The Daily Reckoning - (Un)Constrained Discretion

verfasst von Firmian, 11.09.2003, 23:10

-->(Un)Constrained Discretion

The Daily Reckoning

Paris, France

Thursday, 11 September 2003

---------------------

*** Bubble in China... bubbleheads in Congress... how many
yuan to the dollar?

*** Dow down... average family borrows 11 cents out of every
dollar it spends! Smallest pay raises in 27 years...

*** Poor Mr. Grasso... pretending not to work... Pyrrhic
victories... and more!

---------------------

Shui pao!

Our friend Jim Rogers says that if you want your family to
succeed in the 21st century, you'll teach your children to
speak Chinese. So, we'll begin with the phrase for
'bubble.'

Bubbles eventually blow up... but while they are swelling,
they draw admiration, investment, envy, and resentment.
(Daily Reckoning readers who want to gamble on the Chinese
bubble might want to buy in now - while it is still
expanding. More below... )

So it was when Japan swelled to Godzilla proportions in the
'80s. People rushed to get in. Others rushed to protect
themselves. In America, business school students wedged so
many Japanese words onto their resumes that employers
needed interpreters to pry loose what they were trying to
say. But in Congress, Senators railed against the invasion
of Japanese products as if Pearl Harbor were being
attacked, not realizing that the assault on U.S. markets
was financed by America itself.

And now, it is China's turn. The great wash of consumer
credit - created by the Dollar Standard system - has made
its way across the vast Pacific, sloshed over Japan, and
now floods up the Yangtze and Pearl rivers.

And now, once again, we see the sordid spectacle of U.S.
senators rising to defend American commercial interests by
claiming that competition from China is 'unfair.'

"This legislation is a tough-love effort," explained
Senator Charles Schumer of the great state of New York,
sounding a bit like Richard Nixon,"to get the Chinese to
stop playing games with their currency in order to level
the playing field for American companies trying to compete
with goods and services coming from China."

The specific injustice with which China stands accused is
leaving its currency too low against the dollar. How Mr.
Schumer knows what the exchange rate between the dollar and
the yuan should be has not been revealed to us. But, while
we have no laser transit, a brief gaze at the lay of the
land suggests that the senator desires not so much to level
the playing field as to tilt it further.

China fixed its yuan to the world's reserve currency - the
dollar - nearly 10 years ago. It has kept its word ever
since, faithfully exchanging 8.3 yuan for every dollar that
came its way. No one complained about this arrangement; it
seemed almost laudatory.

Now, China is accused of failing to adjust its currency
upward against the devaluing dollar. Bernanke can print all
the dollars he wants... but as long as the yuan is pegged to
the dollar, when the later goes down, so does the former.
Cheapening the dollar gave American companies a slight
selling edge against other countries... but not against
China. More than $125 billion of Chinese-made goods came
into the U.S. last year, and the total continues to rise
sharply.

Other foreigners, whose investments and credits were
denominated in dollars, lost trillions as the dollar went
down. But not the Chinese; in yuan terms their dollar
assets remained unchanged. In the words of one eminent
Senator, whose malignant pensées were reported by several
newspapers, this is 'cheating' on the part of the Chinese;
presumably, they should stand still and let themselves be
robbed along with everyone else.

Oh, those crafty inscrutable Chinese. They work around the
clock in unheated factories for $5 a day. And as the dollar
goes down - against gold and other currencies - the $5
shrinks; they receive less and less real value for the
goods they sell to America. Still, they don't complain;
they continue stuffing containers for shipment to the U.S..
Is that slick, or what? What devious plot will they get up
to next? Maybe they will just give away their TVs and
geegaws?

Sooner or later the yuan will be revalued upward, we
predict. When that happens, investments in China will go up
in dollar terms, perhaps considerably so.

Friend and colleague Porter Stansberry has developed a
unique strategy to profit from what he terms"the
inevitable yuan revaluation." Daily Reckoning readers
wishing to take a gamble on the yuan and China's shui pao
might want to do so now; we can't say how long this
opportunity will last...

See: The China Strategy Report
http://www.agora-inc.com/reports/CSR/WCSRD835/

A lower dollar, however, will not stop Chinese imports or
suddenly make U.S. companies competitive. Even if the
dollar fell to half its current value against the yuan, it
would only increase the real wage rate in China from, say,
$5 a day to $10.

Elsewhere in the news we read that this year, American
workers are getting the smallest pay increases in 27 years.
Is it any wonder?

Eric, give us the latest news, please:

-------------

Eric Fry, writing from lower Manhattan...

- Overcoming the"Curse of Septembers Past" is easier said
than done. The Nasdaq Composite tumbled 2.6% yesterday to
1,824, while the Dow slumped 87 points to 9,420. After
yesterday's selloff, the major averages cling to very slim
gains for the month. Perhaps the market is taking a well-
deserved rest... or perhaps it is going into hibernation for
the winter... or the rest of the decade.

- Who can blame investors if they have tired of paying 30,
40 or 50 times earnings for the shares of companies that
are barely growing? Likewise, who can blame consumers if
they have tired of buying things they don't really need
with money they don't really have?

- As we noted yesterday, credit is supporting consumer
spending... Folks have been sucking the equity out of their
houses to buy dishwashers, Disney vacations and Dell
computers."The consumer has become so debt-dependent that
he now borrows 11 cents of every dollar he spends, compared
to 9 cents in the 2001 recovery episode," observes
Stephanie Pomboy's Macro Mavens.

- Eventually - whenever that might be - consumers will need
actual income, rather than credit, to pay for their
consumption. Unfortunately, income growth has stagnated.
That's because payroll employment has dropped for seven
months in a row and shows no sign of rebounding. Worse,
"the household debt-asset ratio (18% in the 2003:Q1) is the
highest on record since Word War II," notes Northern
Trust's Asha Bangalore."This ratio was 13.3% in 1999. The
sharp increase in household debt implies that debt-service
burdens will be another constraint on household budgets."

- Is it any wonder that many Americans are reacquainting
themselves with the ancient art of saving money?... And now,
let's welcome NYSE chairman Dick Grasso to the nation's
growing roster of savers. Now that Mr. Grasso has agreed to
forego $48 million in future compensation, he will have to
find a way to make ends meet on only $92 million.

- But at least Mr. Grasso is still drawing a paycheck,
unlike many of the unfortunate souls in the mortgage
industry. As predicted in this column two months ago, the
mortgage industry is launching its first wave of job cuts.
This wave will not be the last.

- The mortgage industry was until recently one of the
economy's few bright spots, having added about 175,000 jobs
since 2000. But now the industry is starting to wilt under
the strain of rising interest rates. Mortgage refinancing
activity has fallen by 78% since May, according to a late-
August Mortgage Bankers Association of American report.

-"The cooling refinancing boom is claiming its first
casualties: employees of the big mortgage lenders," the
Wall Street Journal reports."Rising interest rates already
have slowed the refinancing boom that has sustained the
industry, raising the prospect that mortgage providers will
lose more than 150,000 employees from their payroll over
the next six months." Thousands more jobs will likely
disappear in supporting industries.

- The economy can ill-afford additional job losses. But
what can be done? Even if other industries resume hiring
workers, the prodigious job losses in the mortgage industry
could restrain the economy's overall employment growth.

- Speaking of struggling industries, General Motors
reiterated earnings guidance yesterday, saying that it
still expects to earn about $5 a share this year. But we
wonder: how does GM know what it will earn? Does GM
management read copies of the morning paper the night
before it hits the newsstand?

- GM's earnings are not simply a function of car sales.
Things like mortgage financing volumes, pension plan return
assumptions and the rate of health-care cost growth are all
important parts of the net income number. GM may have a
vague idea of how many cars it will sell and how much money
it will make (or lose) per car. And it may have some kind
of guess about how many mortgages it will originate this
year. But it seems to have absolutely no clue how much
health-care costs will rise.

- GM expects health-care inflation to drop to about 5%
annually by the end of the decade. But health-care costs
are rising much faster than that currently. For
perspective, GM's CFO, John Devine, said the company has
held health-care inflation in the first half of the year to
an annualized 7.1-7.2 per cent. And health-care price hikes
at most companies are much higher still."Health-insurance
premiums climbed 13.9% this year," the Wall Street Journal
reports,"marking the third year in a row of double-digit
premium increases in the highest jump since 1990." Health-
care costs will likely jump another 12% or so this year. So
GM faces an uphill climb if it hopes to hold the annual
growth of health-care costs to less than 5% by the end of
the decade.

- One percentage point may not seem like much, but to GM,
each 1% is worth more than half a billion in net profit
annually. For example, if long-term inflation runs one
point higher than GM hopes, it will cost the company $523
million a year extra - almost a fifth of this year's
expected group profits. It would also add $5.3 billion to
the unfunded pension hole.

- Share prices may rise, but the difficulties remain.

-------------

Bill Bonner, back in Paris...

*** Rare is the politician, we pointed out yesterday, who
will rise and tell his constituents what they don't want to
hear - especially if it is true. Now cometh that rare bird,
flapping his lips in the U.S. House of Representatives just
last week.

"In the short run," explained our friend, Congressman Ron
Paul of Texas,"the current [Dollar Standard] system gives
us a free ride, our paper [currency] buys cheap goods from
overseas, and foreigners risk all by financing our
extravagance. But in the long run, we will surely pay for
living beyond our means. Debt will be paid for one way or
another. An inflated currency always comes back to haunt
those who enjoyed the 'benefits' of inflation."

And then Congressman Paul rounded on his colleagues...

"Although this process is extremely dangerous, many
economists and politicians do not see it as a currency
problem and are only too willing to find a villain to
attack [China]. Surprisingly, the villain is often the
foreigner who foolishly takes our paper for useful goods
and accommodates us by loaning the proceeds back to us.
It's true that the system encourages exportation of jobs as
we buy more and more foreign goods. But nobody understands
the Fed role in this [except us, dear reader], so the cries
go out to punish the competition with tariffs.
Protectionism is a predictable consequence of paper-money
inflation, just as is the impoverishment of an entire
middle class..."

[Ed note: You can find our favorite senator's address in
its entirety on the Daily Reckoning website:

Paper Money and Tyranny
http://www.dailyreckoning.com/body_headline.cfm?id=3416 ]

***"Please leave by 6 P.M.," pleaded a French colleague at
the office yesterday."The inspectors are here."

Many are the ways a man can get into trouble in Paris. In
other parts of the world, he gets into trouble by claiming
to be working late at the office, when he is really up to
something else. But here, actually staying late at the
office can lead to serious problems.

It is against the law to work more than 35 hours a week in
France - subject to various provisions and exclusions that
no one seems to understand. Still, few serious people work
only 35 hours. Contrary to the impression in the U.S. and
England, the Frenchman works at least as hard as his
counterparts in the anglo-saxon world. He just does it
differently. He arrives at the office at 9 A.M. or so. He
takes an hour for lunch, often a business lunch. And then
he may work until 7 or 8 in the evening. He does, however,
take longer holidays... typically 5 or 6 weeks per year.

The French know they must work hard. But at the same time,
they think the man who works too hard is a bit of a fool.
He must not be able to get his work done in a reasonable
amount of time, they think to themselves. And, since
working long hours is illegal, too, many people take work
home or work surreptitiously, while they feign to be doing
something else.

So, yesterday, we were all set to pretend to work less than
we actually do. But just as your editor began packing up
his papers, he noticed that the inspectors had left. At
least they work 35 hours.

*** An interesting email from a friend:

"A book I just finished tells the story of where the term
'Pyrrhic victory' (a win at too high a price), comes from.

"Pyrrhus was a king of Epirus who lived in the third
century B.C.. In 279, he decided to take on the mighty
Roman Army. But before he sailed for Italy, he had a
conversation with Cineas, his chief ambassador.

"Cineas: 'The Romans are reported to be great warriors and
conquerors of many nations. If the gods permit us to
overcome them, how shall we use the victory?'

"'That is an easy question,' responded Pyrrhus. 'Once we
conquer the Romans, there will not be any city in all of
Italy that will resist us.'

"Cineas: 'Once we have Italy, what next?'

"Pyrrhus: 'Sicily, which is a wealthy island, should be
easy to take.'

"Cineas: 'You speak what is perfectly probable, but will
the possession of Sicily put an end to the war?'

"Pyrrhus: 'Carthage and Africa would then be within reach.
And once we have them, who in the world would dare oppose
us?'

"Cineas: 'No one, certainly. And then what shall we do?'

"Pyrrhus did not see where he had been led by this
argument, so he said: 'Then, my dear Cineas, we will relax,
and drink all day, and amuse ourselves with pleasant
conversation.'

"'What prevents us from doing that now?' said Cineas. 'We
already have enough to make that possible without any more
hard work, suffering, and danger.'

"But Pyrrhus didn't get the point. He attacked and defeated
the Roman Army at Asculum in Apulia. He won, but his
casualties were so heavy he observed that, 'One more such
victory and I am lost.' Later, his weakened army attacked
Sparta and lost.

"Pyrrhus was hunted down and killed by an angry mob in the
streets of Argos.

"The book this comes from, by the way, is called 'Buck Up,
Suck Up, and Come Back When You Foul Up - 12 Secrets From
the War Room,' by James Carville and Paul Begala. Politics
aside, this is a great book. It details how these two have
had such success on so many political campaigns."

---------------------

The Daily Reckoning PRESENTS: In the"current environment
of 'guess what Greenspan is feeling today,'" as John
Mauldin puts it below, how's an investor to know where to
place his bets?


(UN)CONSTRAINED DISCRETION
By John Mauldin

The Fed and Greenspan have been given a free ride for quite
a long time. All throughout the bull market, in fact. As
long as things were going well, who wanted to rock the
boat, other than some bond traders and a few Austrian
(economist) curmudgeons?

But now that the economic weather is no longer as fair, a
chorus of doubting analysts calls louder and louder for
'transparency' in what they see as inscrutable Fed policy.
As Pimco's Paul McCulley put it:

"In a nutshell, Mr. Greenspan's management style is best
described as 'trust me' - sometimes known as 'constructive
ambiguity.'... Greenspan disagrees [with specified
policies], when it comes to carrying out his job mission.
His definitions of the Fed goals are what his gut says they
are, but what he cannot bring his lips to say, subject to
change when he has an undisclosed stomach ache."

McCulley goes on to argue for"constrained discretion" on
the part of the Fed. By that he is not arguing that the Fed
should not have discretion to make decisions and even to
change its mind as the facts change. But these decisions
should be constrained (limited) by a set policy, which
everyone understands.

"If Mr. Greenspan ever wanted evidence of the cost of his
infectious hubris," writes McCulley,"he need not look any
further than the money market futures market, as displayed
on the cover. Unconstrained discretion, as Mr. Greenspan
advocates, is not a free good, because it raises risk
premiums for uncertainty about monetary policy, acting as a
headwind to the FOMC's accommodative will."

Why is Greenspan resisting such a reasonable guy like
McCulley's request for transparency? Why is he saying
"trust me" is a better policy than understandable
parameters? And why, if the economy is growing so well, is
the Fed telling us that rates will remain low for a
'considerable' period of time?

Let's look at some uncomfortable long-term facts facing the
Fed.

First, Fed governors must clearly mistrust that the
currently forecasted economic growth spurt has 'legs.' In
my opinion, if they thought for one minute that the economy
was going to grow on its own at 5% real growth for the next
18 months, I cannot imagine they would not begin to raise
rates, if for no other reason than to have some room to
lower them the next recession.

Why mistrust this growth? Because much of the growth is
from stimulus that is not lasting. This growth is caused by
(1) Bush's tax rebates, which are clearly kicking in (Wal-
Mart's sales are up 5-6% year over year), (2) a huge
government deficit spending (more than half the GDP growth
last quarter was government [mostly defense] related) and,
(3) massive mortgage refinancing which was done in the
second quarter which produced a huge amount of spendable
cash, which is now being spent.

But where are the jobs? With productivity at 6% plus (a
number about which I think there is reason to doubt), you
would need somewhat more than 5% growth to produce jobs. A
jobless recovery is not sustainable, and the Fed knows it.

Greg Weldon slices and dices the numbers from last week's
ugly jobs report for us. Employment is down 113,000 since
June. Unemployment is down 453,000. That means 340,000 of
those formerly classified as unemployed have now dropped
out of the labor force. Part-time employment is down
200,000 in the month of August. Thus, the 'lower'
unemployment rate does not reflect any real growth in jobs,
but statistical games.

He does an analysis of the breakdown by sector and sex and
comes up with this conclusion:"Bottom line... there is one
macro-conclusion of significance to be gleaned from today's
labor market input: 'second income jobs,' many of them
part-time jobs, held primarily by women, are being
eliminated."

In addition, the Fed is all too aware that even as GDP was
revised upward for the 2nd quarter, housing investment was
cut by half from the first quarter. And this before rates
began to rise.

Thus it comes as no surprise that the Fed governors are out
and about, trying to talk rates down. It is apparent to me
that they feel the recovery is fragile and thus are willing
to risk a return of inflation.

But the really uncomfortable dilemma faced by the Fed hails
from foreign shores. The yawning U.S. trade imbalance - and
the plethora of disastrous consequences that would result
should a 'correction' occur - are at the forefront of every
Fed governor's mind.

But it's not just the bankers who are biting their nails.
GM, Ford and Chrysler, for example, watch their domestic
auto sales drop year over year by a respective -8.2%, -
27.7% and -28.6%(!) as sales for Nissan and Toyota rise by
over 17%. Thus, it must be frustrating in Detroit to see
Snow rebuffed in Tokyo, while even as he was talking about
letting the market set the exchange rates, the Bank of
Japan was massively intervening again and again to force
the yen lower, making Japanese automakers more competitive.

China said,"We will allow the yuan to rise when we decide
it is in our own best interests and not a moment sooner."

This competitive currency devaluation cannot go on forever.
As Bill Gross of Pimco points out quite succinctly:

"... The hundreds of billions that the Japanese and other
Asian countries have been buying in order to keep their
currencies competitive with the Chinese Yuan (Renminbi) and
the U.S. dollar will be subject to a sanity check... The
currency/bonds/stocks of a reflating [U.S.] economy engaged
in guns and butter, Hummer and Hummvee spending of near
historical proportions are bad investments. Sooner, perhaps
later, our Asian creditors will wake up and smell the
coffee.

"Perhaps their java will take the form of dollar or
Treasury Note sales. Perhaps the aroma will resemble a
revaluation of the Yuan and then the Yen. Either way we pay
the price: higher import costs, a cutback in spending on
cheap foreign goods, rising inflation, perhaps chaotic
financial markets, a lower standard of living.

"Mark these words well for what they're worth (not much
some will say): China holds the keys to our kingdom, and
our Hummers. Their willingness to buy our bonds, their
philosophy of fixing their currency to the U.S. dollar will
one day be tested. And should their patience be found
wanting, all of their neighboring Asian China wannabes will
move in near unison. Reflation's second round will have
begun, U.S. interest rates will rise, our goods in the
malls and the showrooms will be less affordable, and the
process of national belt tightening and increased savings
will have begun."

The Fed is between the devil and the deep blue sea. If the
trade imbalance keeps to current levels, then foreign
holding of U.S. bonds will rise dramatically. At low
interest rates, this is not a huge drag on the economy. But
what if rates rise and we start having to send $100 billion
or $200 billion to foreign bondholders, which would only
add to our trade deficit? Can the Fed really allow rates to
rise prior to a drop in the trade deficit?

What's a central banker to do? The above problems, if
allowed to develop before the recovery is clearly
established, will mean a recession and deflation. Thus, the
Fed must feel, as evidenced by their policies, that they
have to do everything possible to get an economy to grow
its way out of the problem, even if it means a little
inflation.

And there is the disconnect. The bond market can see
exactly what I have described. Inflation will ultimately
mean higher rates. The Fed does not think we can afford
higher rates, which might possibly choke off a fragile
recovery. Thus, just as Volcker caused a recession to bring
down inflation, the Fed is willing to risk inflation to try
and avoid the scenario Gross describes.

Do you think the Fed governors do not see the same
imbalances that Gross and a hundred other analysts -
including your Paris and New York editors, as well as yours
truly - see? However, rather than acquiescing to the
decline of our"hegemonic rule," as Gross terms it, central
bankers seem genetically compelled to at least attempt to
fight the tides of said decline.

And thus, establishing a 'reasonable' set of policies, such
as Paul McCulley suggests, would mean the Fed may to all
too soon feel forced to abandon them in order to deal with
the potential crisis resulting from today's imbalances.
Such a reversal has the potential for creating far more
havoc than the current environment of 'guess what Greenspan
is feeling today.' Since the exact nature of the potential
crisis is unknown, how can you set a proper course? Better,
says Greenspan, to allow them ultimate flexibility than
adopting polices. Trust me.


Regards,

John Mauldin,
For the Daily Reckoning

P.S. Maybe there won't be a crisis and we will grow
ourselves out of the problems, at least for a while. The
current economic growth is very for real, at least for the
next 6-9 months. What if oil then comes down in price?
Rates drop again? Jobs pick up and the economy gets on
sound footing. A new round of technology investment ensues.
There are lots of good things that can happen in the short
term on the road to balancing the twin deficits. If you are
a central banker, you are counting on them.

At the end of the day, it does not matter whether McCulley,
Mises or Greenspan is right. Greenspan is going to win this
debate, as he holds the cards until someone takes them
away. Rates will stay low until the recovery is on a sound
footing and producing jobs or inflation is truly back. We
will know when that moment is when he tells us. And
therefore risk premiums are going to stay high.

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• The Daily Reckoning - (Un)Constrained Discretion - Firmian, 11.09.2003, 23:10