Fin/Inv

Yesterday, we discussed Infrastructure spending, following the WSJ article on more tax cuts as a stimulus.

We know from history that rather than temporary tax cuts or spending, its been the big infrastructure projects that leave behind usable assets for the private sector are the biggest bang for the tax backed buck.

Think Interstate Highways, Apollo Space Program, Darpanet (internet), Manhattan Project.

Question: What sort of projects should the US be doing in terms of Infrastructure development?

A couple of quotes from Kathleen Pender at the San Francisco Chronicle: Little support for new home-buyer tax credit

"We are not advocating another one. We think it's important for the market to have time to recover on its own," says Walter Molony, spokesman for the National Association of Realtors.
...
"From a political standpoint, with Congress not wanting to increase the debt, it would be too expensive," [Bernard Markstein, senior economist with the National Association of Home Builders] says. "In terms of advisable, we are bordering on where tax credits become ineffective."

And HUD Secretary Shaun Donovan said yesterday, via Reuters: No talk of new homebuyer tax credit

"It is not high on anyone's list that we have heard. We have not heard Congress talking about renewing it," Housing and Urban Development Secretary Shaun Donovan said in response to a reporter's question about a possible tax credit renewal.

Aufschwung Made in USA: Im Juni 2010 stieg die Zahl der Food Stamps Bezieher, bereits den 20. Monat in Folge, um +474'036 Bedürftige im Vergleich zum Vormonat und um +6,393411 Millionen im Vergleich zum Vorjahresmonat, so die heutigen Daten aus dem US-Landwirtschaftsministerium (United States Department of Agriculture)!Beschämende 41,275411 Millionen US-Bürger bezogen im Juni die moderne Version

Except for the puddles.

Except for the puddles.

When futures ramped into the close on Tuesday, with heavier volume, I had an inkling the ISM number would be hot Wednesday morning. Indeed, that was the case.

However, a hot manufacturing ISM makes little sense (not that any economic numbers have to make sense except perhaps in the long haul).

One thing that struck me right off the bat was how the monthly ADP jobs report does not confirm the ISM number. Nor do the regional Fed reports that I have been following, especially the Philly Fed report as noted in 58 out of 58 Economists Overoptimistic on Philly Fed Manufacturing Estimate; Median Forecast +7 Actual Result -7.7, a "Veritable Disaster".

August ADP Employment Reports Shows Contraction in Manufacturing Jobs

Inquiring minds are reading the ADP August 2010 National Employment Report for clues on strength of hiring trends.

Private-sector employment decreased by 10,000 from July to August on a seasonally adjusted basis, according to the latest ADP National Employment Report® released today. The estimated change of employment from June to July was revised down slightly, from the previously reported increase of 42,000 to an increase of 37,000.

The decline in private employment in August confirms a pause in the recovery, already evident in other economic data. The deceleration in employment was evident in the major sectors and by size of business. This month’s decline in employment followed six monthly increases from February through July. Over those six months, the average monthly gain in employment was 37,000 with no evidence of acceleration.

August’s ADP Report estimates nonfarm private employment in the service-providing sector rose by 30,000, the seventh consecutive monthly gain. This increase was not enough to offset an employment decline in the goods-producing sector of 40,000. Employment in the manufacturing sector decreased 6,000, the second consecutive monthly decline.

Large businesses, defined as those with 500 or more workers, saw employment remain essentially flat while employment among medium-size businesses, defined as those with between 50 and 499 workers, decreased by 5,000. Employment among small-size businesses, defined as those with fewer than 50 workers, decreased by 6,000. In August, construction employment dropped 33,000. Construction employment has declined for over three years and the total decline in construction jobs since the peak in January 2007 is 2,275,000. Employment in the financial services sector dropped 5,000. Financial Services employment has declined for over 3 years.

ISM Smell Test

Rosenberg blasted the ISM report in Breakfast with Dave.

STRANGE ISM NUMBER ... DOESN’T PASS “SNIFF TEST”

Here’s why:

1.Most of the regional reports were very poor in August. Either they are collectively all wrong or the ISM is.

2. The share of respondents saying they experienced “growth” was 61%, the exact same as a year ago when ISM was sitting at 52.8.

3. The ISM gain was led by employment (58.6 to 60.4 — best since December 1983) in the same month that ADP manufacturing fell 6,000 (second decline in a row — it was -11k in July when ISM employment was 58.6, so clearly the latter is proving to be, at least for now, an unreliable labour market barometer). Production also ticked up to 59.9 from 57.0 and inventories rose to 51.4 from 50.2. These are all coincident indicators, as an aside (but an important aside).
Strange ISM number, it doesn’t pass the sniff test and here is one reason: most of the regional reports were very poor in August... either they’re wrong or the ISM is

4. According to the ISM, 76% of the manufacturers surveyed said that in August, their customer inventory levels were either “too high” or “about right”. At the turn of the year, just ahead of the big inventory swing that bolstered the GDP data, this metric was sitting at 60%. As a result, it would be folly to assume that the inventory and production categories will contribute to further ISM increases in the near- and intermediate-term. Norbert Ore, who presides over the ISM survey, had this to say about inventories: “If the inventory build isn't voluntary then we have a huge issue on our hands.”

5. Meanwhile, the more forward-looking components dropped, though were hardly a disaster. But orders slipped for the third month in a row, to 53.1 from 53.5 in July, 58.5 in June and 65.7 in both April and May. That is still a sharp squeeze in the growth rate of capital goods-related order books. At 53.1, ISM orders index is down to levels last seen in June 2009 (but when they were rising in “green shooty” fashion).

6. Backlogs were down as well, to 51.5 from 54.5 in July, 57.0 in June and 59.5 in May (and peaked in February at 61.0). At 51.5, order backlogs stand at their low-water mark of the year.

7. Supplier deliveries (measure of production bottlenecks) eased for the fifth month in a row — to 56.6 from 58.3 in July and well off the March peak of 64.9.

8. Looking at five decades worth of data, the share of the time in which we see orders, backlogs and vendor deliveries all decline in tandem, and the headline ISM index rise, is the grand total of 1%. No wonder equities rallies so much — we just witnessed a 1-in-100 event! Bring your camera.

9. Export orders dipped to 55.5 from 56.5 — the lowest they have been since last December. If the overseas economy is rocking and rolling, then why on earth would this component be declining? Not only that, but it looks as though, yet again, a good part of the inventory boost we still seem to be getting is being filled by imports — that sub-index jumped four points in August and does not bode well for the trade deficit, which subtracted 3.4 percentage points from headline GDP growth in Q2.

MORE ON THE DATA

It would be something if the ISM was being fuelled by broad based increases and occurring alongside a decent path in domestic spending. But the ISM gains were narrowly based and the inventories are continuing to be built up even as domestic demand is slowing down. And it is spending that drives production, not the other way around. The fact that fewer respondents are saying inventories are at low or desirable levels is going to set us up for some pretty hefty production and ISM reversals through the fall.

Art Cashin says "ISM is an Outlier"



For more from Art Cashin, please see 26 of Last 88 Trading Days have been 90% Days (Either Up or Down); 7 More Lean Years in Stock Market?

Let's assume for a moment the ISM number is correct. If so, manufacturers are ramping up production just as the economy is dramatically slowing by nearly every other measure.

I smell huge inventory problems coming up in the 4th quarter. In the meantime, let's party over a ramp in production with no buyers.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

I wanted to write an update early today because I am busy tonight.

I will start with a chart and then share a conversation with a credit trader that I had yesterday.

Let me first start real quick with a chart on bonds because this is what we talked about.

Folks, the volatility we are seeing in the treasury market over the past week is truly historic. Let's take a look at the 10 year the last few trading sessions:


My Take:

As you can see the 10 year is moving a full point per day in either direction at times.   This type of volatility has never been seen before according to my c friend that I have in the credit markets.

In 30 years on the street he told me that he has NEVER seen moves this big on a daily basis in treasuries.  It's unheard of to see moves like this and he added that it's not a good sign.

My friend explained that the bond market is getting extremely speculative and  traders are loving the volatility. 

He also added that this is not a "healthy" situation.  In fact, he is horrified by the price action.  As he put it "this is not going to end well". 

I'll be honest:  I have never heard him so bearish over the longer term.  He has no answer as to how we ever get out of this.

I brought up the idea of a "reset" and he pretty much hammered me on this.  He said "how do you reset?".  I sat for a second and thought about it and I then threw him a few scenarios.

I offered explanations like inflating out of the debt with a currency devaluation, a new world currency, or a 50% cut in government spending where the debt gets defaulted on etc.  He didn't buy any of it. 

In his view, all of the answers ended up with the same result: Failure.  The way he sees it from what I gathered, it plays out just like the plot in the 1980's movie "War Games" where a computer and a boy play a simulation game of nuclear war between the USA and Russia.

The two played the game several times and it always ended in the same way:  One side launches the nukes and the other side then retaliates.  The result always ends up with total nuclear destruction of the planet.

The various triggers of what started the war was triggered didn't matter because the result was always the same. 

In my friends view the same thing will happen with our economic system:

No matter what the economic trigger is, the end game will always be the same:  Systemic failure and chaos.  He just didn't see how any of my scenarios could rationally "work".  He put holes in all of my "reset" solutions. 

In the end I agreed with him which is sad because I really want to find a way out this mess and I am still hoping for a miracle.  The reality is a solution is a long shot at best.

We also concluded that nobody really has the answer as to how this plays out.  This is why you are seeing large hedge fund managers retiring(more on that later)..

You can read a million blogs on the financial markets many will claim that they have this all figured out.  The reality is they really don't. 

We have never dug a hole like this so deep before so how can anyone actually predict how we come out the other side.

As my friend said:  "We are in uncharted waters".  I think this is why you are seeing bond prices at near all time highs at the same time gold is also near all time highs.

The way I see it, most investors really don't know if the US dollar will explode into a hyperinflationary event or soar as the Japan scenario continues to develop.

The market is telling you it doesn't have an answer by taking bonds and gold to new highs at the same time.

The Bottom Line

He ended our conversation with a question that I thought was a good one:  " Jeff, What I want to know is what the big big money is doing?".   He added "When guys like Druckenmiller are walking away it's time to be nervous".

His point was if he is if guys like Druckenmiller are willing to walk away from their billions in fees, then it's fair to assume that they don't understand how the game works anymore, and if this is the case, tou can then assume they are also asking themselves if the game can actually still work moving forward.

I think this is an excellent point and it's why my friend asked the question about the big money.  He believes some of them are asking themselves questions like this:

What do I do with my billions if the system or the USD is going to fail? 

We finally finished up our conversation by offering up various scenarios on this question like moving to Asia, buying farmland etc etc. 

We came to the same conclusion on this question as we called it a night:  "Nobody has the answer".

I am guessing this will all end in a way that no one can predict because we have never been through anything like this before.  We have never seen a country that held the world's reserve currency potentially default.

Like they say....."There is a first time for everything". 

I'll be back with a writeup on the big jobs report tomorrow.

Disclosure:  No new positions taken at the time of publication.

Gastbeitrag von HajoZunächst eine Karikatur von "Helicopter Ben", dem aktuellen Fed-Chef Bernanke, der einmal angedroht hatte, die Fed werde zur Bekämpfung einer drohenden Deflation - falls erforderlich - Geld aus Hubschraubern abwerfen. Die US-Zentralbank Fed definiert die Geldmengenaggregate wie folgt:M1: alle US-Dollar-Barbestände in Banknoten und Münzen und laufende $-Girokontenbestände,M2:

Debtors and creditors are not the same.

Do Student Loans Make Eduction Affordable ?

You just assumed they did. It turns out to be a far seedier picture, if you ask College Scholarships.org!

Jess Bachman, who did several of the fantastic illustrations for Bailout Nation, turns his attention to this infographic of the scam that is Student Loan collections:

>

click for ginormous graphic

Hotel occupancy is one of several industry specific indicators I follow ...

From HotelNewsNow.com: STR: Chain scales report weekly increases

Overall, the industry’s occupancy increased 10.6% to 60.1%, ADR rose 2.4% to US$96.50, and revenue per available room increased 13.2% to US$57.98.

The following graph shows the four week moving average for the occupancy rate by week for 2008, 2009 and 2010 (and a median for 2000 through 2007).

Click on graph for larger image in new window.

Notes: the scale doesn't start at zero to better show the change. The graph shows the 4-week average, not the weekly occupancy rate.

On a 4-week basis, occupancy is up 7.9% compared to last year (the worst year since the Great Depression) and 3.9% below the median for 2000 through 2007.

The occupancy rate is just below the levels of 2008 - but 2008 was a tough year for the hotel industry!

Data Source: Smith Travel Research, Courtesy of HotelNewsNow.com

Three cheers for Eurosclerosis?

click for video

via C/SPAN

One of my Harvard colleagues recommends this critique.

Last week, we reviewed the History of US Interest Rates: 1790-Present via Doug Kass.

Following that Stephen (of Wells Fargo Advisors) pointed us to this fascinating 60 year cycle in interest rates.

It is quite compelling, to say the least:

>

Chart courtesy of McClennan Publications

The Nelson Rockefeller Institute reports State Tax Revenues Are Slowly Rebounding. However, as always, the devil is in the details. Let's take a look.

Preliminary tax collection data for the April-June quarter of 2010 show improvement in overall state tax collections as well as for personal income tax and sales tax revenue. However, revenue collections remain significantly below peak levels and are still weak in a number of states.

The Rockefeller Institute’s compilation of data from 47 early reporting states shows collections from major tax sources increased by 2.2 percent in nominal terms compared to the second quarter of 2009, but was 17.2 percent below the same period two years ago.

State Tax Collections



Gains were widespread, with 30 states showing an increase in revenues compared to a year earlier. After adjusting for inflation, tax revenues increased by 1.4 percent in the second quarter of 2010 compared to the same quarter of 2009.

In terms of dollars, California reported the largest increase in personal income tax collections in the second quarter of 2010, where revenue collections rose by $1.6 billion or 11.5 percent. Such increase is mostly attributable to legislated changes. Without California, personal income tax collections for the second quarter of 2010 show a 1.1 percent decline nationally in the April-June quarter, compared to the same period of 2009.

Sales tax collections increased by 5.9 percent in the second quarter of 2010 compared to the same quarter of 2009, but were still 5.4 percent lower than two years ago. With 42 of 45 sales-tax states reporting so far, only seven states reported declines in sales tax collections compared with the same quarter last year.



Among the corporate income tax states, 19 of 43 early reporting states reported declines for the second quarter compared to the same quarter of the previous year, while 24 showed gains. Fourteen states reported double-digit declines, while seventeen states reported double-digit growth in corporate income tax collections in the second quarter of 2010. The large variation among states’ corporate income tax revenues is due to volatility in corporate profits and in the timing of tax payments.

Among individual states, California reported the largest decline in corporate income tax collections in the second quarter of 2010, where revenue collections declined by $2.7 billion or 42.3 percent. California’s corporate income tax collections were strong in the April-June quarter of 2009 due to legislation that required taxpayers to pay 30 percent of annual estimated payments in each of their two first prepayments (April and June for calendar year corporations) versus the prior requirement of 25 percent. Without California, corporate income tax collections for the second quarter of 2010 show a 1.9 percent decline nationally in the April-June quarter, compared to the same period of 2009.

The Outlook

The state tax revenue picture in the first two quarters of the calendar year 2010 represented significant improvement from the collapse of the preceding quarters. Still, in most states, the overall trend for fiscal 2010 was very much in the negative. Now that most states have closed the books for fiscal year 2010, preliminary figures show that 34 of 44 states for which complete fiscal 2010 data are available saw declines in overall tax collections for the year. Collections from the two major tax sources — personal income and sales — were also negative for the fiscal year. With revenues still below prerecession levels and question marks surrounding the national economy, states face continued uncertainty at best — with continuing budget challenges a sure bet.

Improvement Mirage

Please see article for more charts, data, and analysis.

The "improvement" in personal income taxes was a mirage caused by California speeding up collection of personal income taxes. California required payment of estimated taxes before money was even earned! Ignoring California, income tax collections actually declined from a year ago.

Much of the improvement in sales taxes is a result of tax hikes, not increased sales. Those effects will soon wear off in year-over-year comparisons (assuming of course there is not another round of sales tax hikes, by no means a good bet).

In simple terms that dramatic rebound shown in the first chart merely means things have stabilized but only vs. the rock bottom depressed level of second quarter of 2009.

Gallup Polls and sales data from MasterCard Advisors paints the same grim picture. Please see Gallup Poll Shows Consumer Spending Pullback, Consumer Confidence Levels Below Depressed 2009 Levels ; Back-to-School Sales Bust Says WSJ for details.

States remain in a world of hurt and the economy is slowing once again. I expect GDP contraction in the third quarter.

Thus, states are going to have to address the problem of public union wages and pension benefits whether they like it or not.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

Here is a graph from the Council of Foreign Relations blog: Greek Debt Crisis – Apocalypse Later

Click on graph for larger image in new window.

This graph from Paul Swartz at the CFR shows the default probabilities on three different dates:

On April 30th, no European plan was yet in place to address the ballooning Greek debt, and default was considered a real possibility in the short term. On May 11th, just after the European Stabilization Mechanism (ESM) was announced, markets sharply cut their view on the odds of default across all time horizons. ... On September 1st, the market’s view of the probability of default within two years was lower than before the ESM was announced, but higher over longer time frames.

So initially the policy response lowered the default probabilities across all time frames (from red to light blue), but now - after further analysis - the default probabilities have increased for longer time frames (green).

News is preliminary, no idea yet whether it is a production well or not, but all 13 crew members on the Mariner Energy rig are accounted for. The Journal’s story here (which presumably will be updated); Bloomberg’s here.

Fed chief Ben Bernanke told the financial crisis inquiry commission today:

If the crisis has a single lesson, it is that the too-big-to-fail problem must be solved

***

Too-big-to-fail financial institutions were both a source ... of the crisis and among the primary impediments to policymakers' efforts to contain it ....

That's funny, given that Bernanke has been one of the biggest defenders of the too big to fail banks, arguing strenuously against breaking them up, throwing trillions of dollars their way, and begging the banks to play nice with one hand, while patting them on the back with the other hand and giving them a big wink.

And Christina Romer - Obama's outgoing chief economist and Chair of the Council of Economic Advisers - said in her outgoing speech yesterday, as summarized by Dana Milbank at the Washington Post:

She had no idea how bad the economic collapse would be. She still doesn't understand exactly why it was so bad. The response to the collapse was inadequate. And she doesn't have much of an idea about how to fix things.

Many have tried to explain to the neoclassical economists running the show exactly how bad the economic collapse would be, why it was so bad, and how to mount an adequate response to fix things. But Bernanke, Romer and the rest of the gang ignored them.

Who Knew?

As I pointed out in March:

Greenspan's big defense is that the financial crisis was caused by a "once-in-a-century" event.

Forget about the fact that the "once-in-a-century event" couldn't have happened if Greenspan's Fed hadn't:

• Turned its cheek and allowed massive fraud

• Acted as cheerleader in chief for unregulated use of derivatives at least as far back as 1999 (see this and this)

• And for subprime loans
  

• Allowed the giant banks to grow into mega-banks. For example, Citigroup's former chief executive says that when Citigroup was formed in 1998 out of the merger of banking and insurance giants, Greenspan told him, “I have nothing against size. It doesn’t bother me at all”
  

• Argued that economists had conquered the business cycle, and that modern, technologically advanced financial markets are best left to police themselves
  

• Preached that a new bubble be blown every time the last one bursts

• Kept interest rates too low

• And did alot of other hinky things
  

More importantly, as Nassim Taleb repeatedly points out, financial experts who don't plan for rare events are like pilots who don't know about storms.

There are storms out there, Taleb says, and any pilot who doesn't know how to deal with storms shouldn't be flying. Similarly, no one should be in a position of financial leadership if they don't know about - and plan for - the infrequent event:

High Priests Shake their Magic Wands Even Harder


As Australian economist Steve Keen wrote last week, mainstream economists have been acting like religious fundamentalists, rather than scientists:

Bernanke’s failure to realize this: it’s a failing that he shares in common with the vast majority of economists. His problem is the theory he learnt in high school and university that he thought was simply “economics”—as if it was the only way one could think about how the economy operated. In reality, it was “Neoclassical economics”, which is just one of the many schools of thought within economics. In the same way that Christianity is not the only religion in the world, there are other schools of thought in economics. And just as different religions have different beliefs, so too do schools of thought within economics—only economists tend to call their beliefs “assumptions” because this sounds more scientific than “beliefs”.

Let’s call a spade a spade: two of the key beliefs of the Neoclassical school of thought are now coming to haunt Bernanke—because they are false. These are that the economy is (almost) always in equilibrium, and that private debt doesn’t matter.

Indeed, as I wrote in June:

Most economists don't exercise any independent thinking because economists are trained to ignore reality:

As I have repeatedly noted, mainstream economists and financial advisors have been using faulty and unrealistic models for years. See this, this, this, this, this and this.

And I have pointed out numerous times that economists and advisors have a financial incentive to use faulty models. For example, I pointed out last month:

The decision to use faulty models was an economic and political choice, because it benefited the economists and those who hired them.

For example, the elites get wealthy during booms and they get wealthy during busts. Therefore, the boom-and-bust cycle benefits them enormously, as they can trade both ways.

Specifically, as Simon Johnson, William K. Black and others point out, the big boys make bucketloads of money during the booms using fraudulent schemes and knowing that many borrowers will default. Then, during the bust, they know the government will bail them out, and they will be able to buy up competitors for cheap and consolidate power. They may also bet against the same products they are selling during the boom (more here), knowing that they'll make a killing when it busts.

But economists have pretended there is no such thing as a bubble. Indeed, BIS slammed the Fed and other central banks for blowing bubbles and then using "gimmicks and palliatives" afterwards.

It is not like economists weren't warning about booms and busts. Nobel prize winner Hayek and others were, but were ignored because it was "inconvenient" to discuss this "impolite" issue.

Likewise, the entire Federal Reserve model is faulty, benefiting the banks themselves but not the public.

However, as Huffington Post notes:

The Federal Reserve, through its extensive network of consultants, visiting scholars, alumni and staff economists, so thoroughly dominates the field of economics that real criticism of the central bank has become a career liability for members of the profession, an investigation by the Huffington Post has found.

This dominance helps explain how, even after the Fed failed to foresee the greatest economic collapse since the Great Depression, the central bank has largely escaped criticism from academic economists. In the Fed's thrall, the economists missed it, too.

"The Fed has a lock on the economics world," says Joshua Rosner, a Wall Street analyst who correctly called the meltdown. "There is no room for other views, which I guess is why economists got it so wrong."

Read more at: http://www.huffingtonpost.com/2009/09/07/priceless-how-the-federal_n_278805.html

The problems of a massive debt overhang were also thoroughly documented by Minsky, but mainstream economists pretended that debt doesn't matter.

And - even now - mainstream economists are STILL willfully ignoring things like massive leverage, hoping that the economy can be pumped back up to super-leveraged house-of-cards levels.

As the Wall Street Journal article notes:

As they did in the two revolutions in economic thought of the past century, economists are rediscovering relevant work.

It is only "rediscovered" because it was out of favor, and it was only out of favor because it was seen as unnecessarily crimping profits by, for example, arguing for more moderation during boom times.

The powers-that-be do not like economists who say "Boys, if you don't slow down, that bubble is going to get too big and pop right in your face". They don't want to hear that they can't make endless money using crazy levels of leverage and 30-to-1 levels of fractional reserve banking, and credit derivatives. And of course, they don't want to hear that the Federal Reserve is a big part of the problem.

Indeed, the Journal and the economists it quotes seem to be in no hurry whatsoever to change things:

The quest is bringing financial economists -- long viewed by some as a curiosity mostly relevant to Wall Street -- together with macroeconomists. Some believe a viable solution will emerge within a couple of years; others say it could take decades.

Saturday, PhD economist Michael Hudson made the same point:

I think that the question that needs to be asked is how the discipline was untracked and trivialized from its classical flowering? How did it become marginalized and trivialized, taking for granted the social structures and dynamics that should be the substance and focal point of its analysis?...

To answer this question, my book describes the "intellectual engineering" that has turned the economics discipline into a public relations exercise for the rentier classes criticized by the classical economists: landlords, bankers and monopolists. It was largely to counter criticisms of their unearned income and wealth, after all, that the post-classical reaction aimed to limit the conceptual "toolbox" of economists to become so unrealistic, narrow-minded and self-serving to the status quo. It has ended up as an intellectual ploy to distract attention away from the financial and property dynamics that are polarizing our world between debtors and creditors, property owners and renters, while steering politics from democracy to oligarchy...

[As one Nobel prize winning economist stated,] "In pointing out the consequences of a set of abstract assumptions, one need not be committed unduly as to the relation between reality and these assumptions."

This attitude did not deter him from drawing policy conclusions affecting the material world in which real people live. These conclusions are diametrically opposed to the empirically successful protectionism by which Britain, the United States and Germany rose to industrial supremacy.

Typical of this now widespread attitude is the textbook Microeconomics by William Vickery, winner of the 1997 Nobel Economics Prize:

"Economic theory proper, indeed, is nothing more than a system of logical relations between certain sets of assumptions and the conclusions derived from them... The validity of a theory proper does not depend on the correspondence or lack of it between the assumptions of the theory or its conclusions and observations in the real world. A theory as an internally consistent system is valid if the conclusions follow logically from its premises, and the fact that neither the premises nor the conclusions correspond to reality may show that the theory is not very useful, but does not invalidate it. In any pure theory, all propositions are essentially tautological, in the sense that the results are implicit in the assumptions made."

Such disdain for empirical verification is not found in the physical sciences. Its popularity in the social sciences is sponsored by vested interests. There is always self-interest behind methodological madness. That is because success requires heavy subsidies from special interests, who benefit from an erroneous, misleading or deceptive economic logic. Why promote unrealistic abstractions, after all, if not to distract attention from reforms aimed at creating rules that oblige people actually to earn their income rather than simply extracting it from the rest of the economy?

***

Michael Rivero may have the hardest-hitting critique of all:

This seems to be a return to the mindset of the middle ages where only the clergy were allowed to read and interpret the bible and the laity were presumed incapable of comprehending the intricacies and subtle nuances of the faith.

And indeed there is a great deal of similarity between economics and [fundamentalist version of] religion in that both depend on the unquestioning faith of the masses that those pretty printed pieces of paper represent something real, albeit invisible.

But the advent of the printing press led people to take a closer look at the actual content of [fundamentalist version of] religion and it has been revealed not as a complex and sophisticated system but as a mish-mash of half-baked myths and legends often in contradiction with itself and used to enrich the church ....

The same is true of economics. the advent of the blog has led people to take a closer look at the actual content of economics and it has been revealed not as a complex and sophisticated system but as a mish-mash of half-baked theories and math often in contradiction with itself and used to enrich the bankers and conceal their fraud against the public. [Federal Reserve economist Karthik Athreya, who claims that only people with a PhD in economics can comment on economic policy] is reacting to the blogs the way [fundamentalist] priests reacted to Gutenberg's Printing Press.

The fraud and danger of the Federal Reserve system of banking stands exposed to the public eye, sans the "benefit" of correct interpretation by the self-appointed priests of Mammon. The public now understands that when a private bank issues the public currency at interest, debt will always exceed the available money supply. The public now understands that the Federal Reserve is no more Federal than Federal Express. The public now understands that the Federal Reserve is a legalized counterfeiting operation, that creates the money they loan out out of thin air! The public now understands that the Federal Reserve system of banking, since its creation in 1913, has reduced the value of a dollar down to about four cents! The public now understands that the Federal Reserve system is a pyramid scam that only works when ever larger populations of borrowers can be found, and that once an entire nation or planet has borrowed to the max, the system must crash (which is what is happening now).

Just as the [fundamentalist] priests, stripped of the arcane scriptures and rituals, stand exposed ... so too the economists, stripped of their arcane equations and theories, stand exposed ....

Karthik Athreya doesn't like that fact that the public sees the Federal Reserve for what it really is.

What Could Possibly Go Wrong?

Not only have our government "leaders" in the Fed, Treasury, Congress and White House ignored the real world, they have taunted it - like monkeys who pull the tail of the lion and then are surprised when the lion attacks:

• Let the largest U.S. banks go bankrupt repeatedly due to wild speculation, then blessed the speculation and helped cover up the bankruptcies

• Privatized profits and socialized losses, trashed the real value of the dollar, and let corruption run rampant

• Covered up all of the fraud which led to the crisis

• Rewarded looting by the big banks

• Given trillions in bailout or other emergency funds to private companies, but then refusing to disclose to either the media, the American people or even Congress where the money went

• Let banks buy the government lock, stock and barrel (and see this and this)

• Blown bubble after bubble

• Plundered the treasury to effect "a massive redistribution of wealth to the bank shareholders and their top executives"

• Allowed high-frequency trading to completely warp the markets

• Waged unnecessary wars all over the world, so that even our top military commanders are begging to slash defense costs, and otherwise buried our nation under mountains of debt (see this, this, this, this, this and this)

• Failed to take any meaningful steps to stabilize - let alone fix - the economy (see this and this)

Under these conditions, it is impossible to have a decent economy. After pulling these kind of shenanigans, of course the lion of debt and depression is going to eat us alive.

Much ink has been spilt over the question of whether government bonds are in a bubble or not. The bond bubble believers love to cite stats along the lines that bonds are witnessing inflows at the same pace as equity funds did during the TMT bubble.

The bond lovers respond an asset with a finite life and no hope of limitless capital gain can’t really be a ‘bubble’, and beside they argue the ‘fundamentals’ warrant current valuations. (i.e. inflation is low and will remain so).
However, to me this is largely a sterile debate over semantics. The issue shouldn’t be whether bond are a bubble or not, but rather are bonds a good investment or not? Ben Graham defined “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative”.

Do bonds offers long term investors a sensible level of return? I’ve always thought that in essence bond valuation is a rather simple process (at least one level). I generally view bonds as having three components: the real yield, expected inflation and an inflation risk premium.

The real yield can be measured in the market thanks to inflation-linked bonds. In the US, a 10 year Tip is trading at just under 1%. Expected inflation can be assessed in a variety of ways. We could use surveys, for instance, the Survey of Professional forecasters shows an expected inflation rate of just under 2.5% p.a. over the next decade. In contrast, the nominal bonds minus the TIP yields implies a figure of more like 1.5% p.a. The inflation swap market is implying a 2% p.a. inflation rate over the next ten years.

The inflation risk premium (a risk premium to compensate for the uncertainty of future inflation) is generally held to be between 25bps and 50bps. Given the uncertainties surrounding the impact of monetary and fiscal policy I’d argue that using the high end of that range seems reasonable.

Using these inputs a ‘fair value’ under normal inflation would be around 4%. Of course, this assumes that the current market 1% real yield is itself a ‘fair price’. This seems like a questionable assumption to me. In the UK we have a longer history of index linked bonds – introduced in 1986. The average yield since the introduction is 2.6%, in the last decade the average real yield has been 1.5%. Given this ‘parameter’ uncertainty is would be reasonable to say that ‘fair value’ for 10 year bonds is somewhere in the range of 4-5%.

The current 2.5% yield on the US 10 year bond is clearly a long way short of this. So unless you believe that Japan is correct template for the US (i.e. inflation will be zero for the next decade), government bonds don’t offer an attractive return as a buy and hold proposition.

Another way of looking at this problem is to ask how much weight the market is putting on a ‘Japanese’ outcome. Let’s assume three states of the world (a gross simplification, but convenient). In the ‘Normal’ state of the world bonds sit at close to equilibrium, say 4.5%. Under a ‘Japanese’ outcome yields drop to 1%, and under an inflation outcome yield rise to 7.5% (this assumes a 5% inflation rate).

The table below lays out my own estimates (kind of an agnostic view, with a prior biased towards the ‘Normal’ but cognizant of the other two risks), then bond should yield around 4.4%. I can then tinker around with the probabilities to generate something close to the market’s current pricing. In essence, the market is implying a 70% probability that the US turns Japanese.

Bond Yield		JM Probabilities	Market implied
Normal	4.5	0.5	0.2
Japan	1	0.25	0.7
Inflation	7.5	0.25	0.1
Expected Yield		4.4	2.4

It is possible to build a speculative case for bond investment (i.e. riding the deflationary news flow down), however, as ever this leaves participants with the conundrum of  Cinderella’s ball  as described by Warren Buffett “The giddy participants all plan to leave just seconds before midnight. There is a problem though: They are dancing in a room in which the clocks have no hands!” Personally I prefer to stick to investment rather than speculation.

My freshman seminar starts today.  Here are the books we are reading this year:

• The Worldly Philosophers, by Robert Heilbronr
• Reinventing the Bazaar: A Natural History of Markets, by John McMillan
• Thinking Strategically, by Avinash Dixit and Barry Nalebuff
• Capitalism and Freedom, by Milton Friedman
• Equality and Efficiency: The Big Tradeoff, by Arthur Okun
• Nudge, by Richard Thaler and Cass Sunstein
• How the Economy Works, by Roger E.A. Farmer
• The Return of Depression Economics, by Paul Krugman
• The Road to Serfdom, Friedrich Hayek
• The Myth of the Rational Voter, by Bryan Caplan
• The Big Questions, by Steven Landsburg

From the NAR: Pending Home Sales Rise

The Pending Home Sales Index ... rose 5.2 percent to 79.4 based on contracts signed in July from a downwardly revised 75.5 in June, but remains 19.1 percent below July 2009 when it was 98.1. The data reflects contracts and not closings, which normally occur with a lag time of one or two months.

Lawrence Yun, NAR chief economist, cautioned that there would be a long recovery process. “Home sales will remain soft in the months ahead ..."

This suggests a small increase in existing home sales in September (reported when transactions close), but this also suggests double digit months of supply for some time.

As we approach the 21st anniversary of the triumph of freedom and capitalism over oppression and central planning, I keep wondering if we squandered the victory. Political rhetoric aside, you cannot go back in the record book and put an asterisk on it. Free markets are the engine that drives history in “our” direction. The decline in American hegemony corresponds with the rise in computerized manipulation and government involvement in markets. This is the economic equivalent of a generational
snatching of defeat from the jaws of victory.

The real disgrace is the nations on the wrong side of history have learned from the beat down and changed. Russia is the “wild west” of capitalism with the fastest growing number of billionaires (they skipped over the m’s and went straight to the b’s). China has created a strange hybrid of capitalist effort in benefit of the Central Planners. Leaders sleep lightly, however as the masses will not stay down forever.

I expect as we return from Labor day weekend the CEO’s and CFO’s of America’s best companies will lean back against the degradation of capital markets. One decent bond issue by JNJ or P&G could remove half of their shares from the public marketplace. If you worked at P&G and saw your 401k reduced to pennies by the electronic carpet bombing of HFT, would you not support an effort to become less public? With bond rates lower than ever, shouldn’t the concept of taking the upside “private” be tabled at Boards everywhere? I do not “think” we won – I know it. The shocking thing is how we have forgotten what we were fighting for.

-Kevin Ferry
Chief Market Strategist
Cronus Futures