The Bear Facts

The Bank of International Settlements (BIS, which as far as I can gather is the central bank of central banks – conceived as somewhat of a regulator and now mostly an advisor), published its annual report today with a condemnation of recent central bank monetary policy. One can’t help but think that they are pointing fingers at a couple of banks in particular (I wonder where interests rates have been ridiculously low lately?). The following is the WSJ’s summary, see here for more (note that I rearranged the paragraphs and added italics):

“High inflation rates may not ease in 2009, as expected, and central bankers need to be extra vigilant to stop inflation expectations from creeping upward, Malcolm Knight, the BIS general manager told a news conference. There is “a clear and present danger of rising global inflation and inflationary expectations,” Mr. Knight cautioned”

“The BIS said that in the early part of this decade, central banks had failed to set interest rates high enough to restrain an unsustainable credit boom.”

“And it added that if a repeat of the current financial crisis is to be avoided in the future, central banks must be prepared to keep interest rates high even when there are no obvious signs that inflation rates are about to pick up.”

“It urged most central banks to raise their key interest rates”

How’s that for subtle?

And if this weren’t bad enough, here is their long-term potential scenario:

“The global economy may be close to a “tipping point” that could see it enter a slowdown so severe that it transforms the current period of rising inflation into a period of falling prices”

[... T}he impact of rising food and energy prices on consumers' incomes, combined with heavy household debts and a pullback in bank lending, may lead to a slowdown in global growth that "could prove to be much greater and longer-lasting than would be required to keep inflation under control.”

So, the takeaways are: inflation continuing into 2009 and for the foreseeable future unless interest rates start rising and a long-term possibility of an economic overreaction into deflation and a “slowdown so severe” we won’t even give it a name.

This probably deserves reading, so if you’re up for 216 pages, here is the link.

I think I’m going to rename my blog to “The Bear Facts”.

Sometimes I feel like I shouldn’t be a bear – the sun is still shining, the coffee is still warm and bitter, some cool technology continues to be made in the USA. But then I read the facts and notice the mass delusion and denial that abounds and cannot help but be a bear. At least until the next administration gets its bearings…

Today’s op-ed by Thomas Friedman is a case in point. Here are the highlights of “Anxious in America” (rearranged by me):

“My fellow Americans: We are a country in debt and in decline — not terminal, not irreversible, but in decline. Our political system seems incapable of producing long-range answers to big problems or big opportunities. We are the ones who need a better-functioning democracy — more than the Iraqis and Afghans [a bit exaggerated perhaps...]. We are the ones in need of nation-building. It is our political system that is not working.”

“Up to now, the economic crisis we’ve been in has been largely a credit crisis in the capital markets, while consumer spending has kept reasonably steady, as have manufacturing and exports. But with banks still reluctant to lend even to healthy businesses, fuel and food prices soaring and home prices declining, this is starting to affect consumers, shrinking their wallets and crimping spending. Unemployment is already creeping up and manufacturing creeping down.

The straws in the wind are hard to ignore: If you visit any car dealership in America today you will see row after row of unsold S.U.V.’s. And if you own a gas guzzler already, good luck.”

“On top of it all, our bank crisis is not over. Two weeks ago, Goldman Sachs analysts said that U.S. banks may need another $65 billion to cover more write-downs of bad mortgage-related instruments and potential new losses if consumer loans start to buckle. Since President Bush came to office, our national savings have gone from 6 percent of gross domestic product to 1 percent, and consumer debt has climbed from $8 trillion to $14 trillion.”

“If the old saying — that “as General Motors goes, so goes America” — is true, then folks, we’re in a lot of trouble. General Motors’s stock-market value now stands at just $6.47 billion, compared with Toyota’s $162.6 billion. On top of it, G.M. shares sank to a 34-year low last week.”

Well said.

For those of you who think the current housing crisis (let alone the consumer debt, fuel and energy crises), will be solved by a government deus ex machina, see this article from the New York Times (“As Bill Evolves, Mortgage Debt Is Snowballing“). Here are the highlights [italics are mine]:

“When Congress started fashioning a sweeping rescue package for struggling homeowners earlier this year, 2.6 million loans were in trouble. But the problem has grown considerably in just six months and is continuing to worsen.

More than three million borrowers are in distress, and analysts are forecasting a couple of million more will fall behind on their payments in the coming year as home prices fall further and the economy weakens.

Those stark numbers not only illustrate the challenges for the lawmakers trying to provide some relief to their constituents but also hint at what the next administration will be facing after the election. While the proposed program would help some homeowners, analysts say it would touch only a small fraction of those in trouble — the Congressional Budget Office estimates it would be used by 400,000 borrowers [out of the millions!] — and would do little to bolster the housing market.

“It’s not enough, even in the best of circumstances,” said Mark Zandi, chief economist of Moody’s Economy.com. The number of people who will be helped “is going to be overwhelmed by the three million [conservative estimate] that are headed toward default.”

I am renaming my blog. These stats are just ridiculous.

Dow is down to 11300’s.  Has it hit bottom?

Here is my favorite Bear quote of the day, from the WSJ,

“The market will make a bottom when the world seems like it’s coming to an end and sentiment is at rock bottom,” said David Kotok, president of money-management firm Cumberland Advisors in Vineland, N.J. “It’s always hard to tell when that point we’ll be, but for the moment, it doesn’t seem like we have that sort of real panic.”

The Dow industrials average is down to 11500 and I am appropriately in the middle of George Soros’ The New Paradigm of Financial Markets: the credit crisis of 2008 and what it means. It’s a really interesting book and I think it is a very useful and original perspective on the current troubles roiling the markets. Now, something surprising about the book which I didn’t find in the reviews I’ve read is that this is really a book about philosophy (thus the “new paradigm” portion of the title). In this post I will focus on the philosophy and in another on his analysis of the current crisis. Below is my understanding of the philosophical basis of his work.

First, a quote on what he considers to be the current financial markets paradigm:

“The belief that markets tend towards equilibrium has given rise to policies which seek to give financial markets free rein. I call these policies market fundamentalism, and I contend that market fundamentalism is no better than Marxist dogma. Both ideologies cloak themselves in scientific guise in order to make themselves more acceptable, but the theories they invoke do not stand up to the test of reality. [...] By endowing social sciences with the prestige of natural science it allows scientific theories to be used for manipulative rather than cognitive purposes.”

In other words, markets do not tend to equilibrium and the paradigm that they do on their own accord (and therefore that market regulation only gets in the way) is the fundamental source of today’s crisis.

Soros’ new paradigm is “the theory of reflexivity.” In a nutshell, social scientists modify that which they study by studying it – i.e., they can never uncover the complete truth but instead they create their own biased interpretation of reality. If this is true, then their analysis are always biased and can sometimes be grossly and self-perpetuatingly incorrect (e.g., during bubbles and crashes), and consequently institutions and regulations are needed to make sure that self-fulfilling cycles based on illusions/misconceptions don’t get out of hand. As Soros writes,

“Instead of being always right, [in the new paradigm] financial markets are always wrong. They have the ability, however, to correct themselves and occasionally to make their mistakes come true by a reflexive process of self-validation. That is how they can appear to be always right. To be specific, financial markets cannot predict economic downturns accurately, but they can cause them.”

“When do the reflexive connections which are endemic in financial markets turn into self-reinforcing, historically significant processes which affect not only prices in the financial markets but also the so-called fundamentals that those prices are supposed to reflect? [... My] preliminary hypothesis is that there has to be both some form of credit or leverage and some kind of misconception or misinterpretation involved for a boom-bust process to develop. [... The] main insight my conceptual framework has to offer is that misconceptions play a significant role in the making of history. [...] The prevailing paradigm acknowledges only known risks and fails to allow for the consequences of its own deficiencies and misconceptions. That lies at the root of the current turmoil.”

It’s powerful reading and certainly more adequate in explaining the past ten years of market fluctuations than any theory on how markets tend to equilibrium.

I’ll write more soon summarizing what he says about the current crisis and on the historical examples he sprinkles through the text.