Hitting the Iceberg at 4.75 Knots

[EJ]

Didn't take long for US creditors to figure out that whether the US economy sinks from the economic impact of the collapsing housing, private equity, and other bubbles or is kept afloat by inflation, they lose either way.

Fears of dollar collapse as Saudis take fright
Sept. 20, 2007 (Ambrose Evans-Pritchard - Telegraph UK)

Saudi Arabia has refused to cut interest rates in lockstep with the US Federal Reserve for the first time, signalling that the oil-rich Gulf kingdom is preparing to break the dollar currency peg in a move that risks setting off a stampede out of the dollar across the Middle East.

"This is a very dangerous situation for the dollar," said Hans Redeker, currency chief at BNP Paribas.

"Saudi Arabia has $800bn (£400bn) in their future generation fund, and the entire region has $3,500bn under management. They face an inflationary threat and do not want to import an interest rate policy set for the recessionary conditions in the United States," he said.

The Saudi central bank said today that it would take "appropriate measures" to halt huge capital inflows into the country, but analysts say this policy is unsustainable and will inevitably lead to the collapse of the dollar peg.

AntiSpin: Here at iTulip we call this process "Poom" and it ain't pretty. "Poom" is the back end of the Ka-Poom Theory disinflation/inflation cycle that is both monetary cause and effect of the bubble cycle. The bubble cycle replaced the business cycle as the focus of monetary policy since the finance-based economy, popularly mis-labeled the "service economy," aka the FIRE Economy, became the centerpiece of US national industrial/economic policy starting around 1980.

The first Ka-Poom was 2000 - 2006, with disinflation 2000 - 2001 following the crash of the stock market bubble and inflation in everything from oil to gold to houses during the re-inflation cycle 2002 - 2006.

The disinflation phase of the current bubble cycle started after the housing bubble peaked in mid 2005. As the disinflation was gradual due to the nature of the market for houses, which are not marked to market all at once like stock portfolios but only gradually, wealth and employment and thus demand were not suddenly hit. There was little spill-over into the so-called "real economy" such as occurred after the crash of the stock market bubble, so only a muted disinflationary phase occurred. Until May, that is, when the credit markets got the idea to price the creative securities that had for years been the engine of all of the credit for the housing, private equity, and other bubbles. The markets priced them at zero and the credit markets seized up. Then, after a brief pause–quite suddenly and with great force–the demand implosion began in August.

Anyone paying attention could see this coming a mile away. A leading indicator we've been tracking is housing permits, which by plunging 25% below last year's issuance early this year and staying there confirmed, with other data, our Oct. 2006 projection of a recession Q4 2007. Then in August we noted iTulip Prosper Lending Group default rates soaring along with duration of unemployment numbers, a leading indicator of future unemployment.

The cascading economic impact of simultaneously collapsing housing, private equity, and other bubbles is The Iceberg. As recently as two weeks ago the Fed had apparently not spotted it as Bernanke continued to give speeches indicating a focus on inflation, which is in our view well justified. In fact, we actually thought he was serious, and the iTulip ShadowFed predicted a .25% cut. We thought the Fed's worry about US creditors would trump concerns about the economy. After spotting the iceberg, the Fed re-calculated: if the US economy is sinking like the Titanic, no one is going to want to lend the US money anyway. That is probably true. But lenders may not want to buy anything denominated in dollars if they believe that the only thing really supporting the dollar is their purchases of dollar assets, that the US isn't willing to accept the consequences of the asset bubbles and instead wants to dump them on its creditors. Just ask the Saudis.

That is what "Poom" is about. The no-win choice after a bubble pops between re-inflation to hold off a run-away debt deflation and even more inflation and dollar depreciation as a side effect of re-inflation policy.

1999 Ka-Poom Theory also posits that a final "Poom" happens–the terminal bubble in the bubble cycle–when the Fed attempts to re-inflate the economy via rate cuts and dollar depreciation when the dollar is weak and inflation is already running high–as it is now. Instead of causing long rates to fall, the cuts have the opposite result: long rates rise as the bond market prices in inflation fueled by dollar depreciation. Mortgage rates rise and the housing market tanks some more. A self-reinforcing cycle starts.

The IMF warned of this last year:

IMF Identifies Risk of `Disorderly' U.S. Dollar Drop
September 13, 2006 (Bloomberg)

A "disorderly'' drop in the dollar is the biggest risk to world financial markets, the International Monetary Fund said, urging policy makers to prepare and act quickly when asset prices slump.

Investors are buying U.S. bonds under the assumption that the dollar won't slide, and a drop in the currency might turn into a rout as foreign investors and central banks move to cut losses, the global financial watchdog said.

"A low-probability but potentially high-cost risk to the global financial system is that a dollar decline could become self-reinforcing and hence disorderly,'' the IMF said in its Global Financial Stability Report today.

Last week, IMF Managing Director Rodrigo De Rato singled out lopsided global trade and investment flows, protectionist sentiment and high energy prices as sources of concern to an otherwise benign outlook for the global economy. The IMF says the U.S. current account deficit, running at a record rate, needs to narrow.

Will hitting the iceberg at 4.75 knots versus 5.25 knots make the difference between sinking and staying afloat? Will it matter if the US economy floats but the trade-weighted dollar is half or a quarter of what it is today?

We await the next Fed Flow of Funds report, due out Dec. 7, for our answer.

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[trex]

Re: Hitting the Iceberg at 4.75 Knots

December 7? Interesting date.

[Uncle Jack]

Re: Hitting the Iceberg at 4.75 Knots

I'd like to hear more about those Prosper.com default rates. I have zero in 18 loans, and the default rate for the whole of Prosper.com has not increased that significantly - I've been watching.

The problem may lie in the ability of certain lenders to successfully screen borrowers, or a matter of bad luck on a small sample size. Let's see some stats before we conclude that there is trouble at Prosper.

You can plug anyone's user id into this site and find stats on borrowers and lenders at Prosper.com, and stats on all of Prosper.

http://lendingstats.com/

[RebbePete]

Re: Hitting the Iceberg at 4.75 Knots

It's interesting to see a spark of independence from the House of Saud, which has traditionally depended so much on US good will to stay in power. I wonder if they haven't cut a deal with another major power that allows them to stray a bit from the US script, or if they see that they need to go their own way in order not to create too much trouble for even the US to be able preserve their rule. If so, that has far-reaching implications for all sorts of things, including oil prices.

- Pete

[BiscayneSunrise]

Re: Hitting the Iceberg at 4.75 Knots

This Saudi announcement portends the answer that is asked by Fred on a different thread. Are the Chinese dumping US Treasuries? I think the answer now has to be unquestionably, yes. The Chinese will unwind slowly, to be careful not to trash the US economy too badly while they develop other export markets around the world.

As you probably figured out, in the short to medium term I like uranium along with gold and other resources. But I am beginning to wonder that in the very long term, if a beaten down dollar will lead to the rejuevenation of the US manufacturing and export industries.

[GRG55]

Re: Hitting the Iceberg at 4.75 Knots

It's interesting to see a spark of independence from the House of Saud, which has traditionally depended so much on US good will to stay in power. I wonder if they haven't cut a deal with another major power that allows them to stray a bit from the US script, or if they see that they need to go their own way in order not to create too much trouble for even the US to be able preserve their rule. If so, that has far-reaching implications for all sorts of things, including oil prices.

- Pete

The Saudi's have been inching away from the American orbit since the first Gulf War. For example, at the request of the House of Saud, the US abandoned the Prince Sultan Air Base near Riyadh (their main air operations centre for the region) to a new facility in State of Qatar a few years ago. Although Saddam didn't cross the border into Saudi Arabia, when the war started the expatriate community bailed out en mass, and nearly brought the entire economy to collapse. The Saudi's implimented a "Saudization" program to make sure that never happened again. This has had several consequences - an even more conservative Islamic society than before the war, and increased political confidence independent of the West. This will continue to have significant global ramifications beyond just energy supply in the years to come.

[metalman]

Re: Hitting the Iceberg at 4.75 Knots

The Saudi's have been inching away from the American orbit since the first Gulf War. For example, at the request of the House of Saud, the US abandoned the Prince Sultan Air Base near Riyadh (their main air operations centre for the region) to a new facility in State of Qatar a few years ago. Although Saddam didn't cross the border into Saudi Arabia, when the war started the expatriate community bailed out en mass, and nearly brought the entire economy to collapse. The Saudi's implimented a "Saudization" program to make sure that never happened again. This has had several consequences - an even more conservative Islamic society than before the war, and increased political confidence independent of the West. This will continue to have significant global ramifications beyond just energy supply in the years to come.

thanks. it's fantstic to have smart guys like GRG55 and c1ue and Christopher and Chris Coles and on and on from all over the planet giving their local take on news like this. awesome!

[FRED]

Re: Hitting the Iceberg at 4.75 Knots

I'd like to hear more about those Prosper.com default rates. I have zero in 18 loans, and the default rate for the whole of Prosper.com has not increased that significantly - I've been watching.

The problem may lie in the ability of certain lenders to successfully screen borrowers, or a matter of bad luck on a small sample size. Let's see some stats before we conclude that there is trouble at Prosper.

You can plug anyone's user id into this site and find stats on borrowers and lenders at Prosper.com, and stats on all of Prosper.

http://lendingstats.com/

We went by a survey of iTulip Prosper members who responded to our request for data who are using the automatic lending function versus hand-picking borrowers. This helps reduce the skewing of results for lenders such as yourself who may be especially good at avoiding higher risk borrowers. Also, one can trade off risk for yield on prosper.com by only lending to borrowers with high credit ratings, low loan to asset ratings, and so on. Defaults across such a lender's portfolio of loans will be low, but the average interest rate paid will also be below the mean.

The data on the lendingstats.com shows some trending in the distribution of defaults as the number of loans that are one or two months late are higher than they were a few months ago, the last time we looked.

Breakdown of late payments and defaults: 10.85% of all loans

[dbarberic]

Re: Hitting the Iceberg at 4.75 Knots

I do not think one needs to wait till December 7th for the answer. We already know what the response is going to be. Either the other foriegn central banks will enter a round of Fed maching competitive devaluations, or they are going to pack up their bags, say F-you to the USA, and allow the US$ to circle down the drain.

In either scenerio, the outcome is all the same, poom inflation big-time for the United States.

[FRED]

Re: Hitting the Iceberg at 4.75 Knots

I do not think one needs to wait till December 7th for the answer. We already know what the response is going to be. Either the other foriegn central banks will enter a round of Fed maching competitive devaluations, or they are going to pack up their bags, say F-you to the USA, and allow the US$ to circle down the drain.

In either scenerio, the outcome is all the same, poom inflation big-time for the United States.

Absolutely. We'll know because the stock markets will dive. But the Flow of Funds report will give us the details of who did and didn't go along with the program. Unless the Fed messes with the report. I know that sounds paranoid, but given the reformulation of the CPI and unemployment numbers, the elimination of M3, it can't be ruled out.

[bill]

Re: Hitting the Iceberg at 4.75 Knots

Will hitting the iceberg at 4.75 knots versus 5.25 knots make the difference between sinking and staying afloat? Will it matter if the US economy floats but the trade-weighted dollar is half or a quarter of what it is today?

As the US economy crashes into the tip of the iceberg (sub prime below) and the Fed throwing interest rate reduction switches, and the economy goes threw the months ahead as seen in the graph below the results will be a weaker dollar and higher inflation. How many more icebergs are still out there looming in the fog?

[c1ue]

Re: Hitting the Iceberg at 4.75 Knots

But I am beginning to wonder that in the very long term, if a beaten down dollar will lead to the rejuevenation of the US manufacturing and export industries.

I wouldn't hold your breath.

Just on the labor front - China's 7x advantage isn't going away anytime soon.

The rise of national commodity champions as well as international (i.e. non-US) commodity oligopolies, plus BRIC demand increase means at least flat and probably increasing raw material prices - especially for dollars.

Unless the dollar does a peso while simultaneously not wrecking the US system - I'm not seeing any major bounceback for decades.

[GRG55]

Re: Hitting the Iceberg at 4.75 Knots

I wouldn't hold your breath.

Just on the labor front - China's 7x advantage isn't going away anytime soon.

The rise of national commodity champions as well as international (i.e. non-US) commodity oligopolies, plus BRIC demand increase means at least flat and probably increasing raw material prices - especially for dollars.

Unless the dollar does a peso while simultaneously not wrecking the US system - I'm not seeing any major bounceback for decades.

No doubt about it, things look pretty challenging for the good ol' U.S. of eh right now. But I can recall similar sentiments about US competitiveness compared to Japan in the late 1980's. Remember back then when the business section book shelves were full of tomes endorsing the manifold benefits of Japanese management systems? And every hack "management consultant" was lecturing about the "Art of War" or some such allegedly Oriental nonsense. In a few short (but perhaps economically tough) years this may happen again, only the books and lectures will be about China (you won't hear anything else at any conference). When the Chinese make a bid for Rockefeller Centre that will the signal to sell Asia and buy America.

[ASH]

Equilibrium

I wanted to comment upon the topic of the competetiveness of America's manufacturing relative to that of China, and the 7x figure mentioned by c1ue. (The same observations also relate to immigration.)

It strikes me that labor is in the process of equilibrating. To the extent that the capital equipment and technical skills required to produce a given good can be assembled in multiple labor markets, then the driving force for movement of that manufacturing activity between labor markets is the total difference in labor costs, transportation costs for shipping raw materials to the point of manufacture and finished goods to the point of sale, and any tax or regulatory expenses imposed by local governments. Local standard of living and available manpower underly the labor and government-imposed tax and regulatory costs. In short, there's a built-in diffusion gradient that transports manufacturing jobs from high-stand-of-living countries to the third world (at least those parts of the third world which have the requisite political stability to safeguard capital). I cannot deny that currency valuations help determine the pattern of trade, but -- and I think this was c1ue's point about the factor of 7 -- it is only one variable. The dollar would have to drop very low indeed for it to be cheaper to manufacture plastic toys in the US rather than China, because of the large difference in standard of living (including worker protections and so forth). In falling this far, the dollar would surely cease to be a reserve currency, and our ability to borrow to support our standard of living would be impaired. Yes, we would gain a price advantage over foreign labor markets -- but those are the same markets which have insulated us from inflation in the costs of manufactured goods. Faced with the real costs of making big screen TVs using American labor (because the cost of using Chinese motherglass is now out of reach, thanks to a weak currency), we would be able to afford far less materially. The end result may be more Americans employed in manufacturing, but still with a lower standard of living.

In short, my view is that equilibration of labor by trade in goods implies long-term equilibration of standard of living. China, and the third world generally, represent an enormous reservoir of labor with a low standard of living, whereas we represent a much smaller pool of labor with a comparatively high standard of living. Equilibration means that things in China get a little better, and things in America get a lot worse.

The tie-in with immigration is that there are jobs which don't produce tradeable goods. If you can't do the jobs with third world labor in the third world, then immigration allows you to import the third world labor to do the jobs locally. Of course, this only has an economic benefit if the cost of the imported third world labor is lower than the cost of the domestic labor. It turns out that living as working poor in America is frequently a better deal than living as jobless poor in the third world, so there is in fact a motive for immigration into the lowest-paid rung of America's labor market. But what is the net effect? The net effect is to import a third world standard of living within our borders, in order to enjoy third world labor costs. Again, the costs paid for labor go down, but so does the overall standard of living of society. (The beauty is that the standard of living of the natives at the top of the economy doesn't go down immediately, because they aren't the ones signing up to live in quasi-third-world conditions; their standard of living actually goes up in the short term because they benefit from the cheap labor. It's only the gradual growth of low-income neighborhoods and stress on public services which manifest for those lucky natives.) In the end, you can't get anything for free. If you want to pay someone minimum wage (or, off the records, less than minimum wage) to build your house or mow your lawn, then you'd best be prepared to live next to him. If you want him to maintain a middleclass lifestyle, volunteer with the PTA, and send his children to college, then you'd best be prepared to pay him a middleclass wage.

I know I must be coming off like a trade and immigration Luddite. My discussion thus far has failed to address issues of efficiency and overall economic growth. It isn't that I think this is a zero-sum game. Ideally, the extra cost efficiency associated with trade and immigration would increase total economic activity so that everybody benefits. My point is that the size of the populations involved -- and the magnitude of the disparity in standard of living -- is such as to invite skepticism that the outcome is good for the average American. The way I see it is that trade and immigration DOES increase the size of the pie, but that we currently have so much more of the pie than anyone else, that when the bigger pie gets divided (by the long-term equilibration process) Americans will ultimately end up with smaller slices. If nothing else, much of the pie we have now is illusory, since it has been purchased on credit... if the dollar drops, then our ability to buy luxuries with the savings of foreigners will be substantially curtailed.

-- Andrew Huntington

[GRG55]

Re: Equilibrium

I wanted to comment upon the topic of the competetiveness of America's manufacturing relative to that of China, and the 7x figure mentioned by c1ue. (The same observations also relate to immigration.)

It strikes me that labor is in the process of equilibrating. To the extent that the capital equipment and technical skills required to produce a given good can be assembled in multiple labor markets, then the driving force for movement of that manufacturing activity between labor markets is the total difference in labor costs, transportation costs for shipping raw materials to the point of manufacture and finished goods to the point of sale, and any tax or regulatory expenses imposed by local governments. Local standard of living and available manpower underly the labor and government-imposed tax and regulatory costs. In short, there's a built-in diffusion gradient that transports manufacturing jobs from high-stand-of-living countries to the third world (at least those parts of the third world which have the requisite political stability to safeguard capital). I cannot deny that currency valuations help determine the pattern of trade, but -- and I think this was c1ue's point about the factor of 7 -- it is only one variable. The dollar would have to drop very low indeed for it to be cheaper to manufacture plastic toys in the US rather than China, because of the large difference in standard of living (including worker protections and so forth). In falling this far, the dollar would surely cease to be a reserve currency, and our ability to borrow to support our standard of living would be impaired. Yes, we would gain a price advantage over foreign labor markets -- but those are the same markets which have insulated us from inflation in the costs of manufactured goods. Faced with the real costs of making big screen TVs using American labor (because the cost of using Chinese motherglass is now out of reach, thanks to a weak currency), we would be able to afford far less materially. The end result may be more Americans employed in manufacturing, but still with a lower standard of living.

In short, my view is that equilibration of labor by trade in goods implies long-term equilibration of standard of living. China, and the third world generally, represent an enormous reservoir of labor with a low standard of living, whereas we represent a much smaller pool of labor with a comparatively high standard of living. Equilibration means that things in China get a little better, and things in America get a lot worse.

The tie-in with immigration is that there are jobs which don't produce tradeable goods. If you can't do the jobs with third world labor in the third world, then immigration allows you to import the third world labor to do the jobs locally. Of course, this only has an economic benefit if the cost of the imported third world labor is lower than the cost of the domestic labor. It turns out that living as working poor in America is frequently a better deal than living as jobless poor in the third world, so there is in fact a motive for immigration into the lowest-paid rung of America's labor market. But what is the net effect? The net effect is to import a third world standard of living within our borders, in order to enjoy third world labor costs. Again, the costs paid for labor go down, but so does the overall standard of living of society. (The beauty is that the standard of living of the natives at the top of the economy doesn't go down immediately, because they aren't the ones signing up to live in quasi-third-world conditions; their standard of living actually goes up in the short term because they benefit from the cheap labor. It's only the gradual growth of low-income neighborhoods and stress on public services which manifest for those lucky natives.) In the end, you can't get anything for free. If you want to pay someone minimum wage (or, off the records, less than minimum wage) to build your house or mow your lawn, then you'd best be prepared to live next to him. If you want him to maintain a middleclass lifestyle, volunteer with the PTA, and send his children to college, then you'd best be prepared to pay him a middleclass wage.

I know I must be coming off like a trade and immigration Luddite. My discussion thus far has failed to address issues of efficiency and overall economic growth. It isn't that I think this is a zero-sum game. Ideally, the extra cost efficiency associated with trade and immigration would increase total economic activity so that everybody benefits. My point is that the size of the populations involved -- and the magnitude of the disparity in standard of living -- is such as to invite skepticism that the outcome is good for the average American. The way I see it is that trade and immigration DOES increase the size of the pie, but that we currently have so much more of the pie than anyone else, that when the bigger pie gets divided (by the long-term equilibration process) Americans will ultimately end up with smaller slices. If nothing else, much of the pie we have now is illusory, since it has been purchased on credit... if the dollar drops, then our ability to buy luxuries with the savings of foreigners will be substantially curtailed.

-- Andrew Huntington

Andrew: I very much enjoyed reading your post (and certainly did not come away with the impression it was authored by a "Luddite"). A few thoughts/questions, in no particular order, related to highlighted parts above:

• Why is it a given that the rate of increase of "the pie" is constrained such that the US experiences a trend decline in absolute standard-of-living, instead of perhaps a slower rate of increase compared to other, faster growing parts of the world? If the rest of the world benefits most from a bigger pie, is it not in everyone's interests to keep expanding it as fast as practical (protectionist Congressmen excepted)?
• Although the "equilibration of labour" (Steve Roach calls it the global labour arbitrage) will continue for some years, like any arbitrage it cannot go on forever. As Chinese (or Indian, or Vietnamese, or...) relative labour costs close in on US levels does this not present an even bigger challenge? Those nations will be priced out of making low value goods like plastic toys, and will necessarily be competing with the USA in the manufacture of more and more higher-value, higher-technology goods. Isn't this one reason that Americans should object to the devaluing of the Dollar and the closing of the 7X gap? Do Americans really want to go back to making plastic toys while the Asians make jet engines? :eek: You suggest this is the way to more manufacturing jobs and a lower standard of living for the US - hard to disagree.
• Might we see a societal shift in the way that US citizens perceive the measurement of "standard-of-living"? You note acquiring luxuries (like Toll Brothers McMansions?) with the savings of foreigners. Perhaps this will give way to a new paradigm about what it means to live well? Failing that, maybe they just change the method of measurement since nobody likes the results (hey, it worked for CPI and the BLS statistics).

One area where I disagree is "...then you'd best be prepared to pay him a middleclass wage". Paying anyone more than a competitive wage for the work performed is simply private-sector welfare, and if performed on a wide scale as destructive as state sector welfare in the form of a minimum wage. Why do I think this? My parents were near-pennyless immigrants (from a third-world country) to North America 50 years ago (as, eventually, were most of my aunts and uncles). Immigrants are among the most motivated, risk-taking slice of their societies (the rest stay home and wait for the government to do something for them). They uproot themselves, move to an alien country, leave their family support system behind, often face prejudice and discrimination - all in an effort to improve economic circumstances for themselves and their kids. In my family every one of my generation has at least one university degree and none of us work for a minimum wage - just one example: one of my nieces is a accomplished surgeon (just try that back in the old country). We didn't get here because someone overpaid us for low value work. The low wages are the incentive to learn a trade, get a skill, go to school, whatever it takes to compete for a higher-paying job and better one's economic circumstances. We were extraordinarily fortunate that our parents chose (lucked out?) to move to a nation that offered such enormous opportunity and a culture of meritocracy - not wage subsidies.

Most immigrants are economic migrants. Modern day North America was built by economic migrants. Despite bin Laden, Chirac and other detractors, it seems to have been a pretty damn successful experiment so far (perma-doomsters might want to think about that).

I am no supporter of illegal immigration, but I have a firm conviction that illegals are largely a symptom of a chronically dysfunctional immigration policy. I simply cannot express enough my profound distress every time I hear about "The Fence" being built along the US - Mexico border. Whether it is "high-net-worth" Americans isolating themselves behind the walls of a gated community, or the nation itself walling out its neighbours, it strikes me as the complete antithesis of what made America such a successful, and widely admired nation. If this insanity continues it will have a lot more influence over America's economy than anything the FOMC ever does.

Which is the real ghetto? A vibrant low-income immigrant neighbourhood or a wealthy, walled-in enclave where residents spend their days inventing new rules, to be imposed on their neighbours by the homeowner association, in a ridiculous effort to "maintain their property values". The "land of the free" indeed...

My apologies to everyone for the rant.