold War.  But we know how those stories ended.  Even if Putin will be able to feel like a studly fellow for a while, time isn't on his side.  Keep the faith.

Monday, March 3, 2014

Why Regulate Bitcoin?

Okay, so Mt. Gox, once the largest Bitcoin exchange, has belly flopped and lots of people have lost lots of Bitcoins (apparently hundreds of millions of dollars worth).  Mt. Gox is in bankruptcy, but unsecured creditors like its erstwhile customers usually get the back of a hand in bankruptcy proceedings.  Last year, Bitcoin was celebrated for its independence from any national authority and the anonymity it supposedly provides.  This year, the losses from Mt. Gox have many crying for regulation.  Is that a good idea?

First, Bitcoin would have to change fundamentally for regulation to work.  Anonymity would have to go.  Regulators need to safeguard the market from thieves, manipulators, and all variety of fraudsters and other crooks.  That necessarily means they need to know who is behind transactions--potentially any transaction.  It is axiomatic among financial regulators that, in order to uncover shenanigans in the market, one follows the money.  And you have to be able to find out who is behind transactions in order to follow the money.  So, if you really want regulation, say goodbye to the anonymity of Bitcoin.

But an even more important question for the nation(s) that might consider regulating Bitcoin is why would regulation serve the public interest?  Bitcoin is economically trivial.  If all Bitcoins disappeared tomorrow, the world economy and all major national economies wouldn't even hiccup.  Setting up an effective regulatory regime would require not just one nation, but the participation of all economically significant nations because Bitcoin can be bought or sold worldwide.  The costs of establishing regulatory agencies, hiring personnel, buying equipment, leasing office space, and funding investigative and regulatory processes would, by all appearances, greatly outweigh the societal benefit. 

Another risk of regulating Bitcoin is that doing so would legitimize it.  Once a government begins to regulate a financial contract, it makes that contract more attractive to mainstream financial markets players.  That would mean the major banks, hedge funds and other big players would start trading all manner of Bitcoin contracts.  A derivatives market in Bitcoins would pop up, and with it all kinds of headaches about risk management, settlement and clearance, and so on.  All for something the world doesn't need. 

And sooner or later, some form of governmentally sponsored deposit insurance would probably be sought by Bitcoin enthusiasts.  If the big banks and hedge funds add their lobbying power, such insurance might make it through Congress.  But deposit insurance could easily, directly or indirectly, end up putting taxpayers on the line to cover Bitcoin losses like those suffered by Mt. Gox customers.  Which would be just peachy--another taxpayer funded bailout in the making.

The bottom line:  don't regulate Bitcoin.  There's nothing in it for national governments or taxpayers.  We don't need more financial risk for regulators, central banks and taxpayers to worry about.  If Bitcoin is truly worth anything, it will survive in the market.  And if it doesn't, good riddance.

Sunday, February 23, 2014

The WhatsApp Deal: Did Zuckerberg Just Blink?

WhatsApp is the antithesis of Facebook.  It doesn't collect personal information.  Messages aren't stored in WhatsApp's servers.  There are no ads on WhatsApp.  As a messaging service, there's nothing on WhatsApp for strangers (or parents) to find via search engines.  It offers the one thing that's almost impossible to obtain on the Internet:  privacy.  No wonder it's growing by a million users a day, many of them in the young adult cohort coveted by commercial websites.

It's unclear what Mark Zuckerberg hopes to achieve by having Facebook buy WhatsApp.  If he engrafts WhatsApp onto Facebook, or makes it semi-clone of Facebook (i.e., has it run ads), it will surely lose much of the privacy it offers.  Facebook's business model, after all, is to vacuum up as much personal information as possible in order to cram advertising into users' faces.  But that could drain away much of WhatsApp's attractiveness to its current user base, and they could easily flee to any of a number of competitors offering private communications. 

If Zuckerberg keeps WhatsApp independent, he'll have to find some way of generating revenue--a shipload of it, since Facebook is paying $19 billion for WhatsApp and the only justification for such a Brobdingnagian price would be freight cars full of revenue.  But you can't charge users much for instant messaging services (the phone companies tried that with text messaging and users are moving away from them).  So there is a big question about what kind of rabbit Zuckerberg will pull out of the hat as a business strategy for WhatsApp.

One thing that seems apparent is that he's blinked.  Zuckerberg evidently has come to realize that Facebook isn't going to be the platform for all users all the time.  He's jumping onto one of the new, hot things on the Internet.  Diversifying Facebook's corporate profile may be a prudent move.  But the company now has two conflicting business models under its corporate roof, and it will have to sort out how to handle these conflicts.  History does not suggest success is assured by any means.  Microsoft entered various lines of business that were potential threats to its basic MS-DOS/Windows business--search engines, portals, mobile software, etc.  It didn't managed them very well, because boosting a newer technology could mean undermining its cash cow.  Newer, nimbler competitors, unburdened by these conflicts, ran circles around Microsoft.  Facebook is one of them.  But now it has taken in-house a conflict between the old (yes, Facebook is getting old) and the new on the Internet.  How Facebook handles that conflict could dictate the future arc of its growth.

Wednesday, February 12, 2014

More Badness in the Bigness of Banks

The problems presented by gargantuan banks aren't limited to just too big to fail.  In recent months, we have seen government investigations and enforcement actions dealing with price fixing by big banks in interest rates (LIBOR), foreign currencies, oil and other commodities.  Cartels and oligopolies are antithetical to free enterprise.  To make things worse, the things that were the subject of the conspiracies--benchmark interest rates, petroleum, and the value of the medium of payment in various countries--affect the prices of numerous contracts, investments, products and other things.  Thus, the impact of the price rigging ripples through national and international economies, with the result that a lot of things aren't accurately priced.

The size of the mega banks allows them to dominate these markets.  The small number of players involved makes collusion easy.  It's hard to rig markets with dozens or hundreds of competitors.  But a few big dogs readily find it more profitable to stack the deck in their favor and reap monopolistic returns than compete with lower prices.

Collusion deprives consumers, investors and others of the benefits of competition and efficient markets.  The oligopolists are richer by their financial hooliganism.  The rest of us are poorer.  When banks are too big to fail, governments--and ultimately taxpayers--prop them up.  It would appear that the big banks return the favor by rigging prices.  It's getting harder and harder to see the societal benefits of really big banks.

Wednesday, February 5, 2014

Is Financial Inequality Constraining Economic Growth?

Businesses are having trouble raising prices.  (See  Consumers resist price increases and look for cheaper alternatives.  The stagnation of middle class incomes surely plays a large role in keeping downward pressure on prices.  With people becoming wary of debt, the decline in the real incomes of the middle class leaves folks with no choice except not to spend money they don't have.

It's become an article of faith among central bankers that a little inflation--in the 2.0 to 2.5% range--promotes economic growth.  And they strive for such a Goldilocks level of inflation.  Whether or not this actually will work isn't clear.  Inflation isn't like the flow of water from a faucet, which can be kept at a desired level while economic growth blossoms.  A slithering rattlesnake, sometimes moving slowly and sometimes moving quickly but always potentially dangerous, is a better analogy for inflation. 

Nevertheless, let's posit for the sake of discussion that Goldilocks inflation can be maintained continuously for long periods of time and that it does indeed give the economy a lively fillip.  The ongoing hollowing out of the middle class stands as a major impediment to the central banks' use of inflation as a stimulus for economic growth.  As income and wealth inequality increases, the middle class--and indeed much of the 99%--will obstinately resist price increases.  Inflation will remain muted and not contribute to growth.

There are plenty of reasons to be concerned about increasing financial inequality--reduced social mobility, decreased social cohesiveness, rising extremism (especially noticeable in Europe), and so on.  We can add to the list that an increasingly plutocratic society may constrain the economy's ability to grow.  And that's not good for anyone.

Saturday, February 1, 2014

Emerging Markets: Another Asset Bubble Popping

The emerging markets asset bubble is popping.  Financial markets in China, Brazil, Turkey, Russia, and India have been falling, with no end in sight.  Commodities prices have declined.  And the major stock markets--in Japan, Europe and the U.S.--have been dragged down in consequence.  All because the Fed began to reduce its quantitative easing program.

We've been here before.  Fed easy money policies contributed to the tech stock craze of the late 1990s and the real estate and mortgage bubbles of the 2000s.  Those earlier bubbles popped when the Fed began to withdraw accommodation.  You have to wonder whether the Fed will ever learn:  long periods of accommodative policies inevitably create asset bubbles somewhere, and when the accommodation is reduced, the bubble will pop.  Painfully, since there is no other way for an asset bubble to pop. 

When tech stocks, and then real estate and mortgage markets, crashed, recession and unemployment followed.  The results included, among other things, higher and higher levels of unemployment and greater inequality of income and wealth over the past 15 years.  When the Fed repeatedly uses its very blunt monetary weaponry to combat economic slowdowns, the rich get richer and everyone else stagnates or declines. 

What will the Fed do in response to the emerging markets downturn?  Initially, nothing.  It will hope that the positive momentum that has emerged in the U.S. and to a limited degree, in Europe, will be enough to maintain overall global economic equanimity.  But if the decline extends for several more months (particularly in major stock markets), expect the Fed to rethink its stance and get the monetary printing presses revved up again.  As we have discussed before (see, fiscal policy will be darn near nonexistent this year.  Fed easy money policy is the only way for the federal government to combat economic distress.  And even if more money printing means yet another asset bubble a few years down the line, and more income and wealth inequality, the only choices nevertheless remain easy money or easy money.  The Fed's policies are the only game in town.

One might lament that the Fed never seems to learn that too much accommodation leads to yet another asset bubble that pops, causing distress and dislocation that leads to more accommodation, which only continues the cycle.  But the problem is the Fed has little choice.  Congress and the White House mostly stare at mirrors and ask who is the fairest of all.  The business community waits for the federal government to stimulate the economy, reduce its risks and heighten the potential for profits.  The Fed personifies moral hazard:  the rest of the world has learned that, when push comes to shove, the Fed will act.  So there's no need for anyone else to step out front and center and take the lead. 

How do we break this vicious cycle?  Well . . . uh . . . there was once a time--long, long ago--when the private sector would lead the way out of recessions.  Businesses would start to expand, banks would start to lend, investors would start to take risks.  But how likely is that to happen now? 

Saturday, January 25, 2014

Questions About Bitcoin

The hype about Bitcoins is reminiscent of some of the early hype about the Internet.  Long, long ago, in the Paleolithic times of 20 years ago, the Internet was seen as an idyllic world where all would be equal and a person could accomplish anything with a computer and just a little effort.  The wide open nature of the Net allowed anyone, however anonymous and humble, to speak out and be heard, create and be seen, reach out and touch untold millions, all with just a few keystrokes.  Wondrous things would happen; lead would be turned into gold; a veritable digital Eden would arise and everyone who entered would attain nirvana.

Well, it didn't quite work out that way.  Gigantic corporations now dominate the Internet, and powerful government agencies lurk in the background, spying high and low, leaving no server unmolested.  Bad people from around the world seek to victimize, defraud and destroy; and the wide open nature of the Net allows them to do so with just a few keystrokes.  The free-standing individual who was supposed to have been the pillar of the digital community has shrunk into an online sheep, waiting helplessly to be fleeced of all personal information, browsing habits, bank funds, and credit lines.

The Norman Rockwellian narrative of Bitcoins would have us believe that they are a pure form of value, unmarred by the pock marks of central bank policy.  "Mined" by solving mathematical problems, transacted anonymously on a peer-to-peer basis, Bitcoins would be finite in amount and invulnerable to inflation since no one, supposedly, would control them.  Those who held Bitcoins would be liberated from the oppression of governments and the highway robbery of fee-charging financial institutions that handle transactions in fiat currencies.  A brave new monetary system would supersede the corrupt, degenerative fiat currencies of yore, the clouds would part and the sun would shine forever.

But reality is turning out to be blemished.  It seems that the use of Bitcoins for payment made an online market for illegal drugs called Silk Road attractive to denizens of dark corners of the Net.  The anonymity of Bitcoin transactions is a godsend for scoundrels and knaves of every variety, with government crime fighters largely unable to figure out who to put on the Ten Most Wanted List.  It's now clear that Bitcoins will attract criminals, organized criminals, terrorists, tax evaders, and other miscreants with something to hide.

But, are there bigger monsters lurking in the shadows?  Rogue nations, which may be facing sanctions in financial systems denominated in fiat currencies, might find Bitcoins a convenient way to get back in business.  And business could be nefarious indeed, with weapons, equipment for processing radioactive materials, drugs, and other suspect cargo changing hands.  Intelligence services--foreign and domestic--would have many reasons to use Bitcoins.  Undercover operatives need to be funded.  Bribes need to be paid.  Deniability would be enhanced.  Detectability--and accountability--would be reduced. 

Then, there's the market for Bitcoins.  Unregulated and opaque, it's ideal for manipulators and fraudsters.  The mining process is getting harder and harder, as the mathematical problems that need to be solved become increasingly difficult.  More and more computing power is needed to solve them.  That means bigger, more complex and more expensive computers must be used. The advantage goes to those that are well-capitalized.  Yet the price of Bitcoins is notoriously volatile.  Who can afford to invest in the massive computing power that it now takes to operate a successful mining operation while withstanding the wild price swings in Bitcoin prices?  Wealthy speculators, rogue nations, organized crime, and financiers operating from secrecy jurisdictions might all see an opportunity to make a fast Bitcoin or two--or maybe a lot more--off of the naive true believers who buy and transact at the retail level.  Trading anonymously, these big boys could bid prices up using multiple accounts they control to trade back and forth with themselves.  They could pay for online ads hyping Bitcoins as they walk the price up, provoking an investment frenzy among the sheep.  Then, as the price reaches meteoric levels, they dump the coins that they've mined, and then walk away, leaving the price to move whichever way it will (which is likely to be down). 

The biggest potential problem for Bitcoins may well be that the big players will move in.  And, as with the Internet, the little people will suffer.  Invest at your peril.