Hold the Champagne on China’s Economy
This month in Hong Kong, a single bottle of wine sold at auction for $93,000 to a Chinese buyer. No matter how good the vintage, that's not something to pop a cork over and celebrate. Those who witnessed Japan's spectacular rise and fall in the 1980s should be getting a familiar feeling watching China these days. In the eyes of the media and much of the world, China's decades of double-digit growth, military modernization, 2008 Olympics hosting, and picture-perfect celebration of the 60th anniversary of the 1949 Communist victory have raised the People's Republic of China to the top rank of global powers.
Yet unsettling questions about the social effects of this stunning climb are also abundant. Of particular concern is an emerging asset bubble, noted by The Economist and Bloomberg, among others. Fueled by an undervalued yuan and disguised by non-transparent accounting practices, its growth highlights the unequal distribution of economic gains in China and raises doubts about the sustainability of current consumption patterns among the newly wealthy. Many observers have ignored some troubling pieces of evidence, and indeed, most have heralded China for being the first major economy to pull out of the current global economic crisis. Yet looking at the underside of growth leads one to consider that China may be headed for a crash similar to Japan's if certain trends continue. That would be devastating not merely for China, but also for a global economy just beginning recovery.
Observers have long noted with concern the growing income gap in China; disposable income in rural areas lag urban centers by 70 percent, according to some studies.
Questions abound over how efficiently resources are allocated in China, particularly those by wealthy individuals and private companies. Observers have long noted with concern the growing income gap between the affluent coastal belt and the poverty-stricken interior, where disposable incomes in rural areas lag urban centers by 70 percent, according to some studies. Yet the economic haves are not simply outstripping the have-nots; they are increasingly profligate and wasteful. China's new millionaires numbered nearly half a million before the economic crisis last year, putting the country in the number five spot globally. BusinessWeek spotlighted a number of these plutocrats several years ago, some of whom live in 22,000-square-foot mansions and wear $50,000 watches. Rolls Royce and Bentley sell thousands of cars each year in China, as well (the massive carbon footprints of which, along with the giant mansions, Western pundits routinely ignore). Builders have transformed China's urban skylines over the past two decades, yet overbuilding has led to increased vacancies and heavy debt holdings, and vacancies in major cities have risen by double digits in the past year. While policy makers in Beijing have managed the country's macro-development better and for longer than most observers would have imagined, the structure may be under increasing strain, precisely from its success.
Banks in China undoubtedly have bad loans, shielded by non-transparent accounting practices, and as wealthy individuals and producers over-leverage themselves, the pieces are in place for a very bumpy road ahead.
If a crash comes to China, it may come from the madness of affluent crowds. The danger is primarily social, in the form of unsustainable consumption patterns that will play out in the economy. Conspicuous consumption is spreading through the upper levels of Chinese society. That nearly $100,000 bottle of Chateau Petrus Imperial was sold in the world's largest wine market, Hong Kong. Similarly, Chinese collectors fueled a nearly $24-million sale of "modest pieces" of Chinese art at Christie's in New York in September, according to the New York Times, consistently paying between five and ten times the expected amounts. And Chinese buyers are just getting started, it seems.
A similar tale of excess unfolded in Japan in the 1980s. When land prices skyrocketed, paper profits followed, leading to ever-easier borrowing of money for both individuals and corporations. At the height of the bubble, the land under the Imperial Palace in central Tokyo was worth more than the entire state of California. Japanese investors bought up trophy properties around the globe, such as Rockefeller Center and Pebble Beach, for highly inflated prices, and one investor paid $40 million for Vincent Van Gogh's "Sunflowers." Japanese officials and business leaders believed in their infallibility, publicly deriding American society.
Back in the 1980s, Japanese companies were assumed to have discovered the secret to hyper-efficient production and thus endless profits, while the country's bureaucrats were lauded as perfect macro-planners.
Just like today with China, pundits, investors, and the media largely proclaimed that the Japanese party would go on forever. Today, the sophisticated management of the Chinese government is offered as proof that China will always experience growth (or if contraction, a soft landing). Back in the 1980s, Japanese companies were assumed to have discovered the secret to hyper-efficient production and thus endless profits, while the country's bureaucrats were lauded as perfect macro-planners. Inefficiencies, protected industries, poor management, and a sclerotic bureaucracy were all ignored by those who wanted to believe the hype. Yet such weaknesses were exacerbated by a culture of excess that destroyed consumer reality. Once it took root in Japan, expectations changed permanently and traditional restraint was abandoned. The savings rate dropped, and people paid exorbitant amounts for new houses and cars. I remember watching as whole parties in Tokyo restaurants walked away from tables full of food that was ordered and then left to be thrown away. The economics fed and then followed the social disease. Eventually, the asset bubble burst and the whole edifice came crashing down.
This is the larger danger in China's future, except that it might be even more destabilizing to a country that has such uneven economic growth. To control it, the Chinese Communist Party will have to clamp down on the very economic exuberance that has driven the country forward. Failing to rein it in, however, could prove devastating, especially in a society whose majority remains poor and hostile to the authorities. In flush economic times in 2004 alone, Chinese authorities put down nearly 70,000 riots in the hinterland. But today's spending binge may lead to deeper resentment against the wealthy, while spillover effects from an economic crash could set the countryside on fire. China has seen enough social revolution in its history that no one should rule it out again, especially if fallout from a collapse of the new rich hurts the countryside.
Added to these domestic reverberations would be a dramatic slowing of the global economy, should China's economic growth derail. Beijing would almost certainly limit if not stop its purchase of U.S. debt, driving interest rates in America sky high, while consumers might be hammered by cheap export goods drying up due to the financial distress of Chinese manufacturers; already tens of thousands of factories have closed due to the current economic crisis, disproportionately affecting lower-wage earners in China. Banks in China undoubtedly have bad loans, shielded by non-transparent accounting practices, and as wealthy individuals and producers over-leverage themselves, the pieces are in place for a very bumpy road ahead.
There's no way to predict if or when China's system becomes a house of cards, but if the world's auction houses continue to crow over massive Chinese purchases, then being a contrarian may be the smartest move of all.
Michael Auslin is a resident scholar at the American Enterprise Institute.
The Copenhagen Climate Extortion
If the upcoming Copenhagen climate change summit fails to result in substantive agreements, as increasingly seems likely, look for the global warming lobby to turn up the extortion heat. Here’s the dilemma:
The United States, Europe, Japan, and other developed countries are steadily cutting per capita emissions. But there remain contentious divisions about what future cuts are technologically and economically feasible. Going into the talks, the delegates appear to be competing over who can offer the most ambitious and least realistic targets so everyone can return from Copenhagen satisfied that they did their part to save the world, at least on paper.
Using 1990 as the benchmark, Britain pledges to reduce emissions by the year 2020, or shortly thereafter, by at least 34 percent. Japan pledges a 25-percent cutback. The U.S. House of Representatives bill passed in June of this year, less ambitious by the airy standards of climate geopolitics but no more realistic, assures a 17-percent reduction from 2005 levels.
But as Roger Pielke, former director of the Center for Science and Technology Policy Research, notes, “the problem with all these promises to achieve deep and rapid cuts in emissions is that no one knows how these cuts are going to happen, and most simply cannot happen as promised. So these countries have turned to designing very complex policies full of accounting tricks, political pork, and policy misdirection.”
Making promises and expecting the future to miraculously take care of itself appears enough to satisfy many enviro-romantics.
Making promises and expecting the future to miraculously take care of itself appears enough to satisfy many enviro-romantics. But the narrative gets worse, far worse. Someone will have to pay for attempting to achieve this scientific Great Fantasy, particularly in the financially strained developing world—and that’s where the extortion factor comes in.
The Stern Review on the Economics of Climate Change, commissioned by the British government, estimates that reorganizing the world energy economy could cut GDP growth by upwards of 1 percent, and perhaps as much as 5 percent, per year. Under current Copenhagen treaty drafts, developed countries are expected to cover the modernization and clean up of the energy sector in developing countries, which could result in an annual transfer of $150 billion by 2020.
Now, some measure of wealth redistribution can have merits, including greater global stability. And if indeed the world faces environmental disruptions from greenhouse gases and the more prosperous countries are in a better position to finance mitigation efforts, then expediency if nothing else dictates that targeted foreign aid to address climate change may be warranted. But there must be limits—and strings. And there’s no sign yet that’s in the cards.
The issue was put in play earlier this month, rather bluntly, in an interview with the incoming president of the summit, Connie Hedegaard, the Danish minister for climate and energy. It’s the obligation of North America, Europe, Australia, and Japan to “prove … to the developing world [that] we know we’re going to pay, or there will be no agreement,” she said.
This alliance of developing countries is aggressively promoting what amounts to a wealth-transfer scheme to lure countries with the dirtiest and fastest growing industrial sectors into the cap-and-trade fold.
Let’s be clear on what she is saying. The economically successful countries of the world are being threatened into reducing emissions far beyond what is possible, its impact on growth and world economic stability be damned, while simultaneously financing the transition of the rest of the world to a lower-carbon economy. Driving the push for a funding mechanism is the Group of 77 (G-77) and China. Its 130 member states from the developing world make up a solid majority in the United Nations. This alliance of developing countries, complimented by a collection of nongovernmental organizations (NGOs), aggressively promotes what amounts to a wealth-transfer scheme to lure countries with the dirtiest and fastest growing industrial sectors—China, India, and Brazil are the Big Dirty Three—into the cap-and-trade fold.
Hedegaard is merely echoing the talking points of developing countries, egged on by anti-globalist NGOs demanding that the industrialized West face its “historical responsibilities” for growing its economies on the back of low-cost coal and oil.
“Developed countries have been accumulating a climate debt for the past 200 years, based on their fossil fuel intensive development,” declared Stephanie Long, a spokesperson for Friends of the Earth. “This climate debt must be repaid … [t]his means that those that are historically responsible for climate change must reduce their emissions to give more resources to developing countries so they can develop sustainable economies.”
Seizing the moment, Ambassador Lumumba D'Aping of oil-rich Sudan, home to the genocidal government of Omar al-Bashir and a member of the G-77, has attacked the developed world as climate terrorists, intent “to maintain their profligate consumption lifestyles at the expense of the rest of humanity, and to do that by spinning it as if the rest of the world is responsible for damaging the environment.” His piece of flesh: “5 percent of the developed countries’ (annual) GDP.”
Reorganizing the world energy economy could cut GDP growth by upwards of 1 percent, and perhaps as much as 5 percent, per year, according to one estimate.
The suddenly emboldened emerging countries want the best of both worlds: limited environmental regulation so they can keep growing, with the West covering their under-funded mitigation and modernization efforts. Can you say “free rent”?
Granted, any person—or as in this case any country—with an opportunity to come into easy money would grab at it. But public policy experts are well aware of the “resource curse” theory, also known as the paradox of plenty: the easier you come by your wealth, the more you waste and the less accountable you are. It applies to mineral and oil rich countries in Latin America, Africa, and much of the Arab World, home to the misgoverned, but also to anybody getting a free lunch. Let’s not fool ourselves. We’re talking about welfare handouts with very few strings attached, and anytime someone or some country gets buckets of money under those conditions, accountability and restraint go out the window.
Climate change activists and their friends in economic dynamos like Denmark not only want the “U.S. and Co.” to share in the cost of modernization, they propose a no-deductible insurance policy covering any and all “climate events” that may—or more than likely may not—have been caused by the incremental carbon emission contributions of developed countries. Every time a typhoon, such as Ketsana that recently roared through the Philippines, wreaks havoc in the developing world or a drought or natural disaster hits, they will expect “rich nations” to foot the bill.
This amounts to naked extortion by emerging economies, aided and abetted by anti-globalist advocacy NGOs. Either the United States and other “rich nations” agree to allow developing countries to belch ever-increasing amounts of carbon and massive industrial pollutants—indeed to increase their per capita emissions—while forking over billions in aid dollars or they face political wrath. If the transfer from the most productive economies to the least efficient occurs at the projected magnitude, a nightmarish growth-dampening scenario is a real possibility.
As Pielke suggests, the world may come out of Copenhagen with the joke on NGOs and climate activists: “they will get just about everything they campaigned for, except any prospect for actual reductions in future emissions.” The more immediate question may be: what price will the growth engines of the world be forced to pay for this latest demonstration of eco-narcissism?
Jon Entine is a visiting fellow at the American Enterprise Institute and co-director of Global Governance Watch/NGOWatch, which just launched a new series, "Gateway to Copenhagen," monitoring the key climate change issues that will be addressed at the December summit.
Commentary by Caroline Baum
Oct. 26 (Bloomberg) -- The recession is over. Yea verily yea, as the knights of old might say with chalice raised.
The Commerce Department is expected to validate that premise later this week when it reports that the U.S. economy expanded at a 3 percent annualized rate or thereabouts in the third quarter, according to economic forecasters. It will be the first positive reading in five quarters and a sign the slump that started in December 2007 is over.
The official arbiter of such things -- the National Bureau of Economic Research’s Business Cycle Dating Committee -- isn’t about to bless the recovery just yet. The BCDC waited until July 2003 to declare an end to the March-to-November 2001 recession.
Of the four coincident indicators the committee uses to determine the onset of expansions and contractions, two have turned up -- industrial production and inflation-adjusted business sales -- and two are still falling, albeit at a slower rate.
The declines in employment and real personal income less transfer payments are one reason Main Street won’t be celebrating Thursday’s news on gross domestic product. The unemployment rate, currently 9.8 percent, is expected to top 10 percent in the next few months and remain elevated into next year, according to both Obama administration economists and private forecasters.
Permanent Separation
After that, it will be a slow slog for the out-of-work. The number of people who have been laid off permanently accounted for 56 percent of the unemployed in September, according to David Altig, senior vice president and research director at the Federal Reserve Bank of Atlanta. The share of permanent job losers (see Table A-8 in the monthly employment report) never rose above 45 percent in the six previous recessions, Altig writes on his blog, another piece of evidence supporting the forecast of a jobless recovery.
High unemployment isn’t the only reason the GDP celebration will be muted. Much of the third-quarter growth was manufactured.
This may sound whacky, but the federal government has been paying people to spend. Honest. You can’t make this stuff up.
Uncle Sam handed out your hard-earned tax dollars to prod people to scrap their old cars for more fuel-efficient models. The “Cash for Clunkers” program sent auto sales on a roller coaster ride -- first up, then down -- in August and September. Some of those buyers would have purchased a new car or truck anyway. Others used the $4,500 rebate as an inducement to strike while the iron was hot.
Pay to Spend
Just to recap: The government is paying people to do what they would have done at some point anyway.
Then there’s the $8,000 tax credit for first-time homebuyers, a program that failed to heed the lessons of the no- questions-asked-mortgage lend-o-rama earlier this decade. Some 74,000 claims may have been ineligible for the credit, including one from a 4-year-old boy, according to a report from the Treasury’s inspector general.
No one would dispute the idea that people respond to incentives: A temporary, one-time tax credit brings demand forward.
But it will take an increasingly large tax credit to get the same bang for the buck, according to Andy Laperriere, a managing director at the ISI Group in Washington.
Using estimates from the National Association of Realtors on the number of home sales that were borrowed from the future, Laperriere calculates that home sales will drop 11.5 percent next year even with an extension of the $8,000 tax credit. That’s better than the 29 percent decline he predicts if the credit expires, but the sign is still negative.
Expanding the eligibility beyond first-time homebuyers -- no toddlers allowed -- would alleviate some of the decline, Laperriere says.
Less with Less
Between the spending on houses and cars, the third quarter won’t look too shabby. The problem is that all these government actions designed to create a short-term economic boost have long-term implications.
For example, not all spending is created equal. Investment in the future, whether it’s the government improving roads or the private sector building a plant, is a plus for future growth.
“If increased government spending on retiree health care comes at the expense of business spending on capital equipment and R&D, then the productivity of the current labor force and long-run growth rate will be adversely affected,” says Paul Kasriel, chief economist at the Northern Trust Corp. in Chicago in his October economic outlook.
Secular Shadow
That’s one reason there’s a secular shadow hanging over the upbeat cyclical indicators, starting with the Index of Leading Economic Indicators itself. The LEI bottomed in March before soaring in the last six months. The six-month annualized change of 11.8 is heralding a rebound, as is the spread between the federal funds rate and 10-year Treasury note yield -- the leadingest of the 10 leading indicators, according to the Conference Board, the keeper of the LEI.
The spread was even steeper in the early 1990s, another period when an impaired banking system depressed the monetary transmission mechanism. Until banks stop hoarding excess reserves and start lending -- they’re buying Treasuries but not making many loans -- the spread is an incentive waiting to happen.
Like all incentives, this one will work in time. I’m just worried it will run smack into some disincentives elsewhere.
By Alisa Odenheimer
Oct. 26 (Bloomberg) -- The Bank of Israel held the benchmark interest rate unchanged for a second month as inflation eased, the shekel strengthened and the global recovery remained unsteady.
Governor Stanley Fischer kept the lending rate at 0.75 percent, the Jerusalem-based central bank said today. Ten of 14 economists surveyed by Bloomberg had forecast no change, while four predicted an increase to 1 percent.
Inflation dropped to within the government’s annual target range of 1 to 3 percent in September for the first time since May. Fischer in August became the first central banker to raise rates since signs of an easing in the global recession began.
“Leaving the interest rate unchanged for a second month sends a message to the market that the bank isn’t interested in an aggressive tightening as long as there is uncertainty regarding the strength of the global recovery,” Rafael Gozlan, chief economist at Leader Capital Markets in Tel Aviv, said in an e-mailed message.
The rate is likely to remain steady for the next few months, unless the inflation rate is significantly higher than expected, Gozlan added.
The shekel was little changed after the decision, adding 0.02 percent to 3.6965 per dollar from its Oct. 23 close of 3.6972.
Containing Inflation
Fischer is aiming to find a balance between containing inflation and nurturing economic growth. Concern that an increase in the rate could strengthen the shekel against the dollar also may have played a part in the decision. Forty-five percent of Israel’s gross domestic product comes from exports and the shekel is trading close to its strongest against the dollar in a year.
The bank, in its statement, said the decision today “will help keep inflation within the target range and underpin the recovery in real activity while supporting financial stability.”
Inflation slowed to 2.8 percent in September, the Central Bureau of Statistics said on Oct. 15. It will ease to 2.4 percent in the next 12 months, according to a Bank of Israel survey of economists, the bank said.
“Inflation seems to be under control, and inflation expectations are around the middle of the target range,” Jonathan Katz, a Jerusalem-based economist at HSBC Holdings Plc, said by telephone prior to the decision. “At the same time, the world economy is still fragile.”
Following Suit
Since Fischer raised rates in August, only Australia has followed suit. In the U.S., the Federal Reserve is expected to increase the target rate for overnight bank loans to 0.5 percent in the second quarter of 2010, according to the average forecast of economists in a Bloomberg survey.
Fischer cut the key interest rate to a record low of 0.5 percent in March and purchased foreign currency and government bonds to bolster the economy which contracted an annualized 3.3 percent in the first quarter. Since then, the economy has started to recover, expanding an annualized 0.8 percent in the second quarter.
In addition to interest rate moves, Fischer has taken other steps to unwind his expansionary monetary policy. He halted bond purchases at the beginning of August and announced that he would end set purchases of foreign currency, while continuing to buy foreign currency in the event of “unusual movements” in the shekel.
By Cordell Eddings and Susanne Walker
Oct. 26 (Bloomberg) -- Treasuries fell, with 10-year note yields touching their highest level in two months, as the U.S. began to sell a record $123 billion of notes to fund its stimulus program and record deficits.
Government securities declined for a fourth day as the Treasury sold of $7 billion of five-year Treasury Inflation Protected Securities at a yield of 0.769 percent. The offering, which drew higher-than-average demand, will be followed by three auctions of fixed-rate notes this week.
“We are still at relatively low yield levels, which in front of so much supply and an economy that seems to be starting to turn the corner, don’t seem justified,” said Ajay Rajadhyaksha, head of U.S. fixed-income strategy in New York at Barclays Plc, one of the 18 primary dealers required to bid at Treasury auctions.
The yield on the 10-year note increased seven basis points, or 0.07 percentage point, to 3.55 percent at 2:48 p.m. in New York, according to BGCantor Market Data. The yield touched 3.58 percent, the highest level since Aug. 24. The 3.625 percent security maturing in August 2019 fell 18/32, or $5.63 per $1,000 face amount, to 100 19/32.
“The momentum suggests we could move higher in yields,” said David Ader, head of U.S. government bond strategy in Stamford, Connecticut, at CRT Capital Group LLC. “If we break 3.52 percent, then the next projection is 3.76 percent. Resistance is at 3.28 percent.”
The 10-year yield will increase to 3.56 percent by year- end, according to the average forecast of analysts in a Bloomberg survey, with the most recent estimates given the heaviest weightings.
Five-Year TIPS
The U.S. is scheduled to sell $44 billion of two-year notes tomorrow, $41 billion of five-year notes on Oct. 28 and $31 billion of seven-year securities on Oct. 29.
The auction today is a reopening of the $8 billion five- year TIPS offering on April 23, and the notes mature in April 2014. The securities drew a yield of 1.278 percent at the April sale.
The bid-to-cover ratio, which gauges demand by comparing the amount bid with the amount offered, was 3.10, the highest level since October 1997’s 3.56 percent. For the past five sales of the securities, the ratio averaged 2.31.
Indirect bidders, the category of investors that includes foreign central banks, bought 47.8 percent of the securities, the most since they received 51.4 percent of the securities at the October 2006 auction. At the past five auctions, the group bought 30.8 percent on average.
Inflation Protection
“Five-year TIPS are superstar today and are of the few asset classes doing well, relative to the other markets,” said George Goncalves, chief fixed-income rates strategist at primary dealer Cantor Fitzgerald LP in New York. “TIPS offer an inflation hedge and offer diversification in fixed income, especially when all other yields are so low.”
The difference between rates on five-year notes and Treasury Inflation Protected Securities, which reflects the outlook among traders for consumer prices for the next five years, widened to 1.7 percentage points from 1.37 percentage points at the beginning of the month.
The previous record for notes sold in a week was $115 billion over the five days ended July 31, when the Treasury sold $6 billion in 20-year TIPS, $42 billion in 2-year notes, $39 billion in 5-year securities, and $28 billion in notes maturing in seven years.
Treasury has sold $1.6 trillion in notes and bonds to finance a budget deficit that reached a record $1.4 trillion in fiscal year 2009 that ended Sept. 30. Debt amounted to 9.9 percent of the nation’s economy, triple the size of the 2008 shortfall.
Average Maturity
After issuing $1.9 trillion of short-term securities to finance President Barack Obama’s efforts to end the worst recession since the 1930s, the Treasury plans to lengthen the average due date of its outstanding debt to 72 months from a 26- year low of 49 months. That may mean boosting sales of 10- and 30-year securities by 40 percent over the next year to $600 billion, according to FTN Financial in Memphis, Tennessee, driving down prices of longer-term securities.
“The talk by the Treasury pertaining to the extension of the debt will continue to weigh on the back-end of the market and allow the trading range to resolve toward higher rates going forward,” John Spinello, chief technical strategist in New York at primary dealer Jefferies Group Inc., wrote in a note to clients.
Fed Purchases
Replacing bills with bonds may drive up the so-called yield curve as the Fed keeps its target rate for overnight loans between banks unchanged near zero until the second quarter of 2010, according to the weighted average of 67 forecasts in a Bloomberg survey. The gap between yields on 2- and 10-year notes widened to 2.53 percentage points from 1.29 percentage points at the end of last year.
The Fed is scheduled on Oct. 29 to complete the $300 billion Treasury purchase program it began in March, part of its effort to cap consumer borrowing costs.
Fed Chairman Ben S. Bernanke and his fellow policy makers cut the target rate for overnight loans between banks to a range of zero to 0.25 percent at the end of 2008. They will keep the benchmark there until August, when central bankers will boost it to 0.5 percent, according to the median estimate of 47 economists surveyed by Bloomberg from Oct. 1 to Oct. 8.
By Rita Nazareth
Oct. 26 (Bloomberg) -- U.S. stocks slid, erasing an early rally, on concern lawmakers will phase out a tax credit for homebuyers and Bank of America Corp. will have to sell shares to pay back its government bailout. The dollar rebounded from a 14- month low against the euro and oil wiped out an early advance.
All 12 shares in a gauge of homebuilders slid. Bank of America sank 5.1 percent on speculation government officials will force the company to raise more capital, while Fifth Third Bancorp, SunTrust Banks Inc. and U.S. Bancorp declined at least 3.2 percent after Rochdale Securities LLC analyst Dick Bove downgraded the shares. Treasuries fell, with 10-year yields touching a two-month high.
The Standard & Poor’s 500 Index lost 1.2 percent to 1,066.95 at 4:04 p.m. in New York. The Dow Jones Industrial Average retreated 104.22 points, or 1.1 percent, to 9,867.96. Almost five stocks fell for each rising on the New York Stock Exchange.
“Plenty of news for traders to sell on,” said James Paulsen, who helps oversee $375 billion as chief investment strategist at Wells Capital Management in Minneapolis. “We’ve still got a rise in loan losses. Some banks will probably have to raise further capital. And on the tax-credit front, we already know we won’t have that forever. But after a nice stock market run, a lot of players wanted to have a pause.”
Equities rallied earlier, sending the S&P 500 up as much as 1.1 percent, as investors grew more confident that better-than- estimated profits will fuel further equity gains. About 80 percent of companies in the S&P 500 that reported third-quarter results have topped analysts’ earnings projections, exceeding the record pace of 72.3 percent for the period ended in June.
Builders Slump
A gauge of 12 homebuilders in S&P indexes slumped 3.4 percent, led by declines of at least 3.8 percent in Pulte Homes Inc. and D.R. Horton Inc. Senate leaders are negotiating to extend and gradually reduce an $8,000 tax credit for first-time homebuyers through 2010, Senator Bill Nelson said. The credit was set to expire at the end of November.
“The phase out is worse than a straight extension and probably worse for housing than the consensus,” ISI Group Inc. analysts said in a note
Banks fell 3.3 percent collectively, the steepest decline in the S&P 500 among 24 industries, after Bove downgraded Fifth Third Bancorp, SunTrust and U.S. Bancorp on concern loan losses will remain high.
Fifth Third, Ohio’s largest lender, retreated 7.9 percent to $9.52. SunTrust, the seventh-largest U.S. bank, lost 5.4 percent to $19.85, while Minneapolis-based U.S. Bancorp dropped 3.1 percent to $24.15. Bank of America, the largest U.S. lender by assets, sank 5.1 percent to $15.40.
‘Meaningfully Harm’
“The government apparently wants the bank to raise $45 billion in the market from a new capital offering before it will let the bank redeem the TARP preferreds,” Bove wrote in a note dated Oct. 23, referring to the Troubled Asset Relief Program. “Selling more stock would meaningfully harm Bank of America’s shareholders. If the bank did what the government wants it would have to sell 3 billion shares or increase its share base by 35 percent.”
Bank of America pared an earlier slide of as much as 7.1 percent after Citigroup Inc. added the stock to its “top picks” list, saying it is “very attractive” after the sell- off.
Federal Deposit Insurance Corp. Chairman Sheila Bair said that banks continue to face “serious challenges.” Bair also said tapping a Treasury Department credit line to replenish funds depleted by a surge of bank failures would harm her agency and the banking industry. She made the comments today during a speech at an American Bankers Association convention in Chicago.
Monsanto Co. fell 6 percent to $70.69, its biggest drop since May. Goldman Sachs Group Inc. lowered its earnings estimates for the world’s largest seed producer, citing company discounts on corn-seed prices.
Lady Liberty
I recently rented the Hollywood blockbuster The Duchess, starring Keira Knightley and Ralph Fiennes. I'll admit, I wasn't looking for any philosophical or economic message in the film, but sometimes I find it hard to help myself. (Come on, I'm sure I wasn't the only one who saw Free Willy as a metaphor for the plight of free markets!)
All I wanted was a mindless, romantic escape movie to take my mind off politics, and Keira Knightly was just the ticket. In the film, she plays Georgiana Cavendish, the Duchess of Devonshire, who, until that point, I had never heard about. The story was fairly typical for movies about the English aristocracy: a young girl marries into power only to find herself trapped in a loveless marriage, and she falls in love with another man. I did not expect that, amid the romance, costumes, and drama, I would strike libertarian gold!
It was one pivotal scene in particular that piqued my curiosity. When Charles Fox (played by Simon McBurney), who was Georgiana's mentor and the leader of the Whig party, argues for the importance of "freedom in moderation," Georgiana responds quickly and firmly that there cannot be scales of freedom. Rather, the "concept of freedom is an absolute."
The Duchess of Devonshire lived in a time that bears striking similarities to our own. In the late 18th century, England was rife with tensions between an increasingly powerful state and a swelling grassroots opposition. The frustrated Whigs were becoming increasingly radicalized in their defense of liberty against the corrupt, ever-expanding powers of King George III.
Georgiana came from a family with a rich Whig legacy. Her father and brother were Whig MPs, and her husband's great-great-grandfather was a member of the Immortal Seven, the band of rebel Whigs who were responsible for overthrowing King James II in the Glorious Revolution of 1688. This legacy made both Georgiana and her husband leaders of the party.
But Georgiana was not a shrinking violet. She was fiercely passionate about her party's ideals. Her favorite book was Vertot's Revolutions of Sweden, which is about, as she put it, a "[h]ero fighting for liberty of his country and to revenge the memory of an injur'd friend against lawless cruelty and oppressive tyranny."
Georgiana recognized that liberal ideals could only be spread through dedicated organizing and savvy marketing.
She was a rock star of the English Enlightenment. According to her biographer, Amanda Foreman, Georgiana was dubbed "the Empress of Fashion." The press noticed that "any report on the Duchess of Devonshire increased their sales." And according to French diplomat Louis Dutens, "When she appeared, every eye was turned towards her; when absent she was the subject of universal conversation."
Lucky for the Whigs, she used her influence with the public, her flair for fashion, and her showmanship to spread the cause of liberty.
Georgiana was a marketing genius,
one of the first to refine political messages for mass communication. She was an image-maker who understood the necessity for public relations, and she became adept at the manipulation of political symbols and the dissemination of party propaganda.… She was simultaneously a public figurehead for the Whigs and an effective politician within the party.
To keep morale alive, she held vibrant, theatrical parties, dinners, and rallies.
Thanks to the liberal market reforms that followed the Glorious Revolution, England was bustling with trade and commerce. Censorship had ended, resulting in the emergence of nine daily newspapers and a plethora of bi- and tri-weekly papers and magazines. It was the perfect environment for a natural star like Georgiana to rise to "It Girl" status.
Her talent for political propaganda was first recognized by Whig grandees during the American Revolutionary War. The Whigs had become unpopular in the country because of their unapologetic support for the revolution. Indeed, the Duchess was frequently adorned with the colors of buff and blue, which the Whigs adopted from the American Revolutionaries.
However, Georgiana led a women's auxiliary unit, which paraded around in feminine military uniforms, entertaining British troops. This PR stunt allowed the Whigs to regain support at home. (She also, through behind-the-scenes mediation, held together the British coalition government that eventually signed the Treaty of Paris.)
Georgiana was also the marketing force behind the 1784 elections of Charles Fox; she traipsed through alleys with "Fox" tails in her hair, touting the importance of English liberty to anyone who would listen. Despite the progovernment newspapers' mistreatment of Georgiana during this election — reporting that she traded votes for kisses — her activities made her the unofficial head of the "opposition public."
Following the election of 1784, the party was practically inactive, which was also frustrating for Edmund Burke who looked for "any plan of conduct in our leaders." Thanks mostly to Georgiana's efforts — including balloon send-offs, political and social events, outrageous fashion statements, and patronage of the arts — by 1785 the party began to fire up once again.
In 1789, the king suffered from a temporary bout of insanity (The Madness of King George) and, paradoxically, the Whigs hoped that their good friend, the Prince of Wales (who greatly admired the Duchess), would come into power. Georgiana designed "regency caps" for the ladies of the Whig party. The king's supporters responded with "God Save the King" caps.
Because of Georgiana's work in political marketing, the people thence associated "Whiggery with taste, fashion and wit."
She was intimately involved in the heated Whig debates between Charles Fox and Edmund Burke over the merits of the French Revolution. She witnessed the revolution's mob rule, firsthand, while saying goodbye to her friend, Marie Antoinette, one week before the Bastille was stormed. While Georgiana understood Fox's position that the revolution was a triumph for the people of France over the corrupt King Louis XVI, she also warned of the dangers of despotic democracy. In many ways, these debates shaped subsequent analyses of socialism and classical liberalism.
Georgiana was instrumental in putting together the "Ministry of All Talents," an all-star team of Whig liberals who took high British office in 1806. Her brother was Home Secretary, her lover was the First Lord of the Admiralty, and Charles Fox was Foreign Secretary. Although Georgiana could not hold political office herself, she was regarded by many as the "head of the administration." She died only a few months later.
Whig politics lost some of its luster after Georgiana's death. Nonetheless, her lover, Charles Grey, went onto become the Prime Minister from 1830 to 1834, and he succeeded in abolishing slavery once and for all. Shortly afterwards, in 1839, the Whig Party became the Liberal Party, from which the term "liberal," in its classical sense, was born.
Georgiana was a powerful asset for the Whigs, serving as campaign manager, strategist, advisor, inspiration, and symbol of the movement. She brought Whig ideals back into fashion with her costumes, balls, and events. She helped shape the strategy and direction of the party, and she charged along when her comrades lost steam.
Driven by strong convictions and a fervent belief in freedom, Georgiana was a master political propagandist, a powerful negotiator, an impassioned orator, and a keen political strategist. In many ways, she was the woman behind the men of the Enlightenment.
Healthcare and Insurance on a Desert Island
The US healthcare system appears to many people as broken beyond repair. While there is debate on whether government intervention in healthcare and in insurance for healthcare has been helpful or harmful, there is no debate that such intervention has occurred. Similarly, whether one considers the effects of redistributive policies to be helpful or harmful, one can surely agree that something must already exist for it to be redistributed. I would like to consider what healthcare would look like on an idyllic island in order to see how best to fix the US healthcare system.
Consider an idyllic island where there is more food and water available than what is needed by the inhabitants for sustenance. Consider, also, that there is no contact with the outside world, so this island is a closed system. For simplicity, the food source will be fish in the surrounding ocean and the water source is a lake sustained by rainfall.
The initial activities of the inhabitants will be divided into fishing, gathering water, and leisure. Some people will work in spurts and gather surpluses to sustain them during their vacation periods. Some people will do only enough fishing and water gathering each day to maintain them that day.
Insurance
While the inhabitants can provide for their needs, there are uncertainties to face. Fishing will be affected by the weather. There will be seasonal variations.
An incentive exists for people to accumulate savings of fish and water to sustain them during bad days or bad seasons. Once these savings have been accumulated, however, the gathering activity will return to that needed for sustenance.
These risks are shared equally by everyone, so there is no reason to pool risk. The risk of a rainy day is not insurable other than by self-insurance.
There are a number of hazards on the island. One might cut feet or hands on sharp rocks. There may be predators in the fishing ground. One might sprain an ankle or break a bone climbing a tree or mountain. Thus, a need exists for people to have additional savings to sustain them during illness or injury.
These risks, unlike the risks of bad weather, are not equal. Bad luck and bad habits determine who gets ill and who does not. For now, we will ignore bad habits and look only at bad luck.
A shark bite will be an uncommon event but one that everyone is familiar with. Everyone will see the need for savings to sustain themselves during recovery in case of being bitten. One possibility is that everyone will self-insure and maintain their own savings.
Somebody will notice, however, that shark bites are rare events and that everyone need not have their own savings for a shark bite, but that the group need only take a little from everyone to have a pool of savings to sustain a shark-bite victim.
The insurance premium required from each person will be a lot smaller than what is needed to sustain a shark-bite victim. In fact, the premium would be the savings required to sustain the recovery from a shark bite divided by the number of people, and multiplied by the average prevalence of shark bites.
Healthcare
How might healthcare be distributed? Each person might divert leisure time as needed to deal with his or her own healthcare problems. Like all human activity, however, some people are more skilled in treating shark bites than others.
It is more efficient for those most skilled in treating shark bites to do so for everyone. If shark bites were very rare, a single person might divert time from leisure to treating shark bites. While unfair, this would be sustainable.
It is quite possible, however, that the time required for treating shark bites would exceed the available leisure time of the most skilled at treating shark bites. In that event, the "doctor" would have to charge fish for his efforts. The remaining inhabitants would have to divert some of their leisure time to catch more fish in order to pay the doctor.
As discussed above, the inhabitants could pool their risk for shark bites and contribute fish premiums to a fund that would pay the doctor to treat shark bites. Presumably the doctor adds value and the recovery time from a shark bite under his care is shorter (and requires less fish) than would otherwise be the case.
Potential Problems
I ignored bad habits in the previous discussion. Some people are better at avoiding sharks than others. Over time, everyone will be aware that some people are bitten more often than others. Those who are not bitten very often may not agree to pool their risk with a person who gets bitten as soon as they have recovered from their previous bite.
Prior to making an agreement, some people may not want to insure an individual who has already been bitten badly and who may never recover. Any effort to compel people to accept those less fortunate may result in the individuals with the lowest risk from dropping out of the insurance pool altogether.
It is not possible to fake a shark bite. What about a headache? Suppose an individual demands payment from the insurance pool for disability due to a headache? If one tried to insure against headaches, one might see an epidemic of them, especially during the worst weather. Some illnesses are not insurable without destroying the insurance system.
Whether insured or not, there are limits to how much healthcare can be demanded. The activity of the doctor must be supported by fish. Whether the doctor diverts leisure time to his healthcare activity or somebody else diverts leisure time to gather fish in order to pay him, somebody must sustain the doctor.
It is not possible for everyone on the island to become a doctor. In that case everyone would starve.
The only way to support more doctors (or more of any other activity) is for fishing productivity to be high enough that the remaining fishermen can sustain everyone and still have enough leisure time. The group in aggregate must value the other activities more than or equal to additional leisure time.
The US Problem
A common complaint is that healthcare is too expensive. What would happen on the island if the most skilled at treating shark bites demanded all the fish? Either the inhabitants would recover from shark bites without aid or the next most medically skilled would make a more reasonable offer.
The United States has a system where the government guarantees payment for some people (Medicare). Any healthcare provider can choose between leisure time and providing for more people. One can easily see why providers will divert leisure for someone covered by Blue Cross but refuse to do so for someone without means of payment. Government payment therefore determines how healthcare providers will spend their time and effort.
Another common complaint is about preexisting conditions. On our island prior to any insurance agreement, a man with the misfortune of having his leg bitten off would be in no position to demand anything. If he were liked by the other inhabitants, they might very well provide him fish out of kindness.
His chance of continuing to receive kindness would likely depend on whether he managed to contribute anything useful despite his disability. Any attempt to demand that the other inhabitants give him insurance would be laughed at. Note the distinction that the leg was bitten off before the insurance agreement. If the leg had been bitten off after the agreement, the shark victim would be entitled to his support.
My greatest concern about the US Healthcare system is whether we have reached a point that we cannot catch enough fish to sustain the doctors (or will not divert more leisure to catch the fish required to do so). The Medicare system seems to have been borrowed against future fish.
It is not enough that people are available to do the healthcare work. Somebody else must divert leisure to generating real wealth (fish) to pay the healthcare providers. The healthcare problem cannot be solved by money. The problem can only be solved by people able and willing to generate real wealth in order to sustain healthcare workers.
Professor Hoppe put forward a simple proposal to solve healthcare. His four suggestions appear draconian, but when one considers our island it becomes clear that Hoppe's methods are the only ones that will work.
America's Jobs Disaster
America's Jobs Disaster
Is the Great Recession about to end? This has been the dominant meme at least since June, when my local paper, the Anniston Star, ran a front page story by McClatchy's Kevin Hall with the headline, "Economists: Recession Nearing End as Unemployment Dips."
Sad to say, though, that if such news is the basis for optimism, in June or today, then we are in trouble.
Before I explain why, let's review Hall's article. The July job figures turned out to be much less bad than predicted. Job losses for the month were reported at a mere 247,000, which was about 25 percent less than the figure anticipated by forecasters.
That, coupled with optimistic labor market revisions for May and June, led some economists to declare that happy days may finally, if slowly, be getting here again. In this spirit, the British investment bank, Barclays Capital Research, concluded in a report, "June is likely to have been the last month of the US recession."
Looking back, though, this was a case of celebrating short-term shifts in the data without checking to see if the fundamentals have changed. These economists, reacting to a monthly unemployment figure of 9.4 percent, were speaking too soon. One month's unemployment report is not very much to base such declarations on. There are many below-the-surface factors that should give us pause.
First, the unemployment figures were released the first month that unemployment benefits ran out for a significant portion of the unemployed. Many of these workers simply stopped looking for work, which erases them (in a statistical sense) from the labor force. These "discouraged workers" were counted in the labor force until the early 1980s, and if they were counted today the unemployment rate would be well into the double digit range, like it was then.
But there were other factors that caused the July figures to reflect what Forbes magazine called the "make-believe world of statisticians." Economist David Rosenberg reported that the automobile industry added 28,000 jobs in July, bucking a long-standing secular trend in job losses. Coupled with July hiring for the federal census, the result, as Rosenberg put it, "added … 100,000 non-recurring payrolls" to the official employment figures.
I submit that these two factors had short-term, positive effects on the labor market, but that taken together, they do not suggest the economy has somehow turned a corner.
It's always good to remember that that a healthy recovery this year, and even more a healthy economy in the future, cannot be measured simply on the basis of jobs figures, because not all jobs produce wealth. Indeed, there are good jobs and bad jobs. Good jobs create wealth and add to the productive capacity of the economy, whereas bad jobs do not.
For years, the Soviet Union proudly reported unemployment rates of zero. Lost in that figure were those who were employed to do the equivalent of digging holes, followed by others paid to do the equivalent of filling them back up.
Ludwig von Mises discussed this phenomenon in his classic Socialism (p. 457): "The interventionist policy provides thousands and thousands of people with safe, placid, and not too strenuous jobs at the expense of the rest of society." Murray Rothbard later extended this line of thought by delineating between net tax payers and net tax consumers.
The question is, to what extent are such bad, non-wealth-creating jobs skewing job figures today?
The impressive Michael Mandel of BusinessWeek recently crunched the numbers for job growth over the last 10 years, and the results, shall we say, don't look good.
He calls it a "lost decade for jobs" in the United States. I call it a disaster. Consider his graph depicting the percent change in private-sector job growth over time.
We find a traditional pattern for private-sector job growth that, although volatile (following the business cycle), remains within a 20–30 percent band for the 30-year period starting in 1971. However, this period is followed by an ominous decline in the 2000s, which approaches zero job growth by May of 2009. What's going on?
Mandel doesn't say, although he points out that the real story is somewhat worse than the data suggest. Throughout the 2000s, there was significant growth in public sector jobs, doubling that of the private sector in absolute terms. Mandel adds that, of the private-sector jobs created during this time period, most were in the "HealthEdGov" sector, meaning that these jobs — technically private — would not have existed without government spending.
The situation is troubling, to say the least. From May 1999 to May 2009, private-sector employment increased by only 1.1 percent — the lowest rate of job growth since the 1930s. This reflects structural problems within the US labor force that have increased in severity during this decade.
Consider the last economic correction in the United States. The economy was in recession at the time of 9/11, a tragedy that squelched what looked like a normal private-sector jobs rebound starting several months earlier. (In the graph above, see the bump that was well established by May 2001.)
But the tragedy of 9/11 must include its use as a justification for the largest increase in government spending since the Great Depression. The massive increase in both the welfare and warfare states following 9/11, and the conscription of capital that they entailed, forestalled the inevitable market correction for several years. And since it allowed existing malinvestments to fester, it made the present correction all the worse.
Today, the main response to ill-effects of past interventions seems to be to create even greater ones. This must stop if private-sector job growth is to recover. If not — well, don't look to individual monthly job figures as a source of optimism.
The fiscal 2010 bills grow domestic programs by 12.1%.
The White House disclosed the other day that the fiscal 2009 budget deficit clocked in at $1.4 trillion, amid the usual promises to do something about it. Yet even as budget director Peter Orszag was speaking, House Democrats were moving on a dozen spending bills for fiscal 2010 that total 12.1% in more domestic discretionary increases.
Yes, 12.1%.
Remember, inflation is running close to zero, or 0.8%. The good news, if we can call it that, is that Senate Democrats only want to increase nondefense appropriations by 8% for 2010. Because these funding increases become part of the permanent baseline for future appropriations, the 2010 House budget bills would permanently raise annual outlays for discretionary programs by about $75 billion a year from now until, well, forever.
These spending hikes do not include the so-called mandatory spending programs like Medicare and Medicaid, which exploded by 9.8% and 24.7%, respectively, in the just-ended 2009 fiscal year. All of this largesse is also on top of the stimulus funding that agencies received in 2009. The budget for the Environmental Protection Agency rose 126%, the Department of Education budget 209% and energy programs 146%.
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House Republicans on the Budget Committee added up the 2009 appropriations, the stimulus funding and 2010 budgets and found that federal agencies will, on average, receive a 57% increase in appropriated funds from 2008-2010. By contrast, real family incomes fell by 3.6% last year. There's no recession in Washington.
More broadly, the White House and the 111th Congress have already enacted or proposed $3.4 trillion of new spending through 2019 for things like the health-care plan, cap and tax, and the children's health bill passed earlier this year. Very little of this has been financed with offsetting spending cuts elsewhere in the budget.
Throughout the era of Republican rule in Washington, we scored GOP lawmakers for their overspending and earmarks—and so did Nancy Pelosi and other Congressional Democrats. So how do their records compare? From 2001-2008 the average annual increase in appropriations bills came in at 6.4%—or about double the rate of inflation. In this Congress spending is now growing six times faster than inflation.
And here is the kicker. Mr. Obama's 10-year budget forecast predicts that the budget deficit will fall in future years in part because federal spending on discretionary programs will grow at less than the rate of inflation. But spending is already up nearly 8% (including defense) in the first year alone.
For a laugh-out-loud moment on all of this, we recommend yesterday's performance by New York Senator Chuck Schumer on NBC's "Meet the Press." Mr. Schumer declared that "Barack Obama and we Democrats—this is counterintuitive but true—are really trying to get a handle on balancing the budget and we're making real efforts to do it." Counterintiutive? He said this four days after Senate Democrats lost a vote to add $250 billion to the deficit for doctor payments without any compensating spending cuts.
Democrats must figure that they can get away with this sort of rap because no one will call them on the reality of what they're spending. And they're probably right about a press corps that has ignored the spending boom since Democrats took over Congress in 2006. Meanwhile, the spending machine rolls on, all but guaranteeing monumental future tax increases.
We need one regulator that can see a company's entire balance sheet. Pay caps will only drive talent abroad.
By SANFORD I. WEILL AND JUDAH S. KRAUSHAAR
The debate over financial services reform has meandered for weeks without a clear sense of urgency. It would be a huge opportunity lost if our political, regulatory and business leaders cannot craft a credible new regulatory foundation for one of America's pre-eminent industries. It's time to set politics and regulatory infighting aside and establish the new rules of the road for this critically important business.
Several principles should guide reform. Our country needs to strive for transparency in financial-company balance sheets and recognize the direct correlation between clarity in asset value and how financial enterprises are valued by investors. Mark-to-market based accounting must be revitalized, and complex instruments and securities must be subject to regular market-valuation tests whenever possible.
To accomplish this, a single regulator needs to be tasked with overseeing systemic risks and must be empowered to monitor risks in all sorts of financial institutions. There should be no more balkanization of regulation.
At the same time, regulators and industry leaders must come together and develop workable arrangements whereby innovation in financial services can once again flourish. We need to agree upon new capital requirements and rules for how the securitization market will operate. All parties need to operate with dispatch because the revitalization of the U.S. economy is what's at stake.
One thing our public officials should not do is get caught up in a debate over "too big to fail." It's a catchy phrase, but that's about it. Indeed, it is important to recognize that our recent financial crisis was provoked by last year's failure of Lehman Brothers, a company that few, if anyone, would have argued was too big to fail. Rather than get side-tracked on this and other complex questions, our policy leaders should focus directly on how to create and enhance market discipline.
We have six specific recommendations for reforming the financial services business:
1) Make the Federal Reserve the super-regulator responsible for overseeing systemic risk. It is vital that one regulator be able to see the entire balance sheet of the country's largest financial institutions, and this regulator needs to cut across artificial institutional lines. Large banks, securities firms, insurers and hedge funds should all come under the Fed's aegis. Anything less risks a perpetuation of regulatory arbitrage, where industry participants house their riskiest activities in the unit overseen by the most lenient regulator.
Other regulators would continue to focus on their respective industry segments exclusive of the largest, most complex institutions. Policy makers should avoid creating new bureaucracies, as some have recommended. Existing regulatory bodies should be given a broader charge to oversee consumer protection for credit-related products.
2) As much as possible, complex instruments should be subject to regular market valuation tests and clear through a central clearing house. We need a system that encourages valuations to be based on real markets and not on "mark-to-model." These last 18 months have demonstrated to us all that models work until they don't work. For underwritten offerings, a financial institution must be able to find a real public market value or the transaction should not be done. Derivatives with standardized features should be subject to daily valuation marks, and owners of these instruments should be required to maintain a reasonable amount of equity to support the position (i.e., akin to the traditional margin requirement on other securities).
For highly customized products and newer instruments that might not yet be mature enough to enjoy a large and deep market, we would allow an exemption to encourage innovation. Nonetheless, these exemptions should be regularly reviewed with regulators who should establish disclosure and trading rules that would promote maximum transparency or a means of public market price discovery. Lastly, everyone should apply the basic principle that if you don't understand something, you probably shouldn't be doing it in the first place.
3) Reform and revitalize the securitization market. Though the securitization process has been given a black eye over the past couple of years, it is important to recall that this market adds value by allowing issuers and investors to efficiently match risk, return and duration preferences. While portions of the market were abused, it is important that the baby not be thrown out with the bathwater. In the future, issuers should be required to retain on their balance sheets a substantial portion of the securitization and should be required to periodically test for current market values by selling into the market a portion of their holdings. In this fashion, both the issuing institution and the investors who bought the securitized asset would value the same asset equally.
4) The regulators need to engage the rating agencies. Going forward, the rating agencies should develop clearer standards for rating complex securities. The integrity of principal must be paramount whenever a security is given an investment grade rating. Moreover, the activities of the rating agencies should be subject to an annual review by the systemic regulator (i.e., the Federal Reserve), which in turn should publicly report issues that might compromise the safety and soundness of the country's largest financial institutions.
5) Capital requirements and reserve policies need to be overhauled. While excess leverage and imploding asset values provoked the recent crisis, pro-cyclical loan-loss reserve methodologies aggravated the situation. This has been particularly true in consumer credit where the Securities and Exchange Commission in recent years has forced banks to lower reserves as delinquencies have declined and reverse course when problems moved higher. This sort of regime seems foolhardy. Formulas work no better than mark to model.
To address the matter, financial companies should be encouraged (or perhaps required) to securitize credit wherever possible and carry the instruments at current market value. The greater the transparency in asset valuation, the better. For instruments that may not lend themselves to securitization, such as business loans with highly customized terms, the financial institutions should be allowed—in close coordination with the regulators—to set forward-looking reserves that would smooth earnings (and confidence) during periods of credit stress. Assuming an increased percentage of large financial institutions' assets could be subject to market-value accounting, earnings volatility might increase, but improved transparency would be a net positive for how these institutions would be valued. Of course, higher regulatory capital requirements could go a long way toward dampening earnings volatility; and we'd favor a relatively simple and conservative definition for regulatory capital, namely focusing on tangible common equity as a percentage of assets.
6) Align executive compensation with long-term returns. Policy makers need to move past polemics and recognize the importance of fostering loyal and motivated employees in the financial services business. Knee-jerk caps on pay will only drive talented human capital to foreign companies and erode the traditional leadership of U.S. financial institutions. We recommend a system in which equity-based pay and cash compensation be vested over a relatively long period.
The cash portion should be allowed to increase or decrease in value over the vesting period at a rate consistent with the company's return on equity. In this manner, employees would not be allowed to benefit from inherently short-term results, and risk-taking within institutions would be better controlled.
U.S. financial markets are at a unique moment in history. Without comprehensive and thoughtful reform, American leadership in global finance could be compromised, and lingering uncertainty regarding the "rules of the road" could undermine economic recovery and growth. To restore confidence, U.S. policy makers need to create a muscular super-regulator and promote market-based valuations for financial company balance sheets. Such a program would send a powerful message of transparency and integrity to the markets.
Mr. Weill is former chairman and CEO of Citigroup. Mr. Kraushaar is managing partner of Roaring Brook Capital.
U.S. Stocks Pare Gains
U.S. Stocks Pare Gains
DONNA KARDOS YESALAVICH GEOFFREY ROGOW
NEW YORK -- U.S. stocks fell into the red recently in a sudden slide led by financial and materials stocks that pushed the Dow Jones Industrial Average back below the psychologically important 10000 level.
The declines came as oil, which had been up earlier in the day, began to slump, while the dollar extended its earlier gains against the euro.
The Dow was recently down 33 points at 9939 after earlier trading as high as 10072. The earlier gains had come from a jump in oil prices that lifted the energy sector, along with a revenue boost from Marvell Technologythat boosted tech stocks, while consumer discretionary stocks jumped on better-than-expected sales from RadioShack.
![[Markets Data]](http://s.wsj.net/public/resources/images/MDGpromo_D01222009151210.jpg)
But the excitement came to a sudden halt around 11:30 a.m. ET. The S&P 500 was down 4.8% recently as financials -- which had been the only S&P 500 sector in the red for most of the morning -- leading the downhill slide. The sector was recently down 1.8%, followd by a 1.4% decline in materials. The tech sector was the only S&P category solidly in the black recently, up 0.3%.
The tech-heavy Nasdaq Composite also managed to stay in the green, as it eked out a 2-point gain as Marvel remained higher, up 3.2% recently. RadioShack also held on to its earlier gains, up 14% recently.
The declines elsewhere, however, came as stock traders were taking many of their cues from the movement in other markets, particularly currencies. Given that corporate earnings reports have continually beaten expectations for the third quarter and economic data has regularly surprised to the upside, stock traders say the movement in the dollar is the true barometer of investors' risk appetite.
"The dollar went positive, oil reversed and the S&P is just following," said Kevin Kruszenski, director of equity trading for KeyBanc Capital Markets. "An oil and dollar market correlation has been pretty tight lately and on a light news day that's all it takes."
While the dollar was higher against the euro, it was recently lower against the yen. Oil, meanwhile, slid 0.1% to 80.40.
As for the rest of Monday's session and into the rest of the week, Kruszenski noted there was already a lot of attention being paid to a Thursday report on the U.S.'s third-quarter gross domestic product.
The financial sector's slump Monday followed a flurry of bank bankruptcies announced over the weekend that took the bank-failure total to 106 this year.
Bank of Americatumbled 5.6%, while J.P. Morganslid 2.5%, hurting the Dow. The Wall Street Journal reported Saturday that Bank of America's attempt to repay federal bailout funds and escape the government's grasp has been snagged by a disagreement over how much additional capital the bank must raise to satisfy regulators, according to people familiar with the situation.
The markets were also delivered a setback in October in Texas-area manufacturing. The Federal Reserve Bank of Dallas reported its production index came in at -8.0 from -0.5 in September, while new orders index fell to -2.8 from 8.0.
In other markets, gold futures were higher, while the dollar slid against the euro, but edged up against the yen. Treasuries fell, with the two-year note recently down 1/32 to yield 1.029%, and the 10-year note down 17/32 at 3.552%.
Baghdad bombs
Bloodbath in Baghdad
At least 155 die in the worst bombings in Iraq of the past two years
TWO car bombs turned Baghdad into a killing field on Sunday October 25th, claiming the lives of at least 155 people and injuring hundreds more. The main targets were the ministry of justice and public works and the office of the governor of Baghdad province. Almost simultaneously the explosions sent windows and their frames several hundred metres along Haifa Street, near the fortified Green Zone. Burst water mains flooded parts of the area, washing over charred bodies and through burned cars. This was the second such attack in two months, but the bloodiest in two years. On August 19th bombs destroyed several government buildings including the ministries of finance and foreign affairs, killing perhaps 100 people.
The new attack has heightened the sense of crisis in the Iraqi capital. The past two years have seen fewer bombings and fewer people killed than in the years before. But insurgents are now focusing on spectacular assaults in an effort to affect the political situation. Elections are due in January and security is a big issue. As in Afghanistan, where the Taliban stepped up attacks during the election campaign, more bombings are likely in the coming months. Iraq's prime minister, Nuri al-Maliki, had been claiming credit for ending the descent into civil war and is therefore vulnerable. Voters might also punish political parties with their own militias, if they are seen to be associating with terrorists.
The attack comes at a fragile time in the pre-election timetable. Members of parliament last week failed to agree on a new election law, raising the prospect of a delay to the poll. If so, Mr Maliki would continue to rule but as a caretaker, but that would create more uncertainty. At the same time, the American army is continuing with its plans to pull out. It is hoping to have withdrawn 70,000 soldiers by August 2010, leaving a residual force of 50,000 for another year. Barack Obama and other world leaders condemned Sunday's bombs. But violence in Iraq is increasingly a local affair. A small group of American forensics experts visited the sites of the latest attacks but to get there they rode in Iraqi army vehicles.
The Iraqi government, and others, blame Sunni insurgent groups including al-Qaeda and members of Saddam Hussein's former regime for the attacks. But Iraqis are also pointing fingers at political parties. Insurgents, by hitting ministries and other government institutions, are trying to prevent a functioning state from emerging. Some ask darkly whether politicians have an interest in prolonged chaos, as some of them might lose powers of patronage if a modern bureaucracy were to emerge.
Iraqis know that political violence will be with them for a long time, even if full civil war can be avoided. The fortunes of insurgent groups wax and wane, their support base shrinking and expanding depending on how vulnerable sectarian groups feel. But an end to the bombings is not in sight. The locations of the latest attacks were symbolic. Haifa Street was in the hands of insurgents three years ago. American and Iraqi troops fought pitched battles to retake it in what turned out to be the start of the “surge” that eventually helped to improve security in much of Iraq. At the time, bodies were stacked up like bales of hay on Haifa Street. Since then, occupants had returned and a sense of normality had started to take hold.
American bank failures
An uncelebrated century
Smaller American banks are now at the centre of the credit storm
PARTNERS BANK of Naples, Florida, earned a dubious distinction on Friday October 23rd. It became the 100th American bank failure of the year. On the same day six other lenders—two more in Florida and banks in Minnesota, Wisconsin, Illinois and Georgia—joined the rollcall of failure in the aftermath of the credit crisis.
More banks have failed in other years. The post-war record was set in 1989 when 534 banks went under. That was at the peak of the savings-and-loan (S&L) crisis, which erupted in the late 1980s and continued in the early 1990s. This year has seen more failures than any since 1992, but another 75 banks must go under to overhaul that year’s total.
Counting absolute numbers of failures, however, is not the best way to assess the extent of a financial crisis. The number of banks and thrifts has fallen dramatically since the S&L era, from some 16,000 lenders then to around 8,000 now. According to CreditSights, a research firm, when the current cycle is over, the rate of bank failures may be double what it was during the S&L crisis.
The total of failures also disguises the size of individual collapses. The demise of Washington Mutual, the biggest bank to fail in America so far in this crisis, means that banks accounting for more than 3% of the system’s total assets have fallen during the current cycle already, compared with 4.4% of assets over the entire S&L episode.
Yet passing the hundred mark symbolises how the financial crisis has shifted its focus from large banks to small ones. America’s big banks may face regulatory uncertainty but they take the shelter of government support. Most have diversified businesses so they can offset credit losses with buoyant earnings from investment banking. The recent slew of third-quarter results suggests that the number of non-performing loans is approaching a peak.
Small banks have no such comfort. They are too small to pose a threat to the entire system and thus too small to require saving. And they are heavily exposed to commercial property, an asset class that continues to go downhill fast. In the latest sign of distress, Capmark, one of America’s largest commercial-property lenders, filed for bankruptcy on Sunday.
These factors point to a sharp rise in bank failures. There are 416 institutions on the problem list of the Federal Deposit Insurance Corporation (FDIC). CreditSights estimates that more than 600 banks will fail if conditions stay as they are. If things get really sticky, more than 1,000 could go under (compared with over 1,800 in the S&L crisis).
That means lots of buying opportunities for other banks and private-equity investors. But it spells trouble for the FDIC, which administers failed banks and estimates that it will incur total losses of $100 billion over the course of this credit cycle. This weekend’s tally of bank busts added another $357m to the bill. The FDIC has already proposed ways to bolster its depleted deposit-insurance fund by requiring banks to prepay some $45 billion of insurance premiums into the fund. But many think its estimates of losses are too low anyway, particularly since the minnows of American banking, unlike the big fish, do not have the same buffers of equity investors and subordinated debtholders to help bear the costs of failure.
The crisis among small banks may not threaten the system in the same way as big-bank failures. But for taxpayers, there is the prospect of further outlays. A cash-strapped FDIC may yet be forced to tap a $500 billion credit line with America’s Treasury. For big banks, there is the threat that the agency will levy an emergency round of premiums.
As for borrowers, particularly small businesses that rely on local lenders, credit may be hard to come by. Barack Obama unveiled proposals on October 21st to increase the size of government-guaranteed loans to small businesses, and to make it more attractive for small lenders to ask for capital from the Troubled Assets Relief Programme. The national picture may be brightening: the next phase of the financial crisis will be local.
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Associated Press 
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Freeman columnist and George Mason University economics professor Donald Boudreaux has won the 2009 Thomas Szasz Award for Contributions to the Cause of Civil Liberties. The Szasz Award committee recognized Boudreaux for his many years of promoting freedom in all its aspects through his writing and lecturing.
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