Fiscally Dangerous Liaisons
“Take time to know her. It’s not an overnight thing”
– Percy Sledge’s Momma
We boarded a small plane yesterday and traded the chilly shores of the Irish Sea for the chilly banks of the Thames. Here in London, too, it is cold and rainy.
Thank God we have the financial news to warm our hearts…and more.
Bill Gross, who manages PIMCO, the world’s largest bond fund, says that professional investors were seduced by CDOs (collateralized debt obligations) in “hooker heels.” While the moms and pops fell for mortgages in sexy, low-cut dresses, the pros couldn’t resist mortgage-backed securities, tarted up by the financial industry.
The whole financial world has had kind of a bodacious appeal lately. It is as full of strumpets as the Rue St. Denis, and its customers seem to be getting as excited. Stocks in Shanghai are rising so fast – it is as if they had put some of that tiger paw or shark privates into the city water reservoir.
We would like to go on record, dear reader, with this advice to the Chinese: Take a cold shower.
And all over the world, the rich seem desperate to begin expensive liaisons. A mystery buyer apparently paid $300 million for an Airbus A380 double-decker Superjumbo, with room for 853 passengers. The plan will be for private use, say the reports. A big birthday bash, maybe?
And for $84 million, someone has bought himself the most expensive English house outside of London. The place is in such bad repair, says the notice in MoneyWeek, that the poor buyer will have to spend a fortune fixing it up. And another person paid $2,600 for an empty prescription drug bottle once owned by Elvis.
One wild fling after another. But are any of these love objects good enough to take home and introduce to your mother?
Poor Percy Sledge. When he found “a little girl of [his] own,” he took her home to momma. But momma took one look at her and she said: “Take time to know her. It’s not an overnight thing.”
But Percy wouldn’t listen. He went straight to the preacher. And then, later, he came home from work early and “found her kissin’ on another man.”
We keep warning…like Percy Sledge’s momma…but a fat lot of good it does. Some things have to run their course, from the first come-hither invitation…to the last look of revulsion and disgust. So it goes in affairs of the heart…and affairs of the wallet. All begin in hopeful anticipation and end in limp disappointment.
Nothing is sexier today than private equity. Even U2’s Bono is a partner in a private equity firm. But when dim rock singers get into a trend, dear reader, you have to wonder if it isn’t already a little late in the day. M&A activity is still going up, according to the latest reports. But as with everything else, quantity and quality vary inversely in the private equity sector. In the last four years, the debt service ratios of target companies has been cut in half – from 3.4 to 1.7.
But who cares? Now, lenders no longer ask for guarantees. New ‘cove-lit’ deals allow them to destroy their own balance sheets with no fear that their loans will be called.
Even the authorities are getting worried. When we were in Madrid a few weeks ago, we noticed that the Bank of Spain was warning investors to watch out. The world was getting far too deep in debt, said the Spanish bankers. Then, the Bank of England issued almost exactly the same alert…followed by the Bank of International Settlements, which says what we’ve been saying for years: Loose lending policies have caused a dangerous credit bubble; the world economy is more vulnerable to a setback than any time since the late ’20s.
And here comes the central bank of Norway, with reservations of its own. Yesterday, it raised its key-lending rate to 4.5%.
And at home, lawmakers have decided that hedge funds are threatening the well being of the lumpeninvestoriat with the billions in public pension funds that they now have invested in alternative investments. Lawmakers want to hike the tax rate on private equity firms that go public from 15% to 35% and one even complained to the Department of Homeland Security that Blackstone’s deal with China’s state investment fund constitutes a national security risk.
Meanwhile, both the former head of the Fed (Alan Greenspan, remember him?) and the richest man in China – Li Ka-shing – have both joined our warning that China’s stocks are in a bubble.
All of this, of course, makes us worry. We are in a camp along with so many prestigious institutions and renowned, straight-laced economists. What are we missing?
The Daily Reckoning
Thursday, June 28, 2007
First, the news:
Addison Wiggin reporting from Charm City…
“With visions of fall 2002, GM also announced this week that it will be offering 0% financing for three years plus 1,000 bucks cash back on select cars and trucks. Ironically, the gimmick is a product tie-in to the movie Transformers. Transform is exactly what GM needs to do right now. Toyota handed them their hat in first-quarter sales…beating them squarely on their home turf: tough trucks for the meathead set.”
For the rest of this story – and more market insights, see today’s issue of The 5 Min. Forecast
And more thoughts:
*** What is going on in the gold market? Our favorite metal fell below $645 yesterday. The price has gone nowhere in a year. Gold bugs are beginning to wonder. Is it time to give up on the yellow metal and embrace the Great Worldwide Credit Bubble?
We wouldn’t do that.
We are still in what Mises referred to as a Crack-Up Boom. It is a great boom, to be sure. Prices of all sorts of strange assets – including Zimbabwe stocks – are going up. But they are going up not because they are becoming inherently more valuable, quite the contrary. They are going up because of inflation. There is much more purchasing power in the world. Much more liquidity. Much more cash and credit – concentrated at the upper end, where people tend to buy high-priced items.
There is no particular reason why a painting or a house should be worth a lot more today than it was 10 years ago. It still gives exactly the same service. It’s just that there is more money bidding for it.
For the moment, this inflation is loved by everyone – because it is boosting asset prices, not so much consumer prices. Still, consumer prices are starting to budge upwards, too – especially in the exporting countries, such as China. As basic costs increase, so does the incentive to use its great pile of cash to pay them – rather than recycle the money into the world credit system. Sooner or later, foreigners will tire of funding U.S. and British excess consumption. They will find it more appealing, or more urgent, to finance their own consumption. Then, the cost of financing will rise. M&A activity will decline. Companies, deals and households that depend on low-priced credit will go belly up. And the credit bubble will be over.
We don’t know when…or even how…this will come about. But at the end of a Crack-Up Boom the currency cracks along with asset prices. When that happens people will wonder what their own dollars, yen, euros and pounds are worth. A few will want to lay in a little gold just in case. Perhaps even a few central banks.
Gold has been in a bull market for almost exactly eight years. The price has risen from $256 to over $700…and since backed off to below $650. Anything could happen, but it would be an odd bull market in gold that produced so little excitement. And it would be an odd Crack-Up Boom that produced so little fear and destruction. And it would be a damned odd world in which a bunch of government employees in central banks could create a truly lasting New Era in monetary history.
No, dear reader, don’t worry. This bull market in gold is far from over. This New Era of paper money, backed only by faith, will crack up. Sooner or later, as we keep saying.
*** Yes, maybe the financial world will go to hell in a handcart, as our old friend Sven Lorenz said over dinner last night. But there are still a lot of ways to make a lot of money.
Sven travels the world regularly – looking for the curious, quirky opportunities that mainstream investors have missed. When he found, for example, a cache of rare St. Petersburg caribou leather, 200 years old, retrieved from the North Sea, he bought the whole thing. Then, he found old Asian safes, which he transformed into cigar humidors. He owns a hotel on one of the Channel Islands…apartments in Germany…and a cosmetic company in Russia. Sven also journeyed to the Falkland Islands to explore the potential of a vast new oil discovery there – and to the Heart of Darkness to look at mining and farming operations in Zimbabwe.
We put the question to him directly: Where do you think the world’s best investment opportunities are today? His reply:
“They are probably in Europe. Low capital costs and a desire for reform are coming together to produce some remarkable opportunities. Some of these companies are controlled by founders and their families for generations. People don’t know much about them…they are often wrapped in Swiss holding companies and Lichtenstein trusts. But they often own very good brands…and sometimes have property – even cash – that most investors don’t know about.
“These companies now are being challenged by shareholder activists. And they’re being drawn out by private equity firms, hedge funds and private investors. Some extraordinary bargains are emerging. We bought one bank – a great franchise – for little more than the cash in its vault. It is as if we had gotten the business for free. I think we’re going to see some more deals like this – even very big ones.
“And one of the nice things about this is that we’re talking about big, solid, old companies. When you buy a start-up…or an emerging market…you don’t know what you’re getting. As long as the market is flying, the paper will stay in the air. But as soon as there’s a setback, you’ll see some very unhappy investors.
“Solid European companies are another story. They’re often very conservative and very profitable. And now we’re getting them at a good price.”
The Daily Reckoning PRESENTS: The U.S. dollar is in freefall. We mention it often, dear reader, only because we want you to be prepared. With major increases in the trade deficit as well as consumer debt, now is the time to be asking yourself, “How will this dollar decline affect me?” Addison Wiggin explains…
Most people can relate to the realities of how jobs and profits shift, and why. The idea that higher-wage manufacturing jobs are being lost and replaced by lower-wage retail jobs, for example, is a reality that working people understand. They get it. The same is not always true when we talk about trade deficits. Like the falling dollar itself, it’s worth asking the question: How does it affect you, the individual?
The trade deficit-the excess of imports over exports-has a direct and serious effect on the value of our dollars. As long as we continue having big trade deficits, it means we’re spending more money overseas than we’re making at home. Our manufacturing profits are lower than our consumption. If your family’s budget has a “trade deficit” of sorts, you’ll soon be in trouble. If your spouse spends $4,000 for every $2,000 you bring home, something eventually gives way. This is what is going on with the trade deficit.
In fact, the trade deficit is one of the most important trends in the economy, and the one most likely to affect the value of the dollar. Combined with our government’s big budget deficit, the trade deficit only accelerates the speed of decline in our dollar’s value. Speaking in terms of spending power of the dollar, the trade deficit is the third rail of the economy. Here is what has been going on: The United States used to produce goods and sell them not only here at home, but throughout the world. We led the way, but not anymore. The shift away from dominance in the production of things people need has allowed other countries (most notably, China and India) to pass us up, and now the U.S. consumer has become a buyer instead of a seller.
This international version of conspicuous consumption is financed not from the profits of commerce, but from debt. Let’s think about this for a minute. If we were buying from domestic profits, the trade deficit wouldn’t be such a bad thing. It would mean we were spending money earned from domestic productivity. But this is not what is going on. We are going further and further into debt to buy goods from other countries.
Our wealth is being transferred overseas and, at the same time, we are sinking deeper into debt. This is taking place individually as well as nationally. Consumer debt (you know: credit cards, mortgages, lines of credit) is growing to record levels, and the federal current account deficit is moving our multi trillion-dollar national debt into new
Sure, we should be concerned about retirement income from savings, investments, pension plans, and Social Security. But a bigger danger is that, even with a comfortable retirement nest egg by today’s standards, what if those dollars are worthless when we retire? What then?
The big question today is, how long can this debt-driven economy continue? If you quit your job and refinance your home, you could live for a while on the money. The higher your equity, the longer you would be able to spend, spend, spend. But then what?
This is precisely what is going on in the U.S. economy and, at some point very soon, we are going to have to face up to it and change our ways. The trade deficit is the best way to track what’s going on. Returning to the analogy of quitting your job and living off of your home equity, you may stay home all day and order an endless array of electronics, furniture, toys, computers . . . in other words, you could consume goods in place of working. But remember, you didn’t win the lottery; you are financing this “new plan” with borrowed money. The lender will want that repaid. So this individual version of a trade deficit (the deficit between generating income and spending money) is what is happening on a national level in the United States.
This is the problem that is directly affecting the value of the dollar; and the situation is getting worse. We know that the dollar is in trouble because we see it depreciating against the floating currencies of other countries. America has a lot of wealth, but that wealth is being consumed very quickly. History shows that no matter how rich you are, you can lose that wealth if you’re not productive. Meanwhile, the dollar’s value falls and – in spite of the Fed’s view that this is a good thing – it means our savings are worth less. Your spending power falls when the dollar falls, and as this continues, the consequences will be sobering.
The dollar’s plunge has taken many people, currency experts of banks included, by surprise. For many of them, it is still impossible to grasp. Some talking head on CNBC said that he was at a complete loss to understand how such weak economies as those seen in the European Union could have a strong currency. For America’s policy makers and most economists, the huge trade deficit is no problem. They find it natural that fast-growing countries import money while slow-growing economies export money. At least, that is the recurring theme.
So Americans traveling abroad may continue to complain that “it has become so expensive to travel in Europe” as though the problem were somehow the fault of the Europeans. But in fact, it is the declining spending power of the dollar that is to blame, and not just the French, the Italians, and the residents of the so-called “chocolate making” countries.
This problem is pegged not to some speculative or fuzzy economic cause, even though the concept of currency exchange rates continues to mystify. A historically large trade deficit is at the core of the declining dollar. Somebody needs to get over the notion that our economy is strong and other economies are weak, merely because this is America. In the United States, the reason for the trade deficit is not a high rate of investment as we see in some other countries, but an abysmally low level of national savings. We are spending, not producing.
A second argument offered by some is that “capital flows from high-saving countries to low-saving countries, wanting to grow faster.” Under this reasoning, a deficit country, looking at both consumption and investment, is absorbing more than its own production. But whether this is good or bad for the economy depends on the source and use of foreign funds. Do those funds pay for the financing of consumption in excess of production (as in the United States) or for investment in excess of saving? That is the key question that ought to be asked in the first place about the huge U.S. capital imports.
To quote Joan Robinson, a well-known economist in the 1920-1930s close to John Maynard Keynes: “If the capital inflows merely permit an excess of consumption over production, the economy is on the road to ruin. If they permit an excess of investment over home saving, the result depends on the nature of the investment.”
The huge U.S. capital inflows (economic jargon for money coming into the country), accounting now for more than 5 percent of gross domestic product (GDP), have not financed productive investment. America’s net investments are among the lowest in the world, meaning we prefer spending and borrowing over actual production and growth. The huge capital inflows have not helped finance a higher rate of investment. America has been selling its factories and financial assets to pay for consumption.
It’s helpful to use a real means for measuring economic strength. Money coming here from overseas finances higher personal consumption. The steep decline in personal saving is a symptom of our spending, and along with that habit we have lower capital investment and a growing federal budget deficit. The U.S. economy has for years been the strongest in the world, leading the rest of the countries. Our Daily Reckoning newsletter routinely gets reader responses saying, in effect, “How dare you impugn the superiority of the American economy! How dare you!”
We’re rather thick-skinned so the insults bounce off rather easily. But “facts are stubborn things.” The fact that the U.S. economy has outperformed the rest of the world in the past several years is easily explained. Our credit machine has been operating in overdrive nonstop.
It is geared to accommodate unlimited credit for two purposes- consumption and financial speculation. Let’s look at these two things a little more deeply. Credit is not the same thing as production, despite the fuzzy logic you get from the financial media. There is a severe imbalance between the huge amount of credit that goes into the economy and the minimal amount that goes into productive investment. Instead of moving to rein in these excesses and imbalances, the Greenspan Fed has clearly opted to sustain and even to encourage them. Today it is customary to measure economic strength by simply comparing recent real GDP growth rates. It is pointed to as proof and applauded by U.S. economists when U.S. economic growth outscores Europe- like some kind of dysfunctional futbol match.
Financial speculation is equally unproductive. An investor puts up capital to generate a sustained and long-term growth plan. For example, buying and holding stocks is a form of investment and a sign that the investor has faith in the management of that company. peculators don’t care about long-term growth. They want to get in and out of positions as quickly as possible, make a profit, and repeat the process. So speculative profits-especially those paid for with borrowed money-tend to be churned over and over in further speculation and increased spending. None of that money goes into investment in the long-term sense. The speculator is invested in short-term profits, nothing more. Even so, the speculator is today’s cowboy, the risk-taking, living-on-the-edge market hero willing to take big chances. He is seen as a guy with big stones because he’s staring the prospect of loss right in the eye.
The Daily Reckoning
June 28, 2007
Editor’s Note: Addison Wiggin is the editorial director and publisher of The Daily Reckoning. Mr. Wiggin is also the author, with Bill Bonner, of the international bestseller Financial Reckoning Day and the upcoming thriller Empire of Debt. Mr. Wiggin is frequent guest on national radio and television programs.
The above essay was taken from Addison’s book, The Demise of the Dollar…and Why It’s Great for Your Investments. To order your copy, please see here: