A couple of noteworthy items made their way to my attention this week and unfortunately both are sad. Let’s start with our official paper of record, The Wall Street Journal. Yesterday, the WSJ featured a 6-column article on the top of page 2 about the Fed’s “Path to Higher Interest Rates”. The article goes to great lengths speculating about how the Fed will raise rates when it ultimately decides to do so. Not only did I waste a few moments of my life reading this useless piece, but my only response was, well, “duh!” More precisely, many many “duhs”.

Why so harsh on this article? Well, Hilsenrath (the author) begins describing that the Fed will “eventually” have to raise interest rates. Duh #1. Then comes the premise of the whole piece in paragraph two: “What will a Fed tightening cycle look like? When will it begin?” And the answer in the very next sentence “Fed officials don’t have answers to either question yet”. Gee, thanks for the insight. Duh #2.

Hilsenrath goes on to say the economy isn’t strong enough to raise rates yet (duh #3) and that this tightening cycle won’t look like the last one (5 duhs for that). He spends a great deal of time expounding on how hard it will be to communicate intent, how little we know, how the market’s reaction may be important and then that it won’t be important. By two thirds of the way through and fifty “duhs” later, I was feeling like Homer Simpson in one of his painful “doh” chain reaction moments. For the creme de la creme of duhs, the chart in the center of the article displays the last tightening cycle with the caption (emphasis mine) “When the Fed starts raising its federal-funds target rate, it may not follow the same pattern as the last time it tightened monetary policy.” Well, thank you Captain Obvious.

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What put me in a mood critical and irritated enough to write nasty things about WSJ articles (from authors I usually like) was The Truth Twister alluded to in the post’s title. The AP reported what former GOP presidential candidate Mitt Romney had to say about Obama’s economic stimulus plan. Since Romney isn’t a name I’ve seen or heard much in the past twelve months, let’s recall that Mitt worked for a prestigious management consulting company before running a private equity group. These credentials were supposed to enable Mitt to lead like a CEO or businessperson instead of a politician. Clearly, Mitt was a credible, financially literate soul who could be trusted to tell it like it is and make decisions based on economic merit rather than political goals.

Such lofty expectations is why I award him the Truth Twister of the Week award. What did Mitt twist the truth about? Well, according to the AP article, Mitt says it is time to stop the stimulus program because the plan “didn’t work”. As evidence of his twisting, I submit to you the latest GDP report from the BEA (Commerce Department).

If you recall, each quarter’s GDP report comes in three reports, an “advanced” report, a “preliminary” report and the final report. You may have already guessed correctly that as the data comes in, more accurate calculations are made and the report is revised. Last Thursday’s report was the “advanced” or first, raw, estimate.

Moving along, what did the report tell us? Well, GDP grew at an annual pace of 3.5% from the second quarter to the third which was above the consensus estimate of 3.2%. That should be good news right? The stock market didn’t like it much and here is why: it doesn’t look as though this performance was possible without the stimulus. Let’s take a closer look. Of the 3.5%,

• 1.7% came from motor vehicle output, courtesy of “cash for clunkers” (which spurred 700,000 unit sales)
• 0.5% from residential construction (breaking a 14 quarter losing streak), courtesy of the 1st time homebuyer tax credit universally acknowledged as sparking buying at the low end of the housing market.
• 0.6% from increased Federal government spending

These add to 2.8% of the 3.5% or fully 80% of the increase in GDP due in some way to the stimulus. (The rest came from a small inventory build, most likely as a result of simply low stocks, seasonality and some multiplier effect from the auto build). As a gut check, consider that $173 billion has been reportedly spend so far. Let’s say $125B was in the 3rd quarter. On a $14.1 trillion economy, that works out to a 3.6% annual rate. Net imports subtracted 0.5% this quarter, which calculates to about 3.1% growth. Pretty close huh?

All of this means, that sans stimulus economic “growth” was anemic at best. The silver lining might be “stabilization”, not growth, for the private sector. As for Mitt, he certainly isn’t above twisting the truth to make a political statement. It would be naive to expect differently I suppose.

The first two parts of this series dealt with the reasons the dollar is not about to collapse, but could the dollar weaken anyway? The short answer is a resounding ‘yes’. The dollar’s value will fluctuate and it may even decline fairly significantly in value as a result of all the recent monetary policy. However, hyperinflation is not in the cards, nor is an outright dollar crisis.

Take a look at the Real Trade Weighted Dollar index. This index maintained by the Fed weights the various exchange rates by the amount of trade conducted in each country. Thus, it is a good representation of the supply and demand for dollars as priced in a basket of currencies. I am specifically choosing the real index as opposed to the nominal index because when inflation various between countries, the effect on the index can be one of massive distortion. Fortunately the Fed has made the appropriate adjustments in the real index presented below. (If you’d like to see the nominal index, you can here. It can either be interpreted as a massive bubble in the dollar popping or as a fairly meaningless chart. I submit it is the latter because the value of the dollar actually fell quite a bit when Nixon closed the gold window ending the Brenton Woods paradigm of fixing the dollar to gold. That devaluation is not reflected in the nominal index at all).

As you can see from the chart above, the dollar has recently gone through two mini-bubbles. The first was in the 1980s. As then Fed chair Volcker raised rates and broke the inflationary spiral, real interest rates remained unusually high (a “real” rate is the interest rate in excess of inflation). High real rates make a currency attractive and the dollar entered a bit of a boom.

Beginning in the early 1990’s, the dollar entered its second mini-bubble. As American conspicuous consumption ramped up along with the tech bubble and demand for US tech stocks, the dollar gained considerable strength. At the time, it wasn’t viewed as an overvaluation in part because Clinton’s Treasury Secretary, Robert Rubin, proclaimed a “strong dollar policy” as desirable while China and Japan began keeping the dollar artificially strong in earnest.

It is the slide down from that height that appears so dramatic. However, as you can plainly see from the chart, the current value is not in any way new territory. The dollar has been here before, for considerable stretches of time, without unraveling the world.

Consider that when the dollar weakens, it forces other countries to stop depending so much on the American consumer buying their exports. A more balanced, healthier and growing global economy should result. A weak dollar is part of the solution and it is being reflected accordingly.

How low can it go? That’s hard to say. It could certainly get weaker, particularly since the nominal exchange rate value is still quite high. And it may stay down for some time. The major adjustment so far has been against the Euro, when the bulk of our trade deficit is with Asia, which leads me to believe the index won’t bottom until China (and other significant Asian exporters) allows the currency to trade more freely, something Chinese leaders are loathe to do.

Another very bad outcome for the dollar may happen if Congress starts dismantling the Fed’s independence and/or doesn’t reign in long-term deficit spending. (The Fed is technically independent of both the President and Congress; a few years of large deficits are ok, but watch out if Congress can’t get control of it). Be wary of any politician that thinks the Fed is the problem.

However, an Icelandic experience (the country went bankrupt and even McDonalds closed their stores there) or Weimar Republic style inflation is so unlikely that I’d call it nuts. (Don’t hold me to that in 50 or 100 years though, I’m talking about in the next decade).

So what happens if the Chinese stop buying our debt? Let’s start with a some perspective: China currently owns about 11% of all the outstanding U.S. Treasury notes and agency debt (Fannie, Freddie, etc). While this is a large, significant and growing proportion, it is hardly enough to consider the Chinese our economic masters. Consider that the UK, Cayman Islands, Luxembourg, Belgium and Canada collectively own twice as much as the Chinese. Indeed, Japan alone is still our largest creditor holding a little more than the Chinese.

Perhaps even more important than the relative size of the Chinese or Japanese or whichever creditor’s position is why they have lent us so much and why that isn’t likely to change overnight. When a country imports a lot more than it exports, the importing country’s currency should fall. For example, when we buy something made in China, we pay in dollars. The Chinese seller doesn’t want dollars, so they must trade the dollars for Yuan. If China is accumulating dollars because we are buying more than we export, then the Chinese will have lots of dollars to sell. All that selling will cause the dollar to weaken and fall. As the dollar falls it can buy less and consequently we can’t buy as much from China as before. Now, China’s number one goal is to grow fast and employ as many peasants as possible. In order to keep growing, the Chinese central bank manipulates the exchange rate (by buying our debt) so the Yuan doesn’t rise too much relative to the dollar. This keeps the dollar artificially strong and Americans buying cheap Chinese goods.

Given that the U.S. consumer is the ultimate destination for most of China’s exports, the Chinese are dependent on our buying. The last thing the Chinese want is for the dollar to weaken so much that we stop buying from the Chinese. This is precisely why China has recycled all those dollars into our debt- it is a safe place to park those dollars while supporting the exchange rate so they can continue to grow. Japan and other countries have also followed a similar strategy. (Now, there is another issue not addressed here, which who is going to buy all the debt to be issued in the next few years. We’ll address this next time as it does not relate to China specifically.)

Can the dollar lose its reserve currency status?

For the sake of discussion, let’s assume something goes awry and the world decides it wants another reserve currency in lieu of the dollar (which will happen someday). Replacing the dollar as the world’s reserve currency is not as simple as a central bank committee making a choice between this or that currency. A “reserve currency” is a currency that is held in significant quantities by governments and central banks to help stabilize their own currency. For example, in most systems currency is an obligation of the central bank. Here in the US, our bills say “Federal Reserve Note” on them. The note has value because we trust that the Fed has the authority and assets to keep those bills valuable. People aren’t so trusting of smaller countries and their money however. A country like Brazil or South Korea will occasionally have to “defend” their currency. They are able to “prove” it has value by showing that the bills are backed up by more than just a promise; rather those bills are backed up by a giant vault of cash from another country. The value of the foreign money can’t be tinkered with and so it “backs up” the home country’s currency.

64% of the world’s official reserves are currently in U.S. dollars. If you are a Brazilian, South Korean, Yemeni or Indian central banker for instance, what currency are you going to hoard in order to protect your own country’s money? You’d look for a currency with a giant, liquid market so it can always be traded. Since that reserve currency needs to be secure, the country must be able to defend itself and its interests regardless of what happens. No one holds the Ukrainian Grivna as a reserve currency, because who knows if they will be around in a few years? Or if Russia decides to cut off their natural gas, what can the Ukraine do to protect its economy? A reserve currency must also hold its value because the country issuing it is an economic powerhouse. Despite bumps and potholes in the road, does the country have the stability, natural resources, economic system and culture that will enable it to be and remain prosperous in the long run?

The answers to all these questions point only to the United States. Is a central bank going to trust the Chinese, who are command and control communists that regularly manipulate their currency? Or the Yen, when the Japanese debt is double the amount of ours, the population is shrinking and they can’t defend themselves? The Russians who play energy politics? Maybe the Euro is the alternative- and indeed it is- the Euro is roughly 27% of the world’s reserves. However, the Euro is really just an experiment, not a currency. It is not supported by one country or government; its member states have wildly different agendas; the European Central bank was more or less powerless to help European banks during this crisis; and let’s not forget that the Europeans have never gotten along with each other for more than a half century or so. In sum, reserve currencies are born, not agreed upon. The U.S. dollar is the only currency that can currently serve this role and its position has actually increased since the crisis began.

Next up: Part III: Can the Dollar weaken anyway?

We hear many prognosticators talk negatively about the dollar (I call them “dollar bears”). Some predict the dollar will get so weak it will crush the economy, cease to be the world’s reserve currency, and drive interest rates to double-digits. Some even talk about Zimbabwe or Weimar Republic style hyperinflation due to the all the money the Federal Reserve is “printing”.  These fears are overblown and unrealistic in my opinion and I’d like to take a moment to explain why this is not something we should fear. Since this is an extensive topic, I will break it into several parts.
The “falling” or “weak” dollar hypothesis is based on several items in particular. Reasons include that the Chinese will stop buying our debt; that the Fed is “printing” money which will result in hyperinflation; and how massive government deficits will scare lenders and cause higher interest rates. Let’s examine these in more detail.

The government is just “printing” money
This was discussed in a recent post. Aside from the Fed creating large reserves which aren’t being translated into the money supply, they are also engaging in “quantitative easing”. One way to increase the number of currency units (dollars) in circulation or “get more dollars out there” is to actually “print” bills like $20s or $100s. In eras gone by, governments actually used to run the printing presses and create money. You may remember pictures of Germans in the 1920s carrying wheelbarrows full of money just to buy bread.

Today, money is “printed” by the Fed simply by buying bonds and other assets from banks. When they buy a treasury note, they credit cash to the bank. The bank then has excess reserves which it can lend out and increase the amount of dollars in the world. This process is sometimes referred to as “quantitative easing”. Currently, quantitative easing is NOT increasing the money supply.

What about other countries also printing money?
The UK, China, Japan and even Switzerland are also printing money (with others like Canada, Sweden seriously considering it soon). If everyone grows their money supply at the same time, we might get some inflation, but the relative value between currencies ought to remain about the same. If there are 1,000 dollars and 500 pounds in a hypothetical world, we have an exchange rate of $2 per £1. If both countries print 50% more currency, we have $1,500 and £750 which is still $2 per £1. A dollar might be worth less, but it will still buy the same amount of foreign stuff. As someone said recently (and my apologies to the witty originator of this) “the dollar is the worst currency, except for all the rest”.

What about all the printing plus all the debt our country is borrowing?
The Fed has expanded its balance sheet about $1.3 trillion and the Treasury is borrowing another $1.8 trillion this year. So the country is trying to expand its spending by about $3 trillion. In 2008, the stock market lost some $6 trillion and housing has another $6 trillion since 2007. That is $12 trillion in wealth destroyed compared to a hoped for creation of just $3 trillion. We’re still left with much less money than before. Yes, budget deficits can be problematic for the dollar but aren’t sufficient to cause its decline on their own.

Next up: Part II, the Chinese and the Dollar

Many commentators still seem to be screaming that hyper-inflation is around the corner. The crux of their argument is that the Fed has pumped hundreds of billions into bank reserves. There is a chart circulating, which you may have seen, illustrating this explosion of credit. After all, reserves normally translate directly into fresh lending. I have reproduced the chart for you here:

It is a scary chart, I admit. The inflation fear-mongers forget several things though. First and foremost, reserves don’t become part of the money supply until loans are actually made from those reserves. So how are we doing on that front? Well, the Fed reported consumer credit yesterday and it was dismal despite “cash for clunkers”. Total consumer credit fell, again, and has contracted some 4.6% since its peak. For the record, it hasn’t declined more than 1.8% from any peak since WWII. Take a look:

Might those reserves be lent to businesses instead? Well, here is a chart of total loans and investments at commercial banks- in other words, this is lending to businesses:

No loan growth there either. This makes perfect sense when you stop to think about it. All banks care about (or should care about) is how likely they are to have their loans repaid. Aside from credit bubbles when banks act like drunken sailors, that is all they need to figure out. In an economy this bad, the most credit worthy borrowers don’t want more debt, nor do they need it. The less credit worthy are too risky, so less lending takes place. On the business side, what business is eagerly borrowing to finance expansion? When consumers are clearly retrenching, global trade is slowing and massive uncertainty about growth prospects remain, who is going to borrow in order to expand? Companies are in survival mode and are using cash flow to maintain their business or even shrink it. Without demand for loans from credit worthy borrowers, lots of new loans are not going to be made.

This scenario is what a develeraging cycle is all about. It is by its very nature deflationary. As I have written about before, deflation is your worst enemy. Those screaming about inflation seem to ignore this dynamic. It is also this very deleveraging cycle which helps cause velocity to fall. For everyone’s sake, you better hope the Fed can create some inflation before serious deflation takes hold.

“Cadbury shareholders stand to lose out massively” is the language a shareholder has used in suing Cadbury to reconsider the Kraft offer. More specifically, according to a Reuters story today:

“Cadbury shareholders stand to lose out massively if the Cadbury board continues to refuse to negotiate a transaction with Kraft,” the lawsuit said. “But Cadbury’s board stands to lose its lavish compensation and positions of power if Cadbury is sold.”

And there you have it. Either this shareholder reads TLRB or more likely came to the conclusion that I hypothesized: management has a lot to lose when the company gets sold, while shareholders have a lot to gain. The agency dilemma is alive and well. I for one have my popcorn and comfy chair ready to watch as the Kraft-Cadbury saga gets even more interesting (to me at least).

Brett is probably too shy to toot his own, but I interviewed him about China, money, the gold standard, and trade on my podcast The Conspiracy Skeptic. Not much conspiracy talk, just some econ 101 stuff:

http://www.yrad.com/cs/
http://www.yrad.com/cs/feed.xml

Anyway, enjoy. I think I know why he’s successful as a fund manager. He’s got a very calming voice.

As I watch takeover announcements, something called the principal-agent problem crosses my mind. Also called “the agency dilemma”, it can be described as follows (paraphrasing from wikipedia):

“the difficulties that arise under when a principal hires an agent, such as the problem that the two may not have the same interests”

More specifically, the owners of a company hire managers to run the company on their behalf. Those managers, often called “officers” are better known as the CEO, President and other corner office, executive suite titles. The owners or shareholders elect a board of directors who are supposed to find, hire and compensate managers so that owners’ interests are aligned with management’s interests. Put more simply, if management makes the company more money, the managers earn more money too- at least that is usually the intent.

We have discussed compensation a number of times here at TLRB, but here is yet another way this issue crops up: when one company bids to take over another company. The case in point that brought this to mind is Kraft’s bid for Cadbury. Kraft is seeking to acquire Cadbury on the basis that each has different strengths in different markets: Cadbury is strong in developing markets and could help accelerate the distribution of Kraft products there, while Kraft has increased buying power and distribution might in other markets. The combination makes a certain amount of sound strategic sense, depending on the price Kraft is willing to pay for Cadbury.

When the offer was made in early September, Kraft offered a 31% premium to Cadbury’s stock price at the time. Cadbury’s management immediately rejected Kraft’s offer. Here is where it gets interesting: in a statement, Cadbury said the proposal “fundamentally undervalues the group and its prospects,” adding that the board is confident in the company’s stand-alone strategy. The first take on this statement seems to mean that management and the board believe the company is worth more and are going to reject the first offer in hopes of a higher offer. That is exactly what they should do.

But, we could also read that management wants to protect its interests, namely jobs, compensation and future stock appreciation. The board, which we all know is handpicked by management, is generally on the side of management. After all, they have cushy director jobs to protect too. The idea that a 31% premium to the market price is fundamentally undervaluing the company is a pretty weak claim. If the company was really that attractive on its own, don’t you think the market and the shareholders would have valued more? We aren’t talking about tech or biotech companies with unknown growth potential. Instead we’re talking about well established businesses that are easy to understand, easy to handicap and easy to value. So the “fundamentally undervalued” argument is disingenuous at best.

How can we tell if this is the agency dilemma at work or simply the merger dance in action? I’m not so sure you can tell. Management should be doing what it can to maximize the sale price, including rejecting the offer and talking tough. On the other hand, Cadbury’s CEO, is acting a bit dodgy. Quoting from the WSJ:

The company claimed in a brief statement that Chief Executive Todd Stitzer’s comments at an investor conference this week had been “misconstrued.”

“For the avoidance of doubt, Mr. Stitzer does not believe that Kraft’s proposal makes strategic or financial sense for Cadbury and his comments should not be interpreted in any other way,” the company said.

Those are some harsh words. It is tough to deny the merger makes strategic sense, which he does anyway. Furthermore, no competing offers have arisen yet- so other companies don’t see value in paying more for Cadbury either. Can the CEO really think the company is better off worth 30% less? Will the shareholders be pleased? How will the CEO reverse his sentiment if Kraft decides to offer a little more?

As it stands now, it looks as though this may end up as a tender offer where shareholders will either approve or disapprove. Management will get to make its case and try to convince them that going it alone and foregoing the payday and expanded global reach is a good idea. As an investor who has met with both sides of similar deals many times, I can tell you that I’ve never been confident whose side management is really on.

I hope watching this merger mambo is as fun for you as it is for me.

Russ Roberts, host of EconTalk, occasionally makes the point economics is referred to as the “dismal science“. Those who refer to economics that way have never listened to Russ’ podcast. Listening to EconTalk always leaves me feeling a little bit better about the world.

The media and politicians like to spin economics in a way that makes you scared and favorable to whatever solution they happen to offer. Russ in his podcast frequently examines these claims and exposes them either as false or highly misleading. For example, Russ many times points out it’s a myth America doesn’t make anything anymore, that its manufacturing base is being hollowed out. America is the world’s largest manufacturer. America just becomes increasingly efficient over time. America can make more with less people. When your economy can make more with fewer resources (be it iron or human resources) that’s actually a good thing for your economy.

Another one Russ tackles is the notion economies should strive to be self reliant. Historically, self reliant economies are subsistence economies (consider, North Korea).

Another is the notion that someone’s economic gain is another person’s loss. If taking a slice of the pie actually makes the pie bigger, no one loses.

In skepticism, you quickly learn that just because something seems to make sense, it might not actually be the case. The Monty Hall “paradox” is a great example. Russ is best when he’s taking on topics that tackle topics where reality is actually counter intuitive.

Anyway, I’ve compiled a list of some of my favorite EconTalk podcasts. If you’ve never heard Russ’ podcast, these are some great ones to start with:

Graham on Start-ups, Innovation, and Creativity: An interesting podcast with a venture capitalist (who claims he’s not really a VC) how technology has changed the risks involved in starting up a new company.

Eric Raymond on Hacking, Open Source, and the Cathedral and the Bazaar
: One of the originators of the open source concept stops in to talk about different incentives people have to do stuff.

Lipstein on Hospitals: A real eye opener on how people with good, private health insurance end up subsidizing the rest of healthcare.

Munger on Middlemen: Anything with guest Mike Munger is a joy to listen to. This one is doubly good. They examines the role of the middle man in business. The middle man has acquired a reputation for being a parasite but middle men perform highly valuable roles in modern economies.

Cole on the Market for New Cars: Russ actually gets a real car salesguy he bought a car from and they talk about how cars are priced.

Nye on Wine, War and Trade: Another interesting episode where Russ and the guest challenge your assumptions. Was Britain historically the free trader or was France actually a bigger free trader?

Munger on Subsidies and Externalities: Munger again. Who knew he was also a farmer? Are those massive subsidies the government pays to farmers a good thing?

Don Boudreaux on Globalization and Trade Deficits: A great intro to global trade. Is it a bad thing to send dollars abroad? Does the money really ever come back?

Munger on Fair Trade and Free Trade: Munger has some interesting insights into so called “fair trade” coffee. This show offers a great thought experiment about putting a tip jar at Wal-Mart and how that might be a bad thing.

McCraw on Schumpeter, Innovation, and Creative Destruction: A good primer on an economic concept called “creative destruction”.

Shlaes on the Great Depression: Russ and guest bust some of the myths about the Great Depression.

Boudreaux on the Economics of “Buy Local”: Is buying local really a positive? What is local? Does it stop being local when you cross an arbitrary border?

Legislators vs. Wal-Mart: Russ and guest examine everyone’s favorite whipping post.

– Karl Mamer

I don’t know about you, but I’m tired of the anniversary of the fall crap lately. Lehman, being the poster child for that fateful week, is always the topic of conversation. As a commentator on the financial world, I suppose it is my duty, accepted when they let me write a blog, to make some sort of acerbic, snide, honorary mention of Lehman. So, I’m going to do just that:

For a laugh, or cry- or outrage- visit Lehman’s official eBay store. Here you can buy all the left over corporate logo items the employees never had a chance to sport. Like the Lehman Brothers gym bag or the Lehman Brothers long vented umbrella. Not stately enough for you? Try the canvas & leather weekender bag or the “vineyard ties”. Perhaps the silver plated baby rattle or Vinyard Vines Red White & Blue Tennis Scarves are more your fancy.

In case you are wondering, this eBay store is actually the official Lehman store selling unsold inventory from the corporate store. The proceeds go to pay Lehman’s creditors, of which there seems to be no shortage. Of course, one could always buy the Lehman Brothers Herrington Teddy Bear and use it for target practice or burn the Lehman surplus stationary in effigy. Too bad they don’t have Lehman playing cards or dice- wouldn’t that be apropos? What is my favorite? Well, I actually have a set of Lehman Brothers Wine Accessories in Wooden Box. It was given to me years ago by, you guessed it, a Lehman salesperson. I used it to help calm my nerves that miserable week one year ago. I’m sure others did too.