Wednesday, September 28, 2011

Why China Won't Bail Out Europe

With $3 trillion in foreign currency reserves, China holds the largest single pot of investment funds in the world. The EU's sovereign debt crisis, which threatens to derail the world's financial system and foster worldwide recession, may require as much as $2 trillion to resolve (see It's not surprising that some have nominated China to be Europe's white knight, contending that the Chinese are so deeply integrated into the world's economy that they can't afford to stand by while the West belly flops. This is wishful thinking.

China has its own problems. It is stuck with a huge imbalance in its own economy, being way too dependent on exports. The economic slowdown in America and other Western nations is hurting growth in China. Unemployment is rising, while the commodities inflation caused by the U.S. Federal Reserve's easy credit policies is spurring consumer price inflation in China. Real estate values have bubbled up deliriously in China, and the bubble could burst soon as China's central government now tries to rein in overly enthusiastic bank lending. Since the Chinese have invested heavily in real estate, the bursting of that bubble could be very painful. From the times of emperors, the central government in China has been expected during crises to alleviate the difficulties of the Chinese people. Its failure to do so has typically meant the overthrow of a dynasty. Today's Communist government is well aware of this history.

Longer term, the Chinese have a severe demographic problem. The Communist government's one family, one child policy has constrained the numbers of younger people. Gen X and Y, and Millenials in China are proportionately fewer than they are in America. That means a smaller number of younger workers to support retiring older folks. The $3 trillion the government has in the piggy bank could play a valuable role in keeping generational warfare to a minimum in China.

Then, there's the question of optics. China's per capita income is about $4300, just a fraction of America's $47,000 and the EU's $32,000. China's government couldn't afford politically to bail out wealthy (from the perspective of the ordinary Chinese) Westerners while a majority of its people still don't have central heating or indoor plumbing.

The possibility that the EU needs $2 trillion to extract itself from the swirl in the porcelain bowl illustrates the intractability of the EU sovereign debt crisis. There simply isn't that much hard cash floating around to pay the debts Europeans incurred to live large for the past decade. The EU's latest talk of establishing a special purpose vehicle to leverage the capital of the EU bailout fund is simply another maneuver to shuffle paper and kick the can down the road. It tries to solve a problem of too much debt by creating more debt, and could increase the EU's overall debt load without providing any means for actual repayment. Indeed, the only concept under consideration for actual resolution of part of the EU's debt problems is forcing creditors to take haircuts on Greek debt (of somewhere between 21% and 50%). Haircuts, in this instance, means losses. These losses, and perhaps many more to follow, may be the only way to truly end the EU sovereign debt crisis. The losses would land initially in Europe's big banks, and then flow through the European Central Bank and Europe's governments to taxpayers. Slow growth and recession could follow. Europe is a long way from Lake Wobegon. There simply isn't a happy ending to every story.

Monday, September 26, 2011

The EU Paper Shuffle Continues

The Dow Jones Industrial Average closed up 272 points today, mostly on rumors of an EU bailout plan in the works. As always, the market buys on the rumor, and hopes for good news.

News reports, however, indicate the EU is mucking around with another paper shuffle. The European modus operandi ever since the Greek sovereign debt crisis blew up has been to shuffle and exchange pieces of paper that increase total debt levels without solving problems. Last year, a bailout fund was created, which allowed private sector creditors to ease out of the septic tank while drawing EU member nations and their taxpayers deeper into the muck.

The latest gossip seems to focus on creating a special purpose vehicle, capitalized by the EU bailout facility, which will issue bonds to finance its bailout activities. The funds raised by issuing these bonds will be used to buy up hinky sovereign debt of potential deadbeats among the EU's members.

An interesting feature about these bonds is that they will be useable with the ECB to collateralize borrowings by European banks. This makes the SPV's bonds attractive to EU banks. Those would be the same banks that hold hundreds of billions (or is it trillions?) of Euros of dodgy sovereign debt. By investing in SPV bonds, they'll place themselves in a virtuous (from their perspective) circle where funds they give to the SPV for its bonds will circle back to them as the proceeds obtained from selling toxic debt to the SPV. Stated otherwise, they'll swap snake droppings now stinking up their balance sheets for valuable bonds that can be used as collateral for ECB loans.

It's a very special special purpose entity that, immediately upon inception, is deemed sufficiently creditworthy to serve as an issuer of collateral acceptable to the ECB. Ordinarily, only gilt edged quality securities can be submitted to the ECB for loans. But this special purpose entity is indirectly capitalized by all the EU members, and implicitly is backed by all of them. Of course, no one in a position of authority will acknowledge that the EU's members explicitly or implicitly back the special SPV's bonds. But saddling the ECB with risky collateral could very possibly blow up the entire Euro zone. So, like it or not, the EU would create its own sovereign debt analogue to Fannie Mae and Freddie Mac. Losses from the SPV will land, one way or another, on the good burghers of Northern Europe.

The apparent purpose of the SPV is to be a "bad bank" which scarfs up toxic assets from commercial banks to clean up Europe's banking system. That's not a bad idea, in theory. Such an approach worked in the early 1990s to pull the Scandanavian countries out of a financial crisis. A tough question, though, is who gets to pay Tuesday for the losses that have been sustained today. European leaders have been shuffling and swapping paper since the early stages of the crisis, in the hope that kicking the can down the road would keep the ship afloat until Europe's economies revived and grew enough to produce the wealth to pay for the losses. Unfortunately, Europe's economies, and most of the rest of the world's economies, are slowing or stagnating. Recession may loom. In such a scenario, losses can't be absorbed by economic growth. They have to be allocated among debtors, creditors, taxpayers, or a rich uncle somewhere. Except that there is no rich uncle anywhere--China and Japan might toss in a few nickels each, but not the hundreds of billions needed for a workable bailout. And among debtors, creditors, and taxpayers there is nary a shred of selflessness to be found. This is like a bunch of people at a bar, slyly maneuvering to slip out before the tab comes, sticking the last guy to leave with the bill.

The EU will no doubt try to make the latest bailout sound as elegant and clever as possible. But look beyond all the proposed vehicles, entities, bonds, exchanges and facilities, and focus on who gets stuck with the tab. If the shlemiel won't be able or willing to pay up, then the transaction is just another kick of the can down the road that allows overall debtloads to increase, and pushes the EU farther into the abyss. And right now, no one is bellying up to the bar with a fistful of cash.

Friday, September 23, 2011

Why Gold Isn't A Safe Haven

In the past couple of days, gold has dropped close to 10%, and is now trading around $1650 per ounce. That's 15% down from its recent peak price of around $1920. Why the belly flop? The answer is that, contrary to pronouncements of bug-eyed gold fanatics who drool from the sides of their mouths, gold is not a safe haven from fiat currencies or the financial system. Instead, it is joined at the hip with the financial system.

Among the most active traders in gold are hedge funds and other financial firms. These market players mainline leverage. And when they can't find a vein, they smoke the stuff. Consider the nature of leverage. It's a loan denominated in fiat currencies like the dollar and the euro. Leverage must be repaid in fiat currencies. Banks extending margin loans don't want to speculate in gold themselves, so they require repayment in dollars, euros or some other fiat currency.

Leverage financed the great gold rush of 2008-2011. This time, prospectors didn't search for yellow metal in stream beds or under the ground. They sought riches in the trading platforms of exchanges. The ones that got into the market two or three years ago hit the motherlode. But as gold bubbled up, smart players began to wonder when the party would run out of punch. The financial crisis of 2008 taught us that bubbles will burst at some point. Stocks and real estate both bubbled up and burst, and gold isn't different. Part of today's selling is to lock in profits while the getting is good. Locking in profits involves converting gold holdings to a fiat currency. That's the only way to take your gold profits and use them to repay margin loans, and buy cars, food, housing, and so on. So when money managers think the gold bubble, as valued by fiat currencies, has peaked, they will sell gold in order to obtain fiat currencies.

Other hedge fund managers may be selling gold because their investors, seeing the world go hinky in recent months, are making redemption requests to cash out. Investors may be worried about stocks, oil, or other assets besides gold that the hedge funds invested in and are now falling in value. But gold is easier to sell than some assets because it has a highly liquid market. So investor redemption requests, in effect, hit the gold market. Investors want payments in fiat currencies, not distributions of gold. That means the gold has to be sold to convert it into fiat currencies.

The players who dove into gold also traded on a leveraged basis in stocks, other commodities and maybe derivatives that no one can easily learn about because the derivatives market, three years after the financial debacle of 2008, remains opaque. Part of the selling of gold is due to speculators having to raise cash to meet margin calls resulting from falling prices for stocks, commodities other than gold (such as oil, which has lost some of its sheen) and, perhaps, derivatives contracts. In this way, leverage used to invest broadly on a diversified basis can have an interlinked downward impact when some markets go wobbly.

The recent woes of the euro add to the problem. A fall by the euro has pushed up the comparative value of the dollar. Since gold tends to trade inversely to the dollar, a good day for the dollar means a bad day for gold. That's another reason for gold investors to bail before they sustain more losses. The inverse correlation between the dollar and gold reveals a vulnerability of gold to a fiat currency.

With the financial markets and world getting hinkier by the trading minute, the selling has accelerated in the past two days. The ship seems to be sinking, and you know who is scrambling to get off first. Leverage dramatically pushed up the price of gold, and now deleveraging and other financial factors are driving it down.

Today's gold market is a creature of the financial system, and is subject to the same pressures and constraints as other assets. Gold isn't a safe haven. What is? That's the question people have been asking since they sharpened long sticks for protection and sought shelter in caves. When you have the answer, please clue in the rest of us.

Wednesday, September 21, 2011

A Morally Hazardous Day

Today, the Federal Reserve announced a $400 billion program called Operation Twist, which is designed to decrease interest rates at the longer end of the yield curve without printing money. This monetary action was $100 billion more than expected. Nevertheless, the stock market promptly dropped more than 2%. Like a toddler demanding a pint of ice cream, the market had wanted the Fed to announce another quantitative easing program--i.e., bond purchases that would add hundreds of billions to the money supply. In other words, the market wanted money (see And, just like a toddler denied a pint of ice cream, the market threw a hissy fit when it didn't get what it wanted. The original Twist was better. See

Don't worry. The market sold off today because the news didn't match the rumors that speculators bought on. Tomorrow is another day, with new rumors to fuel speculation.

The big question mark hangs over Europe. EU leaders are killing entire forests to put out more press releases emphasizing how much they care about the sovereign crisis, and how they won't try to get their lives back until it's fixed. If you want talk therapy, you've got it. But things in the EU, already weird, are getting truly bizarre. Today, the European Central Bank announced that it would reduce the amount of exchange listed bank debt it would take as collateral, while lifting limits on non-listed bank obligations offered as collateral. In other words, easily-valued assets are less useful as collateral, while stuff (that's the polite term) with no readily ascertainable market value has become acceptable as collateral. One detects the aroma of ink used to print money. After all, if you can't readily determine the value of collateral, you can't easily determine how much you can safely lend. When the ECB lends more than collateral may be worth, skeptics would suggest that it's printing money. Then again, maybe it doesn't care; or at least it doesn't want others who care to have an easy time looking over its shoulder.

It's doubtful Operation Twist will have much impact on the economy. And the ECB's futzing around with collateral almost approaches alchemy. That takes us back to the Middle Ages. During the time of the Black Death, when the world seemed to be falling apart, some people believed that if they banded together and danced from village to village, their "jollity" would defeat the plague. There is no scientific record as to the effectiveness of dance on this illness. But when nothing else seems to be working, why not twist and shout?

Sunday, September 18, 2011

The European Union: All For . . . Well, Let's Think About This

Like the middle of a horror movie, this weekend's inconclusive meeting in Poland of Europe's finance ministers revealed growing realization of how scary the EU's sovereign debt problems have become. The ministers couldn't agree on how to stop Greece's plunge toward white water. But did they did acknowledge the need to strengthen the capital positions of their banks. In plain English, this means they haven't figured out how to put out the forest fire. But they are leaning toward building firewalls around their own borders.

This subtle shift toward self-preservation is a small step back from Greece's outstretched hand. Just a few months ago, European leaders loudly, if not entirely convincingly, proclaimed all for one, one for all. Now, their eyes flick nervously from side to side as they maneuver to see who gets the hot tamale (read, the cost of yet again bailing out the Greeks). Private capital is vamoosing from the markets for the sovereign debt of weak EU member nations. The ECB has stepped in by buying, or lending against, the dodgy debt. But that can't continue indefinitely, as the ECB isn't supposed to be a bailout fund. Greece has repetitive failure syndrome when it comes to meeting the conditions for bailout monies from the EU. While Germany and France have thus far dispensed enough bailout funds to prevent Greece from technically defaulting, they can't continue writing blank checks forever.

Some of the finance ministers testily rejected suggestions by U.S. Secretary of the Treasury Timothy Geithner to increase leverage for pan-European bailout funding, and to apply greater fiscal stimulus. Of course, it's their money he wants them to spend, and their national wealth he'd put at risk. So he's not quite the hit as was, say, George Marshall.

What the EU would be willing to do--the $64,000 question--remains a mystery. Perhaps the ministers like it that way. Last week, the stock market rallied almost 5% on nothing more than gossip, whisper and innuendo about European intentions to do the right thing, or something like that. If a few leaks and whispers to journalists can turn the markets around like this, why spend any money on bailouts? Just keep gabbing to the financial press, prop up the markets, and wink at your constituents while gullible stock investors make you look good.

Europeans are very good at inaction. As long as the stock market responds so deliriously to talk therapy, expect the EU to yak ad nauseum. There's nothing like a free ride, and last week's stock rally cost the EU nothing. One might harbor suspicions about stock valuations based on politicians babbling. But, then again, as we know from the tech bubble and the real estate/mortgage bubble, markets love bubbles. The European sovereign debt crisis will bubble along until some unexpected singularity pops up and the bubble painfully bursts. Then, investors will once again learn that irrational hope doesn't translate into financial gain.

But, in the short run, the EU and other government officials, ever Pavlovian, will dangle faint glimmers of hope. Today's market is all government, all the time. Take government out of the picture, and the market tanks. Knowing that, the Fed will reincarnate the "Twist" at its meeting this coming week--not the dance (perish the thought of Fed Governors dancing), but a lengthening of maturities in the pool of Treasury securities held by the Fed. This maneuver is meant to make the yield curve undulate, with shorter term rates rising a bit while mid-length maturities drop. Whether it will actually stimulate the economy is open to question, but one suspects that the Fed's main goal is to keep stock investors giddy by at least creating the appearance of not sitting on its hands. (Parenthetically, the Fed's Twist will flatten the yield curve, and a flat or inverted yield curve is often taken by market prognosticators as a sign of an impending recession; but interest rates are now completely controlled by government fiat, and entrails aren't likely to mean what they used to mean.)

The G-20 is meeting toward the end of the week. This consortium of large economies provides the EU and the U.S. with another public relations opportunity to hint at succor for distressed EU member nations. While it's doubtful that the G-20 will offer more than vague expressions of concern, you can bet that it will do a little fan dance for the stock market to lure in those investors desperately seeking any straw to grasp. One could fairly observe that this silliness can't continue forever. But market bubbles last longer and rise higher than anyone might reasonably expect. And this is a government bubble. Politicians, being quintessential windbags, will bloviate as long as anyone is around to listen. So this bubble might last for a while. But when the government bursts--and all bubbles eventually burst--who will provide the bailout?

Thursday, September 15, 2011

The UBS $2 Billion Loss: This and the Banks Want Easy Capital Standards?

Here we go again. Another big bank, this time UBS AG, reports an elephantine loss attributed to unauthorized trading. In this instance, the big boo boo was allegedly made by a derivatives trader identified in the press as Kweku Adoboli. It seems just like yesterday that Societe Generale 'fessed up to a $6.7 billion loss from its own rogue trader, Jerome Kerviel. Then, there was Nick Leeson at Barings bank, Yasuo Hamanaka at Sumitomo Trust, and John Rusnak at Allied Irish, among others, who have attained notoriety for generating leviathan trading losses. The big banks just don't seem to move up the learning curve when it comes to risk management.

It's no surprise that both the UBS mess and the preceding scandals involved lightly regulated markets. Bad behavior is always more likely when there are few hall monitors. But the banks themselves have the primary obligation to watch over their people and preserve their assets. They keep failing.

One has to wonder if the inevitability of government support makes it easier for bank executives to short sheet the risk management budget. Top management knows that no matter how massive losses get, the government will not allow a major bank to fail. Experience teaches that top management will generally not suffer much from one of these financial tectonic events. Some embarrassment, yes, and perhaps a modest haircut off one's bonus. But loss of employment and legal sanctions seem to be out of the question. So, why invest large sums in risk management systems when that would only reduce the amount of net income used to determine executive bonuses?

In addition, truly effective risk management would likely mean lower levels of risk taken. That would probably reduce income. It would also reduce losses. But management compensation tends not to be diminished as much by losses as it is leveraged by gains. So top executives are incentivized to take risks, and collecting outsized gains if the risks pay off. And if the risks fry the bank's butt? That would be a shame for shareholders.

Risk management is not just a problem for trading. One sees weak risk management in recent mortgage-related problems. Alleged poor underwriting standards for mortgage-backed securities may cost some big banks tens of billions each. The robo-signing foreclosure scandal will cost yet billions more.

And then there's Europe's sovereign debt crisis. Europe's major banks were the doofusses that financed the profligacy of Greece, Ireland, Portugal, et al. How the . . . heck . . . did they manage to put the world's financial system and economy at the edge of the abyss? Didn't they have controls that suggested diversification--not exactly a novel concept--might be in order?

For the past half-decade or more now, the world's largest banks have repeatedly imperiled prosperity worldwide. At the same time, they are coddled with bailouts, subsidies, and explicit and implicit government guarantees. Yesterday's announcement by Germany and France of support for Greece, and today's announcement by the Fed and other major central banks offering emergency dollar loans to Europe's commercial banks, are just the latest in a long line of handouts. Europe's banks have been facing growing customer runs, and more government munificence was deemed appropriate. Banks are like kids that never lose a soccer game, no matter how far behind they fall. No wonder they don't act maturely.

The regulators' proposal to end this cycle of wealth transfer from taxpayers to bank executives has been to raise capital standards. The so-called Basel III standards, which are in the process of being implemented, may require major banks to more than double the amounts of capital they hold, compared to the ineffectual Basel II standards. Banks are pushing back as vigorously as they can. Increasing capital means downward pressure on executive compensation, and that can't possibly be, can it? Some regulators may be wavering. The $2 billion loss reported by UBS is a timely reminder that there actually is a purpose to increasing capital standards--and in fact it's a good purpose even though it may likely decrease bank executive compensation.

We must not be lulled into thinking that the $2 billion loss by UBS will motivate banks to clean up their risk management messes. Prior scandals didn't, and this one won't. There surely are more rogue traders who haven't been caught yet. When their losses get big enough, they will be. Bank shareholders will pay the price, and taxpayers may have to pony up another bailout. Even though the Volcker rule will, if ever implemented, make it harder for U.S. banks to self-destruct from unauthorized proprietary trading, international interbank linkages will preclude insulation of the U.S. financial system from the failures of foreign banks.

Truth is we'll never get rid of too big to fail. It's a tax on the citizenry that cannot be repealed, Tea Party or no Tea Party. The next best thing would be to proceed with increasing capital standards. Only when banks are forced to pay, at least in part, for the costs they impose on society, will they begin to stop acting like welfare queens.

Tuesday, September 13, 2011

Why the EU Has No Policy Options

Why has it been so difficult for the EU to resolve its sovereign debt crisis? Because it has no policy options.

Fiscal policy is limited by the EU's ostensible restriction of government deficits to 3% of GDP. Virtually all EU members, including powerhouse Germany, have violated this commandment. With deficits already exceeding 3%, EU members can't go Keynesian (more so than they already have).

The European Central Bank, guardian of the Euro, is constrained by its charter to promote currency stability, meaning that it is duty bound to keep inflation low. At 2.5%, inflation in the Euro zone is moderate. But the ECB can't take the low road of expediency and inflate the Euro in order to ease the burden of repaying the EU's sovereign debt and make the Euro zone more competitive internationally. Aside from violating its charter, the ECB would rile up the Germans, for whom inflation is anathema and perhaps cause enough to leave the EU.

Germany was the wealthiest proponent of the EU, and created the union in its own image. Fiscally prudent and indefatigably vigilant against inflation, the EU allows member nations to combat excessive debt only by enhancing the productivity of workers and elevating economic growth. A very German solution, but not all of the EU is German or inclined toward that persuasion.

So what's left? Right now, talk therapy is being offered. Rumors of Chinese interest in Italian bonds surfaced first. These preliminary discussions are less than first touted, focusing on strategic investments in Italian companies than Chinese purchases of Italian government bonds. In other words, the Chinese are trying to cherry pick the best of Italy's assets in a moment of Italian weakness. That ain't a bailout in anyone's book. The Chinese premier has also made noise about Chinese support for EU debt, but only if China gets improved trade access to Europe. That's just talk for now. Europe's immediate cash flow needs won't be served by this proposal.

Rumor mongers also proffer tales of Brazilian and other BRIC interest in Euro zone sovereign debt purchases. But these eager whispers appear to be just an agreement to meet and talk next week in Washington. The market has bobbed up and down the last couple of days. Its modest rises may be little more than short covering by hedge funds that don't want their butts fried in case some outside money actually wants to bet on Euro debt.

Outside money would appear to be Europe's only hope. It can't use fiscal policy, nor can it deploy monetary policy. But outside money may be far from a panacea. It can be profitably invested in EU sovereign debt only at a discount, something that by definition would preclude a bailout. And, even if the BRICs are willing to lend a helping hand, the hundreds of billions (and maybe more) of hinky Euro sovereign debt may defy the best of BRIC intentions. The BRICs are growing quickly, but don't by themselves have the sheer financial horsepower to haul Europe back from brink.

Europe remains a wealthy part of the world, with substantial economic resources. Europeans won't have to live on air. But the vision of living ever larger indefinitely into the future dangled by EU enthusiasts is as mythical as the chimera. The only way for the EU to survive is to endure a long, painful test of shared sacrifice and loss, leavened only by disappointment and disillusionment, before a true United States of Europe can be forged. And it's far from clear that Europeans will meet that test.

Sunday, September 11, 2011

Is the EU Sunk?

Is it even possible to solve the European debt crisis?

An old adage goes, "lie to me once and shame on you; lie to me twice and shame on me." The financial markets seem to have taken that thought to heart, and now disdain the half-measures peddled by Euro zone leaders as solutions to the crisis. These leaders aren't stupid or uninformed. They know the score. The fact that they won't get to the bottom line suggests the bottom line is ugly.

A standard measure of a nation's ability to service its sovereign debt and still maintain healthy economic growth is that the debt be no more than 60% of GDP. Indeed, the EU theoretically requires new members to have a debt-to-GDP ratio of not more than 60%. What is the reality?

Today, the debt-to-GDP ratio of the EU as a whole is around 90%. Germany, which would be the locomotive for any true EU rescue of its spendthrift members, has a debt-to-GDP ratio of about 80%. Not the best starting point for a bailout. Moreover, Germany's GDP amounts to some 22% of the EU's GDP. With Greece, Ireland, Portugal, Spain and Italy all going the way of dominoes, it's doubtful Germany has the ability to uplift all the sinners.

These figures understate the extent of the problem. The European banking system is one of the largest creditors of the dodgy debtor nations, and would very possibly be insolvent if things fell apart. Indeed, the simple exercise of marking to market European bank holdings of EU debt would likely indicate that the major European banks are insolvent. So the EU would have to guarantee the indebtedness of the major European banks. That would include vast amounts of interbank borrowings, commercial paper, repurchase transactions, and other debt, and all derivatives liabilities (an almost unknowable quantity given the opacity of the derivatives market). How much more would that add to the EU's burdens? It's hard to say, but the amount could easily run into trillions (of dollars or Euros, take your pick).

Measured by typical standards, it would appear that the EU couldn't save itself even if it wanted to. There is, however, one way out. That would be for the European Central Bank to print vast amounts of Euros to create inflation, drive living standards down, and make the Euro zone more competitive worldwide. Such a course of action would violate the ECB's charter, which requires it to stabilize the Euro. Many Europeans surely realize now that the mandate to stabilize the Euro gave profligate EU members an arbitrage opportunity. In other words, they could take the path of expediency, and borrow at the lower rates fostered by a stable Euro in order to raise their living standards. These lower rates were available because the markets assumed all Euro denominated sovereign debt was implicitly guaranteed by Germany and the other economically strong EU nations. With access to unduly cheap credit, the spendthrift nations could live large without having to work hard for the productivity improvements that otherwise would have been required. Give people a choice between hard work and expediency, and what precisely do we think they will do?

Amending the ECB's charter to allow it to inflate the Euro would contradict the most strongly held German imperatives. Rampant inflation after World War I, coupled with enormous war reparations to the victorious Allies, put Germany economically in extremis and opened the door for National Socialism. Germans today would have to stop being German in order to consent to inflation.

The hard data shows the EU is swirling in the porcelain bowl. The political realities of implementing the only feasible solution--inflation--require that Germany, the most powerful EU member, cease being German. Where is there daylight at the end of the tunnel? The EU seems to be gradually realizing how deep in the septic tank it's sunk. The question now isn't how to get out, but whether there even is a way out. And the answer doesn't look pretty.

Thursday, September 8, 2011

Forget Washington. Watch Europe.

The President's $447 billion proposed jobs program is largely irrelevant. Congress will pass it in some form. The Republicans can't afford, 14 months before the next election, to entirely block the proposal. They need to demonstrate that they are part of the solution. Their obstructivism on the debt ceiling legislation hurt them more than it hurt the President. Their obstinacy now would let the President set them up to take the fall next year for high unemployment levels. So we can expect a jobs bill soon, probably in the range of $300 billion to $450 billion. It will help create some jobs, but not enough to dramatically reduce unemployment levels. Net impact: not much for the economy, plenty of grist for the political blame game.

The big stakes are over in Europe. The betting now is pretty much for the entire ranch. Proposals for a United States of Europe, on the one hand, compete with proposals for booting Greece (and perhaps other profligate EU members) out of the European Union. Europeans are facing up to the fact that muddling around with bond exchanges and other kicks of the can down the road won't fend off the swarming bond and derivatives vigilantes.

Neither option is attractive. A United States of Europe would appear to foster stability. But stabilizing its debt problems would soak up a lot of the wealth of the northern EU, leaving less capital available to finance future growth. The unexpectedly large burdens of sovereign and bank debt in Europe could cripple growth for years in a region that already suffers from low growth. Europe's per capita income is on average about a third lower than America's. The costs of unifying may widen that gap (a scary thought for Europeans, considering how stagnant America's economy has become). With the rest of the world's economy slowing, there's no powerful economic engine anywhere for the Europeans to latch onto. (China's economy is only one-third the size of America's, and everyone in the entire world wants a piece of it, so Europe can't count on China.)

Besides, it's unclear that unity would last. It didn't for the Soviet Union. Hell, it didn't for Czechoslovakia and Yugoslavia. Why would it last for the entirety of continental Europe (plus, maybe, the U.K.)? Certainly, unity would last as long as Germany and a few other well-off nations wrote checks to poorer member nations. But that's a gravy train that will run dry, perhaps sooner rather than later. Then what? Singing Kumbaya lasts only for a few minutes.

Splitting up the EU could trigger a financial crisis. Europe's banks have been financing the EU's growth, by making many loans to countries that turn out to be dodgy debtors. The bonds of as many as a third of the EU's members are now suspect. Booting Greece and other libertine nations would likely trigger domino defaults. Banks across the Continent might blow up one after the other, like a string of firecrackers on the Fourth. The well-off countries of Europe would have to commit their national wealth to propping the European banking system. The U.S. financial system would falter as well. But then the big American banks would line up at the Fed to receive their bailouts, which would be forthcoming in nanoseconds with an extra large helping of fries.

Whichever way they go, EU nations may well be damned if they do and damned if they don't. But that won't stop them from doing something, because the status quo is untenable. Whatever they do, the impact in America will likely be big. So read those impenetrable news stories about the EU in the middle of the third section of the newspaper. They're important.

Wednesday, September 7, 2011

Saving on Car Costs

When it comes to the cost of cars, people pay a lot of attention to the price they pay, their financing costs and the trade-in value they get. But the cost of owning a car can be as much or more than the cost of buying it. Maintenance and repairs can add greatly--or not--to your car budget. Insurance is also another major expense. An important way to reduce the costs of owning a car is to drive gently.

The harder you push a car, the faster it wears out. Charging down city and suburban streets as if you were driving in the Grand Prix puts a lot of wear and tear on the brakes, tires, transmission, and suspension. Drive the car gently, and the same items may last a lot longer. Take brakes. If you push the car hard, the brakes may need repairs every 30,000 miles, or maybe less. Drive the car gently, and the brakes may go 50,000 or 60,000 miles, or more, before needing work. If you put 100,000 miles on the car before you trade it in, hard driving could mean the expense of three brake jobs. Gentle driving may require paying for only one.

Tires offer similar savings. Properly inflated and rotated high quality tires, driven gently, may last 50,000 or 60,000 miles or more. The same tires on a car that's put through the paces every time you go to the grocery store may last only 25,000 or 30,000 miles--especially if you don't keep them properly inflated. If you drive the car for 100,000 miles before trading it in, you may have to buy two or three sets of replacement tires, or just one, depending on how you drive.

Suspension systems are vastly improved over the shock absorbers in the classics from the 1950s and 1960s. The shocks of that era might need replacement every 15,000 miles. Today's cars, with McPherson struts up front and better shocks in back, last much longer. Vehicles with rugged suspensions, like pickup trucks and SUVs with offroad capability, may, if driven gently, go 100,000 miles without needing suspension work.

Gentle driving also reduces the chances of accidents and tickets for moving violations, because you're likely to be going slower. That means a better driving record, which translates into lower insurance premiums.

Exhaust systems also last much longer than those of 40 years ago. Back in the days of the General Lee, a car might need a new exhaust system every 15,000 to 20,000 miles. Today, exhaust systems can have much greater longevity. Perhaps counterintuitively, it's a good idea to drive a car at least once every few days to prevent buildup of water condensation in the exhaust system. That will reduce the potential for rust, and help the exhaust system to last.

As for routine maintenance, do what the manufacturer recommends. This is especially important if the car is under original or extended warranty (which will require compliance with the manufacturer's maintenance recommendations). The manufacturer's maintenance schedule can often be found in the owner's manual; or maintenance work will be indicated when necessary by codes or lights on the instrument panel. However, be skeptical of routine maintenance the dealer recommends. Dealers make much larger profits from their service departments than from sales. They will push service managers to foist all kinds of unnecessary routine maintenance on unsuspecting customers. For example, fluid flushes (e.g., power steering or brake fluid) are frequently recommended when not needed. The time to listen to the dealer is when you have a specific problem you've asked the dealer to diagnose (and even then, be on guard).

When it comes to buying a new car, going through dealers' Internet Departments can be a money saver. See

Monday, September 5, 2011

Are Stocks Still a Good Investment?

The latest jobs report, on Friday, which revealed no net job growth, confirms what a lot of people suspected: that the economy is stalled out. The prospects for the future are guarded, at best. Businesses don't want to hire. Consumers don't want to spend. Political pressure from the right prevents further large scale governmental intervention. Except possibly by the Fed, and its options don't look appealing. The most it can hope for is that further money printing might puff up the financial markets and create a "wealth effect" to spur spending by the rich. But Tiffany, Hermes and Louis Vuitton don't employ that many people in America's heartland, so more money for the rich won't do much to revive the overall economy.

Are stocks still a good investment? Whatever the Fed does, it will have only a short run effect. QE2, announced a year ago, is already dissipating. If the Fed does QE3, it will likely have little or no impact beyond the months the Fed is running the money printing presses. After that, we'll probably stagnate again.

Japan's experience suggests pessimism. In the late 1980s, Japan had a real estate and stock market bubble that, if you can believe it, was more extreme than America's recent bubbles. Real estate prices went so high that people were taking out 100 year mortgages to pay for their homes. When it comes to encumbering future generations, that takes the cake.

The Nikkei 225 average peaked at 38,916 on December 29, 1989, and then popped a la Dow Jones Industrial Average circa 1929-1933. It eventually dropped below 8,000 (not a typo; we're talking a belly flop of more than 80%), and now putters around the 8800 level. Adjusted for inflation, that means the Nikkei 225 is still almost 80% below its all time peak. A minus 80% return for over 21 years is, no matter how you look at it, pretty stinky.

An example closer to home of the deleterious effects of an asset bubble is the Nasdaq stock market. The Nasdaq index peaked at 5,048.62 March 10, 2000. Since then it has dropped as much as 70% or so. It has never recovered more than half its peak value, after adjustment for inflation. Today, it trades around 35% of its 2000 peak, on an inflation-adjusted basis. A minus 65% return for 11 years is also pretty stinky.

The performance of other U.S. indexes isn't as bad as the Nasdaq. After adjustment for inflation, the S&P 500 trades around 54% of its all time peak on March 24, 2000 of 1527.46. The Dow Jones Industrial Average trades around 70% of its all time peak on April 11, 2000 of 11,287.08, after adjustment for inflation. Nevertheless, all of the major indexes are significant losers over the past 11 years.

Japan's government did a lot of the things the U.S. government has been doing since the 2008 financial crisis--deficit spending, money printing, zero interest rates, keeping downward pressure on its currency. None of it revived the economic locomotive that was the Japanese economy during the 1970s and 80s (although these measures may have prevented things from getting worse). The Japanese government protected jobs by keeping zombie corporations and zombie banks on life support. After ten or more years, the Japanese government began to eliminate zombie businesses. By the time it was done, however, the Japanese consumer was thoroughly beaten down, and China and other Asian nations had muscled into the export markets that Japan had previously dominated. While Japan remains a wealthy nation with a large export sector, it has limited potential for growth. Its stock market may not ever, in a time relevant to anyone reading this blog, recover its luster.

What of U.S. stocks? Economic growth is one factor crucial to future stock values--growth in America and growth overseas where U.S. corporations have markets. At this juncture, that's anyone's guess. Add to the mix downward pressure from Baby Boomers (in Europe and Aisa, as well as America) selling stocks to finance their retirements, and stocks appear to be a speculative bet. It is true that, after the 1929-33 crash, stocks recovered to about 50% of their pre-crash value after 21 years. But the enormous stimulus of wartime spending for the Second World War, plus the fact that America had most of the world's functioning industrial base immediately after the war, account to a large degree for that partial recovery.

Or course, not being in stocks means missing market upswings. If you buy today, you aren't paying the peak prices of 2000, but today's somewhat beaten down prices. Your basis is lower and future returns may be positive. It makes sense to have part of your portfolio in stocks. But don't think in terms of maximizing upside potential--that necessarily means maximizing exposure to downside risk. The past 21 years teach that risk of loss isn't a fictional bogeyman from fairy tales. You will lose money from time to time if you invest in stocks. But you may make some or all of it back, and perhaps enjoy net gains.

Put a good chunk of your portfolio in bonds and/or CDs. These investments add stability, and a bit of income. Reinvest the income (along with any dividends you get from your stocks) to get the benefit of compounding (for more on compounding, see

A portfolio invested 60% in stocks and 40% in bonds has historically performed pretty well in capturing most stock market gains while providing greater stability in value than stocks alone. As you get older, avoiding loss becomes more important than securing gains. So shifting as you age to a stocks/bonds and CDs ratio of 50-50, 40-60 and later 30-70 is prudent. None of this means you will necessarily make money. You may lose it. But you might lose more if you invest only in fixed income and money market instruments. Asset values, artificially inflated over the past 15 years by inordinate amounts of easy credit from central banks, have been deflating and may continue deflating for a long time. The only way to predictably increase your net worth is to save more. If you're nervous about the future, increase the amounts you're saving.