from the hip

It goes on and on – the financial crisis. Now Bank of England slashes interest rates to a 53-year low. The Independent writes:

Interest rates were today slashed to a 53-year low to fight off recession – but fears were growing that hard-pressed homeowners would fail to reap the benefit.

The shock 1.5 per cent cut by the Bank of England’s Monetary Policy Committee (MPC) is the biggest move since March 1981 and brings rates to 3 per cent – last seen in 1955.

Stock markets were stunned by the size of the cut and experts predicted rates could reach an all-time low of 1.5 per cent by mid-2009 as the Bank desperately bids to ward off a prolonged slump.

Also, the European Central Bank cut interest rates by 50 basis points today and signaled another reduction was possible later this year. In Germany the no. 2 bank has decided to tap into the government rescue plan, and the government will propose tax breaks on car purchases to stimulate spending!

The bottom still seems distant.

See also:

• New York Times: European Banks Reduce Rates, Some Sharply
• Guardian: Shock as Bank of England slashes rates to 3%
• New York Times: Bleak Reports Keep Markets in Free Fall
• Guardian: Wall Street and London shares plunge

I started writing about the credit crisis in the US and the possible international consequences of that crisis a long time ago. But writing about it gave me a strange feeling. Obviously I was writing about something that interested just a very few. And, equally clear was the feeling that I was writing about something nobody really wanted to hear about. Also, I strongly felt back then, something which major actors in the financial world as well as governments and central banks were more or less in denial about.

I am not happy to have been right. I am not happy that this crisis so far has turned out to be every bit as serious as I and a relatively small number of other people wrote back then. On the contrary, it is sad. Of course.

Today I feel that perhaps it is that unwillingness to see, to listen, to take the right measures at the right time, that has turned what was once a credit crisis in the US, originating in flawed valuation of the so called sub-prime mortgages, into the wild international beast we today speak of as the international financial crisis. Today governments all over the world fight against this crisis. And we have seen, I should think, that the crisis is not due to the price of oil, and that it cannot be solved by interest rate cuts. And a large number of financial institutions, from Lehmann to the Royal Bank of Scotland, have fallen victim to the crisis. At first there was no response. Then there was too little too late, as the Dainish Bank, for instance, noted. And now it is pure panic.

But now the fight is very much an uphill battle. Much time has been lost. And in this case lost time translates into lost confidence. That confidence must, of course, be restored. But it will take time. And even when the confidence in the international financial system has been restored, the battle will not have been won. There will also be serious shake outs in many sectors of the economy, will large companies failing and new winners emerging. And the global recession we are facing will not be over until consumers start increasing their spending again.

I fear they will not do so for quite some time.

See also:

• Financial Times: The week that panic stalked the markets
• Wall Street Journal: EU Writes Menu of Options
• Financial Times: UK to inject £39bn into banks
• Politiken: IMF frygter finansiel nedsmeltning
• Politiken: Eurolande klar med finansiel redningsplan
• Times: Royal Bank of Scotland under state control
• Guardian: Europe follows Brown plan for survival as EU bank bail-out plan is agreed
• Dagbladet: Europeiske land vil samkjøre krisepakker

Every week I receive several offers for American credit cards. And the offers are basically so wild they are completely silly. Mostly I am pre-approved, whatever that means. Now, I am lucky – since I am not an American I don’t have to use any of them. And I don’t.

All of them, of course, have zero interest on something or other and/or have no annual fee. So far all is well. But then the craziness starts.

Wild terms

Stuff like cash-APR 20.9%-26.9%. What? And 3% of the US dollar amount on transactions that are made abroad. Why? Are they nuts? I buy for 2000, they want 60 bucks for doing exactly what?

And then, of course, a so called “finance charge”, up and above the interest rate charged, of 3-5% – depending on the offer – for cash advances. WHAT? So, I take out 1000 dollars in cash, and the buggers want 50 for doing exactly what? Having a machine count bills? Come on!

What to do?

So, on one level my conclusion is: American credit cards are all scams – don’t use them! On another level – for Christ’s sake don’t use them abroad – use cash or travelers cheques!

Efficiency in the credit industry

But then – and this is far more serious: How can the US and Americans tolerate this? An efficient banking and credit industry reduces transaction costs across the board – improves the efficiency for every sector in the economy!

My thinking is that electronic payments are much more efficient than other types. So America must want 99.99% of payments to be electronic. But how can you persuade people to go electronic when the banks and the credit card industry make a scam out it? Well, I don’t think you can.

But other countries have achieved that. And those countries are competitors of the US in the world market. So as long as the US doesn’t sharpen it’s act and get efficient, the competitors have a competitive edge.

Regulation needed

And as far as making consumers and businesses go electronic is concerned: It’s easy to achieve! Just takes some federal regulation. Since the costs of electronic payments, ATM cash advances, and so on, are very close to 0, all the regulators need to do it to impose some low maximum rates.

Say 1 US $ max for cash advances, 2 max if abroad, max interest rate 10% above the Fed’s rate, no charges for over-limit (they can be almost eliminated with modern online technology), but instead allow credit providers to terminate the contract in cases of over the limit. All transfers to the credit card account to be debited within 12 hours.

Does this sound outlandish? Well, it is. I have terms like this on my cards. I can’t thank my bank for it – it’s not because they have chosen to give me terms like this. I have these terms because they have been forced to. But they have no problem complying to them. And they still make excellent money.

See also: Plastic Card Tricks (NYT)
               The World’s Worst Credit Card (it is American, of course!)
               FTC Crack down

I am frequently surprised by the ability of American media to explain away or minimize the role of domestic factors in the current recession in the US. Washington Post provide the most recent example of this kind of foolishness. Today it featured the following headline:

Exports Not Hurt by Euro’s Strength, Official Says

BRUSSELS, April 15 — Most European exporters are not yet feeling the pain of the strong euro, a European Union official said Tuesday — even as aircraft maker Airbus, which sells its planes in U.S. dollars, called the level “unbearable.”

Now, if the euro was strong, this would be ok. However, if it is the dollar that is weak, then businesses in the EU don’t really have any big problems. Then it is only sales in the US that are affected.

From a business point of view it matters a lot whether it is the dollar that is weak or the euro that is strong – it is only for trade between those two areas that it does not matter which is what. But for all other trade – and an increasing proportion of world trade falls in that category – it matters.

And really, the Euro has strengthened somewhat versus a number of currencies, but the US dollar has weakened by 30-40% against virtually all currencies that count. Therefore it is much more appropriate and correct to speak of a weak dollar than a strong euro!

Competitively speaking, that means raw materials and goods that are imported have become comparatively cheaper for the EU and other countries, while they have become comparatively more expensive for the US.

Thus, the low interest rates in the US and the recession feeds back on the competitive situation of the US in the world economy.

American media continue to focus on the rising price of oil, and how they drive inflation and increase energy costs.

While this is true, it is only true in an indirect sense. It’s not the oil that is extremely expensive – it was much more expensive in 1980, if measured in other currencies – it is the dollar that is weak.

Here’s that chart for the USD versus the Euro for the last 12 months:

Here is the Brent spot price for the same period:

Adjust oil prices for the dollar slip, and there is still a price increase, but it is actually not all that huge.

The dollar is weak because the US interest rate is low – actually negative when adjusted for inflation – and because the US banking system and credit markets are shaky. And the stock marked is in for a rough ride, whether Americans want to believe it or not. So investors, both inside and outside the US, go into oil and commodities.

This, of course, means the causes for the high oil price to a large extent is found in policy failures within the US. There really isn’t all that much cause to blame the Arabs or the rest of the world, certainly not for the current recession in the US, and only to a limited extent for the current oil prices.

The real interest rate in the US after the last rate cuts by the Fed – the interest rate adjusted for inflation – is negative. Is that good or bad? Seems to me, reading about this in New York Times, that both Obama and Clinton hold much to narrow views on the crisis, and think it is mostly a financial crisis that can be solved by stimulating the economy and regulating the credit market.

Every time the rate has been cut in the last six months, the stock market has reacted positively. And the Fed has been looked upon as an institution that actually does something to reverse the current crisis in the American economy. The rate cuts have been said to stimulate the economy, and so on.

And, yeah, guess what, lower interest rates are great for the stock market. Always have been, always will be. Simply because lower rates means that on the average, and everything being equal (ceteris paribus, it’s often called), and all of that, stocks become more attractive as investment instruments compared to other instruments.

So, if the crisis facing the US had been a financial crisis, that would have shored up things neatly. But the current crisis is not financial – it only has some financial aspects. The crisis in 2008 is structural (I’ve discussed this a bit in previous post, and will get back to it as well in later posts).

Structurally, for the real economy, negative interest rates may be bad news, even if they are good for the stock market and for financial institutions in trouble.

If you think about if, you will quickly realize that negative interest rates simply mean that almost any investment that have a yield equal to the rate of inflation becomes a profitable investment. So, the lower the interest rate, the stupider the investments, so to speak.

And low interest rates were one of the main causes of the current housing crisis (quote from Bonfire of the Builders, Business Week):

A diverse cast of characters combined to launch the once-in-a-lifetime housing boom of the past five years. Traditional mortgage companies and banks unleashed a barrage of loans, many to borrowers with iffy credit histories who didn’t bother to read the fine print about upwardly mobile interest rates. Wall Street egged on the often-reckless underwriting by buying vast quantities of home loans for repackaging as securities. Now that the boom has fizzled and foreclosure rates are rising, the important role of large homebuilders as lenders is also coming into sharper focus.

In addition to spitting out subdivisions, many of which now stand half-empty, builders jumped into the mortgage business to a degree they never had. Wall Street provided the same encouragement it offered other lenders. Even as the housing supply began to exceed demand last year, builders kept sales brisk by pushing adjustable-rate, interest-only, and other risky loans. In some cases they attracted clientele who couldn’t afford conventional mortgages.

So now, with low interest rates, there is the risk of fueling the same speculative building spree again. And also, to make investors spend precious capital on low-yield projects that look good today, but will surely be bad once interest rates come up again.

In my opinion, and I’ll say more about this later, the American economy currently need high interest rates (something like a real interest rate of +3-4%) to ascertain that capital is spent on smart projects and to reduce non-productive speculative investments.

The price fall in the US continues and accelerates. According to The Independent:

The price of the average home was 11 per cent lower than a year ago, the S&P Case-Shiller index showed yesterday, as repossessed homes flood the market – and economists predict that the price adjustment may belittle more than half over.

…. “It does not look like early 2008 is marking any turnaround in the housing market,,” said David Blitzer, S&P index committee chairman. “Home prices continue to fall, decelerate and reach record lows across the nation. No markets seem to be immune from the housing crisis.”

Other indexes point in the same direction. But actually all these indexes most likely underestimate the problems in the housing market for the moment. The reason for this is that a large number of sellers are holding back. So at the same time the market has slowed down (New York Times):

Sales of new U.S. single-family homes fell to the slowest pace in 13 years

On the other hand, real interest rates are now negative. And the Fed is pumping liquidity into the market. So it’s easy to think that the housing market will pick up relatively soon.

However, I don’t think that’s the case. Given the huge structural imbalance in the housing market and the time it will take to achieve balance, on one hand, and the need the Fed has to also look at factors in the much bigger recession picture on the other hand, they can’t and shouldn’t maintain negative real interest rates for an extended period of time. And smart buyers, I think, know this.

Because the bigger picture is a federal budget out of control, a foreign trade deficit that is monumental, a continued weakening of the dollar as a result of low interest rates, low productivity (see NYT, Feb. 7) growth in the economy (see also OECD), cautious lending by the banks (reacting to the current uncertain situation), and the danger of a substantial imported inflation.

Then add to all this that a negative real interest rate most likely is exactly the opposite of what the American economy needs over the slightly longer term, as cheap capital will lead to decline in productivity.

Taken together, these factors should imply that a negative interest rate – which just is plain stupid but may momentarily be necessary – will and should only be maintained until the financial institutions are over the worst.

More to come!

Another popular, somewhat more refined way of explaining away the current crisis in the American economy is to refer to the crash of the sub-prime marked, and its leveraging by means of C.D.O’s (collateralized debt obligations), and perhaps throwing in some blame for Moody’s as well. That’s really blaming the instruments, not finding the cause.

Still, that’s the version presented to the American public today by New York Times. It has all the marks of a great story, and I’m willing to bet it’s going to sell well. While appealing, it doesn’t hold up as more than a partial explanation.

Because the huge mountain built by these three factors – sub-prime loans, CDO’s and high rankings by Moody’s – didn’t stumble upon itself. It wasn’t iself the reason it fell, that is to say.

It fell because the housing marked finally burnt itself out. As it has to. Because for a long time capital (in terms of the real interest rate) has been far too cheap in the US. The US used cheap capital to buy its way out of the last crisis (as indeed it has several times in the past), and it resulted in a far too high rate of construction in the housing sector. As it had to. When capital is cheap, it’s put to use for lots on non-productive purposes.

At the same time, of course, cheap capital means it’s also cheap to borrow for people wanting new homes or wanting to speculate in real estate. So there was supply, and there was demand. And for a long time, – and I am sure history will confirm this – too long a time actually, demand kept up with supply due to speculation using cheap capital.

But even under these circumstances, when the discrepancy between supply and need for capital goods such as housing grow too big, the fun is over, as the demand for these goods are more limited (bounded) than for some other types of goods.

This is one part of the real explanation for the current recession, I think. Not the instruments (C.D.O.’s, subprime loans, or Moody), but the structure on which they rested.

More to come!