Wednesday, April 30, 2008

notions of trichet

once again, the new york times brings us a pair of very important stories:

For months, beleaguered American consumers have defied expert forecasts that they would soon succumb to the pressures of falling home prices, fewer jobs and shrinking paychecks. Now, they appear to have given in. link

and across the pond...

LES ULIS, France — When their local bakery in this town south of Paris raised the price of a baguette for the third time in six months, Anne-Laure Renard and Guy Talpot bought a bread maker. When gasoline became their biggest single expense, they sold one of their two cars. link

at first they may seem similar because they're about people struggling with hard economic times. but let's look closer:

for americans, the problems are: falling home prices, fewer jobs and falling paychecks.

for europeans, it's rising prices.

I know history doesn't repeat itself exactly, but it seems that we're setting up for some interesting paralells to the late 1970s.. this time jean-claude trichet, head of europe's central bank, plays the role of paul volcker, the US Fed chairman who jacked up interest rates to shut down inflation. I say this for at two reasons... first, volcker is recognized as one of the great economic heroes of all time. I think trichet will naturally be drawn to follow his example...

secondly, trichet has a sole mandate of fighting inflation. in contrast the fed has a dual mandate of fighting inflation and maintaining full employment. that means ben bernanke is much more worried about keeping the economy strong. cynically, one might add the fed's second job is actually "full employment (for wall street and bankers in general)" ... that means they don't want people's loans blowing up. europe doesn't have to worry about that because spain and ireland are the only two countries where debt-financed houses are losing value.

home prices find an equilibrium reflecting interest rates and, more importantly, the willingness of lenders to extend credit. given that the people who ultimately finance home mortgages are credit-market investors, let's take their point of view. they price loans based on collateral -- what thing can I take and sell to get my money back? they see home prices rise steadily for decades, and come to view them as good collateral. they may have some doubts about liar loans, but then their boss gives them 50 million to invest right now. they have to hit certain yield targets to keep up with the joneses at the other mutual funds. as a result, everyone follows the crowd, chases yield and buys subprime bonds. bad loans get made and home prices rise more than they should. it's bubble behavior 101.

in a bubble, the market is incapable of scratching its head and asking: does it make sense to lend $300k-500 to a family that has little savings, maybe some other debt, plus unfunded college expenses and retirement needs? millions of loans were made to these people, even though the cost structures of their daily lives are vulnerable to swings in a volatile and increasingly scarce commodity like oil...

speaking of volatile commodities, consider the bubble of that's deflating right now in U.S. fixed income assets. asian exporters like japan originally bought treasury bonds to recycle their surplus dollars... over time, foreign buyers moved into corporate bonds and mortgages in search of greater yield. this was a big part of the general bubble in credit that ended late last year ... these recycled trade dollars were always considered a major source of liquidity. some charts illustrate the trend:



in the top chart, we see the increases in how many US bonds foriegners bought, smoothed with a 4 month moving average. the middle chart is the trade deficit relative to GDP. it basically shows that as americans bought more foreign goods, foreigners bought more US debt. they bought treasuries, corporates and mortgages. by the time I started paying attention to credit in 2004, overseas buyers were just becoming a fundamental pillar in the credit market... bond investors talked about it, and ben bernanke described it as a global savings glut...

thus home prices surged higher before recently pulling back, seen in the bottom chart of the case-shiller index of home prices. I think the similar shape of all three charts is remarkable and noteworthy.

the US went through a trade bubble, a credit bubble, a housing and even a corporate profitability bubble . ( regarding profits, I spoke with a trusted old analyst source who agreed when I suggested that the surge of profits we saw in the 2002-7 period may have resulted heavily from lower input costs due to globalization and outsourcing. it's not to say it's over -- just to suggest that the trade bubble also enabled a profitability bubble. plus, the low hanging fruit may have all been reached.. )

anyway, my basic point in this was about trichet. I just wonder if he isn't looking at the US and realizing he faces a different set of problems. we're facing a semi-implosion of our trade-and-borrow economic model. because we have debt, we want low interest rates..

in contrast, trichet faces high energy prices and an overheating but relatively rigid economy. cutting rates does nothing for him. if anything, it just makes things worse. he knows if he causes a recession now he can always cut rates later.. maybe he says: politicians will finally get serious and fix some of the rigidities and inefficiencies in the European economy... but there's no worry about a bigger collapse. as a result, I posit that trichet may follow the volcker model and remain hawkish -- even in the face of a recession!

one last thing to remember... after also, trichet and volcker probably both believe this:

inflation doesn't just go away. it builds upon itself as people accept higher prices and come to expect increases. it becomes a self-fulfilling prophecy. generally, central banks step in and jack up rates, making it impossible for anyone to pay for anything. prices then collapse and people regain confidence in the system. then interest rates can be lowered, boosting liquidity for all economic activity. usually the period of cutting rates that follows provides some of the best economic times.

now, I know this inflation is qualitatively different than what happened in the late 1970s because it's less the result of income growth in western countries. instead, it's caused by income growth in developing countries. they might go from $30 a month to $300 a month... then $800, then $1500.. even as they climb to these relatively modest levels by US standards, they eat more meat, drive more and buy more stuff in general.

one crazy alternate idea is that perhaps trichet should cut rates. after all, that would trigger a major dollar rally and take much of the froth out of the oil and commodities market. inflation would subside. what a crazy world we live in where trichet's attempts to fight inflation might actually be causing commodity-price inflation!?!?!?

no matter what, I have to think that, these days, opec would defend $100 a barrell oil now that it's been achieved. but, maybe it will all help in the long run when americans wake up and realize the simple solution to fixing social security and medicare in one swoop -- give them ANWR!!! (I know it wouldn't pay for all of the liabilities, but it would be a good start! better than taking it from our taxes!!!)

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