Monday, March 24, 2008

Signs of the Economic Apocalypse, 3-24-08


Gold closed at 920.00 dollars an ounce Thursday (markets were closed Friday for Good Friday), down 8.6% from $999.50 for the week. The dollar closed at 0.6480 euros last week, up 1.5% from 0.6382 at the close of the previous Friday. That put the euro at 1.5432 dollars compared to 1.5670 the Friday before. Gold in euros would be 596.16 euros an ounce, down 7.0% from 637.84 at the close of the previous week. Oil closed at 101.84 dollars a barrel Thursday, down 8.1% from $110.06 for the week. Oil in euros would be 65.99 euros a barrel, down 6.4% from 70.24 at the close of the week before. The gold/oil ratio closed at 9.03, down 0.6% from 9.08 for the week. In U.S. stocks, the Dow Jones Industrial Index closed at 12,361.32 Thursday, up 3.4% from 11,951.09 at the close of the previous week. The NASDAQ closed at 2,258.11 last week, up 2.1% from 2,212.49 at last week’s close. In U.S. interest rates, the yield on the ten-year U.S. Treasury note closed at 3.33 Thursday, down 11 basis points from 3.44% for the week.

Looking back on last week, it is safe to say that the Fed’s odd rescue of Bear Stearns was a success. The price of gold fell the most it has in any week since 1990, almost 9%. The dollar gained on the euro. Oil was down 8%. The Dow rose 3.4%. Not to say there isn’t a whole lot to criticize in the Bear Stearns action. Don Harrold does a great job of that here if you haven’t seen it yet. But it did what it was supposed to do: stop the bleeding.

Now what? Were the recent run-ups in the prices of commodities (gold, other metals, oil, wheat, corn, etc.) just another bubble or were they part of a longer term trend? Will commodity prices go down as the world enters a recession, or will we suffer stagflation (higher prices and low growth)? By “just another bubble” I mean that it could be that the higher prices for commodities represent the lower value of all world currencies, that currencies were inflated by easy credit and there are more dollars, euros, yen, etc. chasing the same amount of commodities and that when a crash comes, we will see a deflationary reduction in commodity prices. Or, it could be that we are reaching limits in the production of commodities, that there is a limited amount of gold, oil, arable land, etc. and that economic growth in Asia means higher prices.
Deflation or Inflation? Money for Nothing

Kenneth Couesbouc

March 21, 2008

The harder they come, the harder they fall one and all.
-- Jimmy Cliff.

There are currently two contradictory forecasts for the times to come, deflation and inflation. Are rising commodity prices mere speculation, a bubble amongst bubbles that will burst as bubbles do? Will the credit crunch lead to a liquidity crisis that must push prices down? Or is legal tender losing its face-value? Is OPEC to blame for the rising price of crude oil, or should the major central banks be held responsible for flooding the market with "money for nothing"?

Trading in commodities is always a speculative business, as it demands a continual anticipation of future prices. But this also applies to stocks and real estate. And these, as shown by recent events, can inflate without inflating currency. However, the price of stocks and real estate only affects the price of stocks and real estate, whereas the price of commodities affects the price of just about everything else. It is also true that company shares and land are practically eternal, whereas commodities are destined to enter the production/consumption process. A barrel of oil is not continuously coming back on the market to be bought and sold. At some stage its value is determined once and for all (without, of course, prejudicing the price of future barrels of oil). Commodities and their value are destined to be consumed and must be produced again. Company shares (as long as the company exists) and land (a part of the Earth's surface) cannot be consumed. Their market value may fluctuate but their material existence persists unchanged. The persistence of stocks and real estate allows the formation of speculative bubbles that drain money from other employment, but do not otherwise affect the prices on the market. Whereas inflated commodity prices inflate all other prices.

The direct effect of a liquidity crisis is that banks hesitate in lending to each other and to the world at large. This means that the biggest banks will take control of the smaller fry, probably after substantial government bail-outs (vis. Bear Stearns). The next to suffer are the market operators on the stock exchange and in real estate, who need regular injections of extra credit to keep their buoyancy. Then come home-buyers, car-buyers, buyers of sofas and TVs, right down to the ordinary overdraft. Less liquidity means less buying power all round. Will this bring prices down generally, or will it reduce spending to the essentials of life, at whatever price? A shrinking demand for non-essential goods and services will push the weak to the wall, and the big companies will swallow the small.

Like the Roman god Janus, money is two-faced. It can be the intermediary of exchange and it can be the finality of exchange. As K. Marx explained long ago, the perpetual chain of exchanges, commodity - money - commodity - money - C - M - C - M - etc., is made up of two separate series of events. One is C - M - C, and the other is M - C - M. The first series concerns the exchange of goods and services, with money as their intermediary. The second series concerns the exchange of money, with goods and services as its intermediary. Selling the produce of labour to buy the produce of different labour is a consequence of the division of labour. Buying the produce of labour to sell it again at a profit is a consequence of the monetary system. Through the intermediary of money, goods and services are exchanged for consumption (productive or not). Use and exchange value changes hands, and the intervening money is a simple formality. Whereas buying to sell at a profit means that the object of the exchange between money and more money is of secondary importance and that, ultimately, everything is bought and sold.

Buying to sell instead of selling to buy means available credit instead of available goods and services, capital instead of labour. It is no longer the product of labour that is sold to buy the product of other labours. It is labour that is bought, and its product is sold at a profit. And the question arises of the nature of profit. Is labour bought at less than its value, or is the product of labour sold at more than its value? This is a moot-point. But the value of a product is the sum of the values that go into its production, and its market price must cover this plus profit. Profit is the difference between the market price and the production costs. This means that profit depends on a market price that is superior to the value of the product. And profit increases as the gap between price and value widens. If the market price of a product is unchanged (if supply matches demand), and its value is reduced by productivity gains (new technology), or by reducing the price of labour (outsourcing), then profit will increase accordingly. But the exchanges on the market are exchanges of value that do not take into account the difference between an excessive and an insufficient price of labour. The value of labour is the price paid for it. Profit means that the market price is in excess of value, and that the currency measuring the price is devalued. And the larger the profit margin, the more currency is devalued.

…The price of non-renewable commodities is entering a new phase. So far, abundance has been the rule, and this may still be true. But the growth curve of supply has been crossed by the growth curve of demand, which is much steeper. Market prices are but a reflection of this new relation, where the planet's resources are pushed to the limit. However, demand must be solvent, and increasing demand depends on increasing amounts of liquidity. And that seems to be in contradiction with the present situation. Unless liquidity is being drained onto the commodity market, thereby accentuating the lack of liquidity elsewhere. Either demand for commodities slackens and the world economy stagnates or recedes, or this demand is sustained by credit and banks will fall like dominoes. Or, and this is the case so far, central banks change their status of ultimate lenders to that of primary lenders. Instead of backing short term discounting and inter-bank lending, central banks are doing the lending themselves at a bargain rate. This is not quite the same as printing larger and larger denomination bank-notes, because credit returns to the creditor, whereas bank-notes stay in circulation. But the principle is the same. The loans granted by central banks will have to be renewed and increased. Renewed to keep the banks afloat, and increased to compensate the liquidity drawn on to the commodities market. And also to compensate the liquidity that is withdrawn to be consumed. As rising commodity prices are passed on to the consumer, the credit squeeze forces him to fall back on his savings. He too needs cash and must sell his stocks and bonds, maybe even his life insurance or his home. This also must be compensated by central bank loans.

It seems that 2008 will be an up and down year, as central banks regularly intervene on a weekly, monthly and quarterly basis with increasing amounts of credit. The real test will come when governments try to fill their abysmal budget deficits by borrowing on the money market. With banks on the verge of asphyxiation and savings being spent on consumption, this will be difficult and costly and will depend on more central bank lending. Handing out swaths of money at close to zero interest, backed by little or no collateral, may be different from printing bank-notes but the result will be just as inflationary. So inflation wipes out debts and borrowing can increase again, drawing growth along with it. Inflation will greatly alleviate government, corporate and all fixed interest debts. But the holders of these debts will loose out. So will wage earners and fixed incomes in general. And the consequence of these recurrent inflationary peaks is always proportionate to the size of the debt. With inflation, the amount of value destroyed is necessarily a percentage of the total sum of all values.

What does Couesbouc mean when he says that central banks are becoming primary lenders? It means the Fed now is lending money directly to to investment firms, rather than what they traditionally did as ultimate lenders, lend money to banks and their own national governments.

Investment firms tap Fed for billions

Jeannine Aversa

March 20, 2008

WASHINGTON (AP) - Big Wall Street investment companies are taking advantage of the Federal Reserve's unprecedented offer to secure emergency loans, the central bank reported Thursday.

The lending is part of a major effort by the Fed to help a financial system in danger of freezing.

Those large firms averaged $13.4 billion in daily borrowing over the past week from the new lending facility. The report does not identify the borrowers.

The Fed, in a bold move Sunday, agreed for the first time to let big investment houses get emergency loans directly from the central bank. This mechanism, similar to one available for commercial banks for years, got under way Monday and will continue for at least six months. It was the broadest use of the Fed's lending authority since the 1930s.

Goldman Sachs, Lehman Brothers and Morgan Stanley said Wednesday they had begun to test the new lending mechanism.

On Wednesday alone, lending reached $28.8 billion, according to the Fed report.

The Fed created a way for financially strapped investment firms to have regular access to a source of short-term cash. This lending facility is seen as similar to the Fed's "discount window" for banks. Commercial banks and investment companies pay 2.5 percent in interest for overnight loans from the Fed.

Investment houses can put up a range of collateral, including investment-grade mortgage backed securities.

The Fed, in another rare move last Friday, agreed to let JP Morgan Chase secure emergency financing from the central bank to rescue the venerable Wall Street firm Bear Stearns from collapse. Two days later, the Fed back a deal for JP Morgan to take over Bear Stearns.

Thursday's report offered insight on how much credit was extended to Bear Stearns via JP Morgan through the transaction the Fed approved last Friday. Average daily borrowing came to $5.5 billion for the week ending Wednesday.

Separately, the Fed said it will make $75 billion of Treasury securities available to big investment firms next week. Investment houses can bid on a slice of the securities at a Fed auction next Thursday; a second is set for April 3.

The Fed will allow investment firms to borrow up to $200 billion in safe Treasury securities by using some of their more risky investments as collateral.

By allowing this, the Fed is hoping to take pressure off financial companies and make them more inclined to lend to people and businesses.

The housing collapse and credit crunch have led to record-high home foreclosures and forced financial companies to rack up multibillion losses in complex mortgage investments that turned sour.

In the past day and weeks, the Fed has taken extraordinary moves aimed at making sure that problems in credit and financial markets do not sink the economy.

One of the things this new lending means is that the Fed will begin to regulate investment firms like they have regulated banking. This is generally a good thing and long overdue. The repeal of the Glass-Steagall Act in 1999, which separated commercial banking from investment banking, opened up a whole world of unregulated credit. That will always lead to a speculative bubble then a crash.

Partying Like It’s 1929

Paul Krugman

March 21, 2008

If Ben Bernanke manages to save the financial system from collapse, he will — rightly — be praised for his heroic efforts.

But what we should be asking is: How did we get here?

Why does the financial system need salvation?

Why do mild-mannered economists have to become superheroes?

The answer, at a fundamental level, is that we’re paying the price for willful amnesia. We chose to forget what happened in the 1930s — and having refused to learn from history, we’re repeating it.

Contrary to popular belief, the stock market crash of 1929 wasn’t the defining moment of the Great Depression. What turned an ordinary recession into a civilization-threatening slump was the wave of bank runs that swept across America in 1930 and 1931.

This banking crisis of the 1930s showed that unregulated, unsupervised financial markets can all too easily suffer catastrophic failure.

As the decades passed, however, that lesson was forgotten — and now we’re relearning it, the hard way.

To grasp the problem, you need to understand what banks do.

Banks exist because they help reconcile the conflicting desires of savers and borrowers. Savers want freedom — access to their money on short notice. Borrowers want commitment: they don’t want to risk facing sudden demands for repayment.

Normally, banks satisfy both desires: depositors have access to their funds whenever they want, yet most of the money placed in a bank’s care is used to make long-term loans. The reason this works is that withdrawals are usually more or less matched by new deposits, so that a bank only needs a modest cash reserve to make good on its promises.

But sometimes — often based on nothing more than a rumor — banks face runs, in which many people try to withdraw their money at the same time. And a bank that faces a run by depositors, lacking the cash to meet their demands, may go bust even if the rumor was false.

Worse yet, bank runs can be contagious. If depositors at one bank lose their money, depositors at other banks are likely to get nervous, too, setting off a chain reaction. And there can be wider economic effects: as the surviving banks try to raise cash by calling in loans, there can be a vicious circle in which bank runs cause a credit crunch, which leads to more business failures, which leads to more financial troubles at banks, and so on.

That, in brief, is what happened in 1930-1931, making the Great Depression the disaster it was. So Congress tried to make sure it would never happen again by creating a system of regulations and guarantees that provided a safety net for the financial system.

And we all lived happily for a while — but not for ever after.

Wall Street chafed at regulations that limited risk, but also limited potential profits. And little by little it wriggled free — partly by persuading politicians to relax the rules, but mainly by creating a “shadow banking system” that relied on complex financial arrangements to bypass regulations designed to ensure that banking was safe.

For example, in the old system, savers had federally insured deposits in tightly regulated savings banks, and banks used that money to make home loans. Over time, however, this was partly replaced by a system in which savers put their money in funds that bought asset-backed commercial paper from special investment vehicles that bought collateralized debt obligations created from securitized mortgages — with nary a regulator in sight.

As the years went by, the shadow banking system took over more and more of the banking business, because the unregulated players in this system seemed to offer better deals than conventional banks. Meanwhile, those who worried about the fact that this brave new world of finance lacked a safety net were dismissed as hopelessly old-fashioned.

In fact, however, we were partying like it was 1929 — and now it’s 1930.

The financial crisis currently under way is basically an updated version of the wave of bank runs that swept the nation three generations ago. People aren’t pulling cash out of banks to put it in their mattresses — but they’re doing the modern equivalent, pulling their money out of the shadow banking system and putting it into Treasury bills. And the result, now as then, is a vicious circle of financial contraction.

Mr. Bernanke and his colleagues at the Fed are doing all they can to end that vicious circle. We can only hope that they succeed. Otherwise, the next few years will be very unpleasant — not another Great Depression, hopefully, but surely the worst slump we’ve seen in decades.

Even if Mr. Bernanke pulls it off, however, this is no way to run an economy. It’s time to relearn the lessons of the 1930s, and get the financial system back under control.

It is clear that the game has changed in the financial capitals of the world. To one degree or another we will see closer regulation of financial markets, if only because there was hardly any regulation at all in the last decade.

The four ‘new sheriffs’ of Wall Street

Francesco Guerrera, Krishna Guha and Gillian Tett

March 21 2008

The Federal Reserve and Treasury are playing a dominant day-to-day role in overseeing Wall Street following this week’s rescue of Bear Stearns, raising the prospect that the central bank might be given more permanent authority over securities firms.

Bankers say the greater authority is a direct consequence of the Fed’s extraordinary decisions to extend a $30bn credit line to help JPMorgan Chase’s takeover of Bear and to lend emergency funds to securities houses for the first time in more than 70 years.

“There is a new sheriff in town,” said a senior banker. “The Bear situation changed everything: people saw death before their eyes. The Fed and Treasury are in charge now and are not going to let go”.

Under a regulatory regime dating back to the 1930s, the Fed oversees commercial banks, but investment banks are primarily regulated by the Securities and Exchange Commission.

But as the credit crunch deepened, Ben Bernanke, Fed chairman, Tim Geithner, president of the New York Fed, Hank Paulson, Treasury secretary, and Robert Steel, his number two, have been in unusually close contact with Wall Street executives.

People close to the situation said the Fed and Treasury feared further problems among securities firms could destabilise the financial system and expose US taxpayers to sizeable losses on the new Fed loans.

Their stance has triggered talk of new financial services legislation, with bankers and politicians, including Barney Frank, House financial services committee chairman, asking whether investment banks should be regulated by the SEC or the Fed.

An extension of the Fed’s powers to investment banks might force them to reduce risk and leverage in order to comply with the tougher requirements faced by deposit-taking banks.

However, any change would require legislative action, which looks increasingly difficult ahead of the November presidential election, and could be even more problematic under a new Administration.

The SEC said different agencies were functioning as “equal partners at the regulatory forefront”.

Whatever happens it is clear that we have reached the end of an era. The end of both the neoliberal era and the era of U.S. hegemony.

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