Chairman Ben and the lost boys (and girls) in Neverland

Each year, when it releases its full transcripts of the Federal Open Market Committee (FOMC) from five years ago, the Fed invites us to cast our minds back to a place long ago and far away. The conversation around the conference table at the Fed's Washington headquarters on January 30 and 31, 2007¹ seemed to take place in Neverland rather than on the verge of the worst financial crisis since the Great Depression.

Housing starts had fallen steeply from almost 2 million (annual rate) in early 2006 to about 1.1 million at year end, just before the FOMC met. The Feds were not worried however (there are few worries in Neverland) because their model predicted that the rate would soon rebound to a normal 1.3 million level. Problem solved! (But in fact, starts fell to 400 thousand by the end of 2008.) The FOMC did fret pleasantly about inflation, however.

In fact, only a relatively few paragraphs of the 200+-page transcript were devoted to the housing crisis. Here is a sampling. Moskow of the Chicago Fed said that that “the economy is clearly showing more underlying strength than we thought in December.” Lacker of Richmond commented that “each batch of housing data has bolstered my confidence in the trajectory we sketched out last fall – namely, that a drag from housing will mostly disappear by midyear with spillover having been relatively limited.” Gov. Bies said, “we feel very good about overall credit quality.” Gov. Mishkin commented, “we're not seeing anything out of the ordinary or a persistent pattern, and that gives me more confidence that nothing bad is going to happen here.” (Mishkin had co-authored a study proving that nothing bad could happen in Iceland either.) Bernanke summarized: “The general view was that housing would cease to subtract from growth later this year.” Yellen of San Francisco agreed: “Housing remains a concern, but I think the prospects for a really serious housing collapse that spreads to consumer spending have diminished substantially. . . To me the upside risk to inflation seems palpable, especially because labor markets have tightened.” (Yellen is the reputed front-runner to succeed Bernanke, assuring a continuation of .. . ah . . continuity; the magical Veil of Nescience that Dr. Greenspan bequeathed to Chairman Bernanke seems to sit well on her brow.)

The Fed GDP forecast at the meeting was a cheery 2.2% rate in the first half of 2007, 2.4% in the second, and 2.5% for 2008, not the 2% for 2007, 0% in 2008, and -4% in 2009 that actually befell the world outside of Neverland. Back on planet earth alarm bells were ringing non-stop.² Barrons had suggested in August 2006 that housing prices could drop 30%. At the Davos conference just before the Fed meeting, Nouriel Rubini made dire predictions, and the Bank for International Settlements warned of a deepening crisis. Despite these warnings, the Fed stuck to its rosy scenario because in Neverland every time someone says “I don't believe in fairies” a fairy dies.

Even Euromoney seems to have got it right! In the January 2007 cover story, “The world on the cusp,” which was well-illustrated by a drawing of a world on a cusp, Clive Harwood introduced a series of articles that presented “the view that the state of global imbalance must come to an end soon, and with painful consequences.” Charles Dumas predicted “a hard landing followed by poor recovery,” that would “likely cause severe deflation.” Brian Reading followed by stating that “the world is suffering unprecedented financial imbalances” and that “their inevitable reduction . . . will dominate global growth prospects. . .”

But even in Neverland where all stories have happy endings, drama exists. Think of Hook and the crocodile. At the Fed meeting, drama came in the form of the interim president of the Atlanta Fed, Mr. Pat Barron, a practical, energetic, and brilliant man who rose from auto mechanic at Buckhead Chrysler Plymouth to COO of the Atlanta Fed. He is a practitioner not of mathematical economics, like Dr. Ben, but of “descriptive economics,” which is now derided in academe and defined as explaining “economic phenomena as they are without making any statements about how they ought to be.” He expressed a “contrarian view” that the housing market was in deepening crisis. The Lost Boys (and Girls) listened politely to this real world Wendy and moved on.³

History suggests that investors should assign a correlation of -1 to the forecasts of certain central bankers. Ben says the exit from QE will be orderly. Where is he leading us? “Second star to the right and straight on till morning.” That's where you'll find Neverland.

1http://www.federalreserve.gov/monetarypolicy/fomchistorical2007.htm

2See Tee,Gillian, Fool's Gold, Free Press, New York, 2009, especially chapter 10: “Tremors.”

3 According to Tett's book, Geithner was also worried, but ever the good subordinate, he kept his peace.

Reserve Bank of NZ claims it's "not a bimbo."

New Zealand's Reserve Bank is putting in place a bank rescue plan that would include forfeiture of deposits. It denies, however, that these deposits are like Cypriote deposits. The bottom line, however, is that bank deposits have entered the mix of assets available to government to solve government problems.

Here is a report from Fairfax New Zealand News:

The Reserve Bank is rejecting suggestions that its new policy for banks facing a collapse is anything like rejected plans to sort out the present banking crisis in Cyprus.

The RBNZ plans that will mean a "haircut" or partial loss on all deposits if a bank fails, are due to come into force in New Zealand at the end of June.

Reserve Bank Deputy Governor Grant Spencer said today that the RBNZ "Open Bank Resolution" (OBR) policy would mean a quick and orderly resolution of a bank collapse.

"It is markedly different from proposals to resolve the banking crisis in Cyprus," Spencer said

Depositors' money in banks here had never been guaranteed, apart from temporary periods, such as under the Deposit Guarantee Scheme from late 2008 to December 2011.

"If their bank fails, depositors have always needed to understand that deposits are not guaranteed," he said.

The perception and reality of deficit spending.

Perception can diverge from reality for a considerable length of time.  Here are two comments that reflect this:

Mayor Bloomberg on the radio:  "“We are spending money we don’t have,” Mr. Bloomberg explained. “It’s not like your household. In your household, people are saying, ‘Oh, you can’t spend money you don’t have.’ That is true for your household because nobody is going to lend you an infinite amount of money. When it comes to the United States federal government, people do seem willing to lend us an infinite amount of money.… Our debt is so big and so many people own it that it’s preposterous to think that they would stop selling us more. It’s the old story: If you owe the bank $50,000, you got a problem. If you owe the bank $50 million, they got a problem. And that’s a problem for the lenders. They can’t stop lending us more money.” (Observer.com)

Warren Buffet on CNBC:  "If the Fed bought $3.5 trillion of Federal debt a year then we would have no deficit and would not have to pay any taxes at all." 

Buffet was being ironic but Bloomberg was not, or was it the other way around?

As goes Venezuela, so goes Germany: A run on the Fed's gold reserves?

Germany is withdrawing its gold from the Bank of France and the Federal Reserve and stocking it in their own vaults in Frankfurt. This follows Bundesbank board member Thiele's visit to all global storage sites.  The German central bank says its move is designed to "build trust and confidence domestically" in its gold reserves.  The statement also suggests that auditing, or lack of it, is an issue.

Are doubts building about the security of reserves held at the Fed by other central banks?

http://www.bloomberg.com/news/2013-01-16/bundesbank-to-repatriate-674-tons-of-gold-to-germany-by-2020.html

Hyperinflation or deflation?

Hyperinflation or deflation? It depends on your standard of comparison. We have had huge inflation since 2008 when measured in shares of RIMM (Research in Motion,) for example. Today it costs 10x as many RIMM shares to buy a McDonald's burger than it did four years ago, but has the price of a burger increased that much? In Latin America, we saw in the late eighties prices doubling each month in some countries in local currencies while they were dropping in terms of dollars. Were they experiencing inflation or deflation? As Einstein pointed out, it is relative to your terms of reference. I think we will eventually have hyperinflation measured in US dollars accompanied by deflation in real terms.

Ecuador loses competitiveness in bananas

Despite the government's efforts to maintain its reputation as the world's foremost banana republic through stupid and corrupt policies, Ecuador's competitiveness in the sector is declining, probably due to the effects of the oil boom.

Comment from Davy Stockbrokers in Dublin:

"FACTS: Ecuador banana sales have dropped by half, according to trade publication Fresh Plaza.

"ANALYSIS: Although Ecuador is a major banana exporting nation, accounting for about 25% of global exports in 2010, it has become less competitive with selling prices around $10.50/box versus $8.00/box in Colombia, Costa Rica and Central America. Fyffes, which sells 900,000 banana boxes to Europe weekly, currently uses Ecuador as one of its sources of supply but, according to a representative, it may soon cease purchases from Ecuador as competitiveness has been eroded."

India tries to curtail gold imports: Will other countries follow suit?

Gold accounts for one half of India's current account deficit, so the authorities want to reduce the imports by raising import duties. The question is whether or not this will increase the public's desire to partake of the forbidden fruit. The article from the FT is below. It is interesting that the FT's headline writers chose to describe of Indians' desire to hold their capital in the form of gold as an "unhealthy addiction." It certainly is unhealthy for those who wish to manipulate the value of money.


FT: Tuesday, January 15:

"India seeks ways to beat unhealthy addiction to gold"

News analysis

A rise in import duties is only one of the ideas under consideration, write Victor Mallet and Jack Farchy

It was no surprise that a deliberate threat at the start of this year by Palaniappan Chidambaram, Indian finance minister, to make gold “a little more expensive to import” sent shudders through the international gold market.

India is the world’s largest gold importer and accounts for more than a fifth of global demand. Last year, a drop in imports of about 20-25 per cent – perhaps caused by a previous increase in import duty but also the result of the slowdown of the domestic economy – was one of the main factors in gold’s relatively lacklustre performance.

“The focus on the cost of India’s gold imports at an official level could be seen as a threat to what is the largest physical bullion market alongside China,” says Tom Kendall, precious metals analyst at Credit Suisse in London.

What is not yet clear is whether the measures contemplated by the Indian authorities will actually curb the volume of gold imports, and so affect the price further.

Mr Chidambaram and other officials are concerned about the apparently unstoppable urge among the country’s 1.2bn people to buy gold jewellery and invest in bullion. There are two main reasons for this: the swelling current account deficit and the risks posed to the stability of the banking system.

India’s current account deficit hit a worrying 5.4 per cent of gross domestic product in the three months to September, and in some months gold imports accounted for half the gap. The “impact of huge gold imports on external stability” was described this month as “a major concern” by a Reserve Bank of India working group set up to study the issue of gold.

In its draft report, the RBI also spoke of “systemic concerns” arising from the “huge borrowings” of a growing number of so-called non-banking financial companies that lend money to Indian retail clients, storing their gold and gold jewellery as collateral.

One option for Mr Chidambaram, analysts say, is to increase the import duty from 4 per cent to, say, 6 per cent in an attempt to stifle demand. The revenue raised would have the beneficial side-effect of helping to trim the fiscal deficit. Higher tax, on the other hand, could simply divert more of the gold trade on to the black market.

In any case, says Kishore Narne, associate director for commodities and currencies at Motilal Oswal commodity brokers, only about 10-15 per cent of Indian consumers are price-sensitive when it comes to gold.

“It’s part of our tradition and we keep on buying gold,” he says. “It’s our compulsion. We can’t do anything about it.” The stock of the precious metal in India is estimated at between 12,000 and 25,000 tonnes, and greater prosperity in rural areas is pushing demand ever higher.

Another approach, championed by Raghuram Rajan, the government’s chief economic adviser, is to focus not on the desire for jewellery but on gold’s weaknesses as an investment. That means promoting non-gold financial investments that produce real returns for citizens, although the strategy has been undermined by gold’s strong performance in rupee terms as the rupee has fallen against the dollar.

Last but not least – and this would cut India’s external demand for gold while meeting domestic demand – the central bank and the government want to make better use of India’s vast existing gold stocks.

Ideas under consideration include various gold-backed financial products not requiring gold from abroad, such as an exchange-traded fund backed by central bank gold and a scheme under which public sector banks could lend on the physical gold they hold as collateral for loans.
Philip Klapwijk, of Thom-son Reuters GFMS, a leading precious metals consultancy, says: “[India is] quite concerned at the impact of gold imports on the balance of payments and that such a high proportion of savings is ‘sterilised’ by being in gold form instead of being put to productive use.”
In the end, however, it may be market forces – and not Mr Chidambaram’s suggested tax increases or any official scheme to recycle hundreds of tonnes of India’s idle gold – that succeed in suppressing demand for gold imports.

With some currency traders forecasting a rise in the rupee this year, and some commodity analysts seeing the end of gold’s international bull run, gold is likely to be a less attractive investment than it was. Indian consumers, however, have a history of ignoring attempts to wean them off their addiction.

“Even a 6 per cent premium over the international price is not going to reduce Indians’ basic desire to hoard the metal,” says Mr Klapwijk, who expects Indian jewellery demand to rise “decently” from last year’s poor showing.

“The Indian affinity with gold runs deep,” agrees Mr Kendall of Credit Suisse, noting that previous efforts to reduce demand, for example in 1962-68 when the government introduced restrictions on gold trading and ownership, merely resulted in an increase in smuggling. “Habits and attitudes towards gold do not change quickly.”