Sarah Palin waves goodby

The liberal press, the home of rabid Palin-haters, sneered, “if you can’t stand the head, get out of the kitchen”, and suggested she was “getting out of Dodge” before an undisclosed scandal broke.

There was talk about her “lack of experience” (ignoring the exceedingly abysmal experience-deficit of the adored Barrack Obama).

There was criticism about her choosing the eve of the Fourth of July to make the announcement, suggesting that she hoped her decision wouldn’t draw much attention over the long holiday weekend.

Criticism of the Fourth of July timing also overlooked the fact that July 4, 2009 was the least patriotic national celebration in years. President Obama spent the day at his daughter’s birthday party. The rest of the nation was absorbed in the details of Michael Jackson’s funeral.

Celebrations of national pride were out of fashion.

Sarah’s reasons

The real reasons for Sarah Palin’s decision to leave office were not disclosed. However, consider the following:

How many honest, decent Americans do you know that have served in high political office for more than one term? If you know any, please put their names in the comments below, so they may be praised and honored.
Most reasonable people, with high standards of personal ethics, will not run for elected office in the United States. The governing consideration is, “If you don’t love the stench, stay out of the sewer.”

Sarah Palin got into politics to help solve problems in the tiny town of Wasilla, Alaska. She did such a good job that she defied all conventional wisdom and became the first woman and youngest governor of Alaska. She had an 80% approval rating in her state by the time John McCain picked here as his running mate in the 2008 Presidential election.

As long as she stayed in Alaska, she could be happy and do good things.

However, on descending to the “lower forty-eight”, she discovered that she was evil incarnate to a huge portion of the American population:

1. She was not a lesbian and did not favor same-sex marriages. Barney Frank, Henry Waxman and the other fifty or so members of the Gay and Lesbian Congressional Caucus had reason to hate her.
2. She did not believe on killing children at birth, when convenient to the mother. Worse still, her daughter, pregnant out of wedlock, did not opt for an abortion — and then, evil of all evils — went about encouraging teenage abstinence. Even worse and totally unforgivable, she insisted on giving birth to a child with Down’s syndrome. No wonder the National Association of Women hated her.

	Professor William Ayers

3. She was a beauty queen, with a large attractive family. She didn’t look at all like the “average American”, who now are generally obese people with multiple tattoos or nose jewelry. Look at the audiences on Dave Letterman’s daily diatribe or the Jerry Springer freak show, or the fans of Oprah Winfrey, or the crowds at Michael Jackson’s funeral — this is what real Americans are supposed to look like. It’s positively unpatriotic to look like Sarah Palin. No wonder so many hate her.
4. She supported her son going to war in Iraq to defend the country. Unlike Nancy Pelosi or Harry Reid, who declared the War in Iraq lost in mid-course, ready to leave the troops to their fate by a hasty retreat, she was a true patriot — not a popular stand with Barrack Obama and his associates from Chicago politics, like “Professor” William Ayers (famous for treading on the American flag and as a home-grown terrorist), or “Reverend” Jeremiah Wright, known for his memorable words, “God Damn America!”

The rational thing to do

Any good mother who loved her family would not expose them to the vile, continuous barrage of invective, invented stories, lies, calumny, and hate-mongering that fell upon the Palin clan.

	The Palin family

When David Letterman falsely stated that her young daughter, barely in high school, was having sex with a depraved football player at half-time — a total fabrication, funny only to Obama supporters and Palin-haters (a large portion of the population) — without being fired from his job — it was clear that Sarah Palin would only face much, much worse if she dared to continue to try to do good in politics.

Sarah Palin is a smart woman and has come to realize the depth of the hatred millions of American have for her and her family. It came as a surprise. She was isolated from the “real America” being up there in Alaska.

This is no longer Norman Rockwell country — it is more like a freak show.

And, only the scum of the earth stay in politics for long.

So Sarah Palin did the only thing she could to protect her family. She gave America the finger.

Unfortunately for her, the liberal media are not yet finished. They will not be satisfied with her out of office. She and her family must be destroyed for all they represent.

And Palin-haters have the money, press coverage, and psychotic mind-set to do it.

What does this have to do with the flow of funds?

Well, leadership of a nation is an essential element in economic policy. The stronger that Obama and his supporters get, the more likely his economic policies will endure.

The exit of an honest leader from the scene suggests continued hard times and bad economic policy.

	The solitary, heroic security analyst is long gone

Actually, Messrs Buffett and Graham moved away from classic securities analysis about two generations ago, as bond yields began to surpass stock yields and as control of most public corporations began to slip from individual shareholders and owner-managers, passing to mutual fund administrators and hired executives.

Mr. Buffett continued in finance in the holding company business (Berkshire Hathaway), while Professor Graham entered academia and life as a financial guru.

What changed since the time of Graham & Dodd?

Security analysts in the Buffett mold spent their days analyzing financial statements.

Most companies were relatively simple, with few subsidiaries and a single line of business.

	A business an analyst could understand

One could tear into a financial statement, rip out some critical ratios (turnover of receivables and inventories, net working capital, return on equity, dividend payout, etc.) and then visit the company.

Touring the factory floor, chatting with workers on the assembly line, and having lunch with the sales manager, a good analyst could ascertain whether the balance sheet appeared to reflect reality, while gaining an insight into the future of the venture. With a little commonsense and willingness to go against the crowd, the solitary hero financial analyst could do quite well.

This was before the days of off-balance sheet financing, outsourcing of production to distant lands, just-in-time inventories and supply-chain management, and the subordination of individual companies to extremely complicated groups of interlocking financial interests.

Why financial statements have become less relevant

Although the SEC and the US Congress have not yet caught on, the organization of modern economic endeavors has far out-stripped the ability of accountants to present easily comprehensible financial statements that provide sufficient information to understand the strengths and weaknesses of a particular security.

The following diagram, is a vast simplification of the actual structure of many major international corporations traded on world stock exchanges today.

	Economic groups easily confound modern accounting

It shows how willy-nilly interlocking relationships, often ultimately circular in nature, based on equity holdings, service contracts, off-balance sheet agreements, and memoranda of understanding, transcending international boundaries, with legal ties passing through non-disclosing offshore financial centers, can easily turn the financial statement of a single unit in the network (say the green box), into an irrelevancy.

A chart showing the myriad contractual and ownership relationships of a major international institution, like Citicorp, would likely cover an entire football field in a spider-web carpet of infinitely complex ownership and contractual relationships that defy attempts of accountants to present a “consolidated” statement of what, in essence, is beyond the capabilities of dual entry bookkeeping.

A decade ago, when I was advising securities regulators in Southeast Asia, my clients would come to me with charts far more complicated than the diagram above, with questions like, “Is Mr. A an affiliated person of Mr. B”, or “If Mrs C gives information about company X to Mr. D, is this insider information?” The answers were never obvious. Complexity can quickly trump the best regulation intended to protect investors.

The criticality of non-accounting information

Although, in the wake of a financial catastrophe, like the failure of Enron, Worldcom, the Crash of 2008, or the Madoff Ponzi scheme, the US Congress likes to call for tighter accounting standards or more effective oversight by market regulators, the truth is that those inclined towards bad behavior in securities markets can dream up complex schemes faster than regulators can write rules.

	Complexity of design may amount to deception

Until a law is passed banning complex financial arrangements or requiring approval for new products and financial operations — as is done in the pharmaceutical industry — accounting information will become ever less central to the task of analysis of investment opportunities.

• Auction rate securities: Analysts at Standard & Poor’s gave most issues of auction rate bonds investment grade ratings because they were asking the wrong question, “What is the risk of default of this bond?”. The better question would have been, “What is the risk that this bond will become illiquid?”, but the analysts were not being paid to answer that question and investors lost billions.
• Behavior of investment management: Billions of dollars were lost in the Ponzi scheme because neither the SEC nor advisors channeling client funds to Bernard Madoff asked the simple question, “Is it reasonable for one man to have sole custody and discretion over billions of dollars of other people’s money, with the oversight of only a tiny auditing firm operating out of a store front in a New York suburb?”
• Rogue operations: The failure of Barings Bank a decade ago and the crisis at AIG following the Market Crash of 2008, both illustrate the fact that in large complex organization, a rogue operator or unit, a tiny part of the whole, can put an entire huge organization at risk. Details that escape the auditor, like a break-down in internal controls in a far off banking unit in Singapore, or unclear, non-standard terms of over-the-counter derivative contracts, not mentioned in the annual report to shareholders, can be instrumental is collapsing a giant financial institution.

Rethinking the analyst’s job

The old-fashioned, heroic security analyst, working alone in a dark room with a stack of annual reports, in a snow-bound house in Omaha, far from Wall Street, is less likely to solve investment riddles today, than fifty years ago.

The first problem of today’s analyst is the sheer volume of information that is freely available over the Internet.

A search for the term “Citicorp” in the SEC files turns up over one thousand documents. The same term on Google, turns up almost one million hits.

Somewhere in this vast sea of information may be the “smoking gun” that either reveals a security as an outstanding opportunity or unacceptable risk.

It is clear that this data should be “mined”, and that the task is greater than any individual can handle alone.

	Capital Market Wiki --- a work in progress

The analyst of the 21st century must be ready to engage in collaborative research. The solitary hero-analyst can not handle the job alone, anymore.

The solution to the problem lies in modern knowledge handling technology, including OSINT techniques, crowdsourcing, wiki software, and capital market taxonomy.

Capital Market Wiki is a project that addresses this issue.

I’ve written on this a bit in previous articles:

See: Crowdsourcing investment research: opportunities in OSINT and Free information and the Efficient Market Hypothesis and Crowdsourcing investment research: Capital Market Taxonomy and Innovation in investment research; dealing with free information and Modern technology for institutional investment research and New technology in open source investment intelligence

This topic is extensive.

I’ll have more to say, later.

However, the essentials are simple:

	Will doctors survive Obamacare?

1. The number of people to be covered by health insurance will expand to cover the entire population, including illegal immigrants.
2. The overall cost of health care will be dramatically reduced. How this will be achieved is not fully disclosed.
3. It takes about ten years to create a new doctor, starting from the initial career choice on graduating from high school.
4. Health care is a service industry and the principal costs are the salaries and earnings of doctors and nurses.

The implications of this plan are straight forward.

If the demand for health care services is to be artificially stimulated by government mandate and if it takes a decade to increase the supply of doctors needed to meet this demand, in the immediate future, to achieve the President’s goals without further inflation of health costs, either health care must be rationed by the government, or doctors and nurses must earn less for less service — or both.

Average earnings of doctors will fall

Because it is not politically expedient for the politicians to tell grandma that she can’t have that hip replacement, rationing health care — especially for over-indulgent Baby Boomers entering their golden years — will be a non-starter, in the early years.

This means that doctors who come to depend upon the Obama health care system, will face a sharp decrease in income and increased bureaucratic paperwork to justify even that.

	Will it still pay to study anatomy?

Medicine will become a far less attractive profession. The Obama plan does not contemplate reducing the fees of their favored constituency, lawyers that sue doctors for malpractice.

Extremely high entry costs (ten years of education and internships), together with diminished returns, will provide strong disincentives for the creation of new doctors.

Normal attrition and retirement will reduced the supply of medical professionals further.

The result will be fewer medical professionals serving more people. Care must eventually be rationed and doctors must earn less.

It’s just textbook supply and demand, operating under artificial restraints.

Some patients will do quite well, thank you

Some Americans will continue to receive excellent health care under the Obama plan:

	The rich and powerful will do just fine

1. The very wealthy. Even in under-developed countries with dicey health care systems, the rich do OK. Factory owners in Indonesia fly to Singapore for routine checkups. In Brazil, the well-to-do go to private doctors rather than to government-run hospitals.
2. The very powerful. President Obama, his family and friends, will not have to face the indignities of public health care, just as they are able to avoid the public school system brought down by the unionized teachers that they support.
3. The unionized proletariat. Government and private sector workers, protected by union contracts and exemptions hidden in the Obama plan, will be given preferences, not on the level of the very rich or powerful, but better than the adoring masses that ushered Obama into office.

The doctors, nurses, and hospitals that cater to the rich and powerful will survive the Obama plan.

The rest of the profession will either fall prey to what I call the “electric wheelchair syndrome”, described below, or will face restricted circumstances.

Some years ago, I visited Brazil and found doctors driving taxicabs in Rio de Janeiro, victims of the government health system. Many moved to the United States.

The electric wheelchair syndrome

Any economic system that is regulated not by the free market, but by government rules, will contain loop holes to be exploited by clever entrepreneurs.

Medicare is a case in point.

In Florida (and perhaps in other places), local television is swamped with advertisements for electric wheelchairs. The pitch is quite simple:

If the wheelchair seller is not able to get Medicare to pay for that electric wheelchair you think you would like to have, after having said that you qualify for the benefit, you’ll get you wheelchair for free!.

	Electric wheelchair and beneficiary

Every year, the ads show the building of the wheelchair seller getting bigger and bigger.

A trip to Disneyworld reveals squadrons of obese wheelchair drivers, scooting around the theme park, competing for parking spaces at the most popular attractions.

Obviously, someone has figured out how to get Medicare to approve requests for electric wheelchairs. Maybe a doctor owns the wheelchair company. Maybe a Medicare official gets a commission. Something is going on. Even President Roosevelt didn’t have an electric wheelchair.

If it’s not electric wheelchairs, it will be something else. Regulations create loop holes to be exploited and if people can figure out how to make money on a loop hole, it will be done.

Some clever doctors will learn to extract cash from Obama care and will do quite well. It will all be quite legal. It just won’t be medicine.

Obamacare is not necessarily inflationary

The projected trillion dollar costs of Obamacare may not eventually be realized, not because of cost savings resulting from efficiency, but rather because of rationing of services.

If there are not enough doctors and nurses to attend the expanded demand for services, inevitably rationing must be imposed. The supply of services, rather than demand, will be the limiting factor.

With rationing, money is simply not spent as fast as it might be otherwise. If money is not spent, and if costs are kept artificially low by cutting doctors fees, inflation will be contained.

This is great news for the rich and powerful people who will continue to enjoy the best health care service on earth. It is also great news for investors (except for investors in hospitals and medical facilities).

Doctors will move away from medicine to more lucrative pursuits — like selling electric wheelchairs.

Meanwhile, grandma, who voted for Obama, will just have to wait for that hip transplant.

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In the 21st Century, money market funds are now the center of the short-term banking system — and are largely unregulated by the US monetary authorities.

In Q1 2009, total assets of money market mutual funds, according to Fed flow of funds table L.206, were $3.7 trillion, 5.6 times the $666.6 billion in checkable demand deposits with commercial banks. Demand deposits are now only 5.1% of commercial bank liabilities.

The MMF: the non-bank bank

Although money market funds are classified as securities and regulated by the SEC, rather than by the banking authorities, they are, in fact, a banking operation. They take money from “depositors”, with the understanding that it may be withdrawn at any time, on demand, by checks that are cleared along with drafts on commercial banks.

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The “depositors” in money market funds do so with the understanding that they will be able to withdraw the amount deposited, plus a variable rate of interest, whenever they feel like it.

Of course, technically, “deposits” in a money market fund are not a liability of the fund, but rather equity in the form of shares, usually with a net asset value adjusted daily to a one dollar benchmark by issuing additional fractional shares in the amount of the interest earned in one day.

Like commercial banks, money market funds invest “depositors’” money in short-term loans, usually commercial paper.

However, unlike commercial banks, money market funds do not have to maintain reserves with the central bank, nor do they normally set up reserves for doubtful receivables. Furthermore, unlike commercial banks, their “deposits” are not guaranteed by the government (until the Crash of 2008).

For practical purposes, a money market fund is the same as a bank. A fund borrows short and lends long and promises to pay depositors on demand, principal plus interest.

An unfair advantage

Because money market funds do not maintain reserves with the central bank, they are able to pay substantially higher interest than available on demand deposits at commercial banks. Nor do money market funds normally offer drive-in tellers, night depositories, or the myriad other services that regular banks offer depositors.

In 1968, when the first money market fund was set up in Brazil, during the years of the economic miracle, the Minister of Finance quickly realized the dangers of this new instrument and slapped strict restraints on marketing.

However, three years later, when money market funds were introduced in the United States, the authorities did not perceive any potential problems, mainly because the instrument seemed to fall under the jurisdiction of the SEC, rather than the banking authorities.

In order to see systemic risk in a new product or operation, regulators must have multiple jurisdictional understanding, reponsibility, and authority. Because the SEC saw only the risks of investors losing money, they could not perceive the larger threat to the banking system.

The problem was, however, that banks, particularly savings banks, had legal limits imposed as to interest that could be paid on deposits. As the Jimmy Carter stagflation grew during the 1970s, and as asset-backed securities were invented to provide a virtually unlimited supply of short-term debt securities to the new money market fund industry, the position of savings banks became untenable.

Since savings bank assets consisted of long term mortgages with fixed interest rates, they were not able to raise rates on deposits to match the rise in short-term interest spurred by the inflation.

The result was the “great sucking sound” (as Ross Perot might put it) of savings bank deposits being transferred to money market funds.

	Inflation's vortex. A great sucking sound.

Because American officials were not as smart as their Brazilian counterparts and were hog-tied in a tangle of conflicting regulatory jurisdictions, the savings banks were ultimately destroyed by unfair competition from money market funds, leading the savings and loan crisis of the 1980s and 1990s.

Short-term interest rates and inflation

When the first money market fund was set up in Brazil in 1968, the internal rate of inflation was about 25%. Six month to one year commercial paper, in retail denominations, yielded rates of from 28% to 32%. Interest on bank deposits were limited by usury laws.

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As a result, the first money market fund was able to offer rates on what essentially were demand deposits, of about 24% — double commercial bank rates — and still charge an annual “administration” fee of 4% on fund assets! Because there are no capital requirements to manage a money market fund, the potential return on the equity of a money fund manager is virtually limitless. The only limit is marketing ability.

In these extreme circumstances, it is no wonder that the Brazilian authorities saw the dangers posed by the money market fund instrument and drastically reduced marketing options.

Years later, after the prudent ministers of the Brazilian miracle were gone, and as money funds had become popular in the US, the Brazilians copied the American example and allowed money market funds to flourish.

After the Crash of 2008 and the 2009 budgetary madness of the Obama-Pelosi-Reid team, we now look forward to the possibility of inflation rates in the United States to which most Americans have never been exposed. In this context, the regulatory status of money market funds becomes extremely relevant.

With inflation of 25% a year, or more, and with money market funds not subject to bank reserve requirements, the Federal Reserve will be unable to control the money supply.

The reason is simple:

1. At 25% a year inflation, long term bonds become worthless. To cover deficit spending, the Treasury will only be able to sell short term bonds. This will push short-term rates to extreme levels.
2. As the Treasury issues checks to pay for the Obama “spending is stimulus” plan, the money will leave commercial banks to be deposited in money market funds, which will have no reserve requirements and therefore will be able to pay much higher rates of interest than commercial banks.
3. As interest rates rise on short-term paper soar, money market funds will be able to charge higher and higher “administration” fees. With the demise of Glass-Steagall, banks will place depositors money directly in money market funds they control.
4. Without the control of reserve requirements on money market funds, the “multiplier effect” of these virtual banks will kick in, as the public moves money from one fund to another, and inflation will get really serious.

What this means is that unless the government cracks down on money market funds, placing them under virtually the same regulatory regime as commercial banks, including the ability to set reserve requirements that can be adjusted upwards as needed, the United States will be at risk of much higher inflation than many can imagine today.

So, what we must watch is the regulatory moves made on money market funds. So far, from the anti-inflationary point of view, noises made by the administration are not encouraging.

	On the road to Damascus ...

This, of course, is consistent with the Irrationality Axiom which is one of the foundations of Capital Flow Analysis.

The Times article goes on to say,

The shift [in thinking] is significant as the assumption of efficient markets is the cornerstone of calculating the value of everything from stocks to pension fund liabilities to executive compensation. … However, the trend appears to reflect a wider intellectual swing. In the past three decades, the global asset management industry has been dominated by the so-called “efficient markets” hypothesis, which has given birth to ideas such as the capital asset pricing model, that portrays investing as a trade-off between risk and return.

Rejection of the Efficient Market Hypothesis has far reaching implications for the structure and management of capital markets, including Modern Portfolio Theory, the use of betas, the justification for index funds, and the M&M Theories.

See: Fallacies of the Nobel Gods.

I suspect that the British CPAs did not come to change their views suddenly, as a result of the Crash of 2008 or a blinding light on the road to Damascus, but rather, like most of us, came to discover from working in the real world that much that is taught in college is nonsense.

Although billed as one of the most significant reforms of the financial system since the New Deal, most observers are skeptical that substantive change will ensue.

A one-party, slap-dash reform with an Obama brand

The historic models for effective financial reform were the Glass-Steagall Banking Act of 1933, the Securities Act of 1933, and the Securities Exchange Act of 1934.

	Ferdinand Pecora (1933)

The financial market reforms of the New Deal lasted for over fifty years and were emulated in other markets throughout the world. These reforms were based on two years of work by the US Senate Pecora Commission that spanned two administrations and had bipartisan support.

The Pecora Commission received testimony from many sources and findings were well-publicized over a long period, allowing solid public support for real reform to develop.

In contrast, the Obama “reforms” are being concocted in secret, within the US Treasury Department, to be rushed through the Pelosi-Reid Congress, already famous for passing substantial legislation in the dark of night, without even reading the text.

A missed opportunity looms

There is consensus that financial reforms are necessary and that events like the Crash of 2008 are to be avoided in the future.

However, there is no wide consensus as to the root causes of the market failure or what should be done.

To reach such consensus, extensive non-partisan hearings would be required, with hundreds of witnesses and with time allowed for opinion to form as to causes and cures.

The only model we have for financial market regulation are the patchwork of agencies, put together over a half-century ago, when investor demographics and market structure and technology were entirely different from today.

A few basic questions to be explored, not currently being considered, are:

• How to protect investors when responsibility is diluted through a chain of fiduciaries?
• How to prevent financial institutions from becoming too complex to manage and regulate?
• How to adjust the tax code so as to support the interests of long-term investors in an inflationary environment?
• How to protect investors against equity dilution through stock buybacks, options, and mergers and acquisitions?
• How to limit dangerous speculative behavior on the part of depository institutions?
• How to regulate money market funds which have become, in effect, depository institutions?

Undoubtedly, some measures being proposed by the Obama administration will be useful.

However, the opportunity for real reform is likely to be missed.

Capitalism is simply not on the Obama agenda

President Obama was not elected on a platform that endorsed free-enterprise capitalism. Instead, his goals are universal health care reform, “green” energy, support for labor unions, and bigger government.

At the same time, the US Congress, dominated by entrenched fiefdoms supported by gerrymandered districts and rights of incumbents, has financial policy firmly under the control of the very people who were most responsible for the current crisis: Barney Frank and Chris Dodd.

There is no spirit of bipartisanship. Instead, there is a rush to push measures through, willy-nilly, without due consideration or backing from the general public.

President Obama has never given a major speech in defense of free enterprise or the capitalist system. Indeed, he has no roots on this side of the economic spectrum. His political support comes from the extreme left.

It is possible that this could change, but highly unlikely.

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In 2006 and 2007, the net annual flows of foreign investment into US financial assets were $1,831 billion and $1,685 billion, respectively. In Q1 2009, these flows, on an annual basis, had fallen to only $14.4 billion — down 99.2% from the 2006 levels.

These foreign investments, largely the result of the continuing US trade deficit with the rest of the world, have been the essential element in financing US government fiscal deficits, residential mortgages, commercial paper (credit cards, auto loans, etc), and corporate bonds.

Foreign holdings still at all time high

However, despite the retraction in Q1 2009, foreign investment in US financial assets is actually at an all time high. Foreigners simply can not get rid of their massive holdings of US financial assets over night.

Federal Reserve flow of funds table L.102 (Rest of the World), shows foreign investment in US financial assets as $16.8 trillion in Q1 2009, compared to $16.0 trillion in 2007 and ‘only’ $7.7 trillion in 2002.

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The trend indicated by flow of funds table F.107 is a movement from financial securities and bank deposits into direct investments and “miscellaneous assets”, such as real estate. This is a logical reaction to the profligate financial behavior of the Pelosi-Reed Congress and the Obama administration.

The world votes on Obama’s ’spending is stimulus’ plan

Inflation is now widely feared and financial assets like bonds and commercial paper do not offer protection.

As the Obama administration moves forward into even greater deficit spending with its trillion dollar health plan, it would be reasonable to expect foreigners to continue to move away from conventional financial assets, seeking safer havens.

This will drive interest rates upwards and bond prices down, making economic recovery more difficult. Corporations that continue to borrow to support stock buybacks will eventually pay the price — or at least, shareholders will.

	Corporate buybacks ... back from the dead!

So, my earlier article heralding the end of the buyback era seems to have been a bit premature.

Federal Reserve flow of funds statistics for Q1 2009 show that the rise in equity prices in the first quarter of 2009 was due almost entirely to stock buybacks, rather than investor confidence in the future.

The harsh criticism of executive remuneration by the Obama administration and the public in general has thrown fear into boardrooms that this might be the last chance to transfer stockholder funds into their own pockets before pay reforms are introduced.

Stock buybacks dominate a thin market

The Fed flow of funds data for corporate equities show the primary purchasers of equities in Q1 2009 were the Federal government and corporate buyback programs, domestic and foreign.

The Federal government equity purchases were directed mainly to financial institutions — absorbing over 70% of stock issued by this sector.

Corporate stock buybacks were sufficient to support a market rally during the quarter, but volumes were down significantly, compared to prior years.

Furthermore, the market faced significant selling pressure from pension and retirement funds, mutual funds, exchange-traded funds, and broker-dealers.

How buybacks were financed in Q1 2009

Net corporate profits after taxes and dividends in Q1 2009 were only $30 billion on an annual basis. (Federal Reserve Flow of Funds Table F.102)

First quarter corporate buybacks of $297 billion (annual basis) were financed at least 90% by depreciation reserves and by substantial new corporate bond issues.

In view of economic hard times, the de-leveraging of banks, and the wisdom of harboring assets to ride out the current storm, the return of financed buybacks in the midst of the most serious recession in over fifty years, signals an abysmal lack of fiduciary responsibility on the part of American corporate directors and executives.

At the same time, despite talk of regulatory reform, the US SEC has not taken steps to revoke the 1983 Rule 10b-18, granting executives safe harbor from charges of stock manipulation and fraud in connection with stock buybacks.

No signs of a return of investor confidence

Substantial net sales of equities by mutual funds, exchange traded funds, and pension funds during Q1 2009, into a rising market, suggest that although the buyback movement might not be entirely dead yet, its vital signs are, at least, not favorable.

Buyback volume is down at least two-thirds from 2007 levels.

Since even at these reduced levels, buybacks are not supported by corporate profits, but by depreciation reserves and borrowing — one might conclude that the fiscal profligacy of the Obama administration is well matched by the lack of fiduciary responsibility of US corporate boards.

These are indeed interesting times.

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US Treasury Secretary Tim Geithner said that this was an idea meriting consideration (but later recanted).

Columbia University economist Jeffrey D. Sachs wrote in the June 2009 “Scientific American” that the Chinese proposal had “much to commend it” and that “Geithner’s first reaction was right”.

Does this mean that the dollar’s role as the global reserve currency is doomed? Can the economists, central bankers, and IMF band together and decree some alternative “world currency”?

Probably not. Here is why.

What importers and exporters want

The main purpose of a global reserve currency is to serve as the means of payment in international trade. The key decisions regarding international trade are not made by central bankers, the IMF, or economists.

The real decision makers are importers and exporters.

Foreign trade is a two-way street: goods flow one way; money flows in the opposite direction.

Both importers and exporters must agree on the goods to be exported and the kind of money to be paid in exchange.

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Furthermore, the importer must actually have available the kind of money that the exporter wants in exchange for his goods — this is a key point.

How many importers in the United States or Europe are holding fat balances of Chinese Renimbi or Brazilian Reais in their bank accounts? Not many. Fewer still have balances worth mentioning in Mongolian Togrog or Algerian Dinar.

If it were possible to change the means of international payment by decree to a currency (or basket of currencies) other than the dollar, the immediate result would be a sharp decline in world trade — a depressive effect similar to the tariff wars of the 1930s — simply because not enough importers hold enough of these alternative currencies to sustain world trade.

Governments would fall. It just ain’t goin’ happen!

The shortage of non-dollars

Now I know that some people think that if you need to get some Chinese Renimbi or Brazilian Reais you just go down to the local bank and buy some.

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The only unlimited suppliers of Renimbi or Reais are the central banks of China and Brazil. Otherwise, you have to buy these currencies from off-shore residents that have accumulated them as a result of international trade, investment, or tourism.

The problem is that both China and Brazil — and almost every other country in the world except the United States — have a tacit or explicit policy to encourage exports and discourage imports (neo-mercantilism).

Brazil, for example, has an implicit tariff of about 100% on imports.

This means that, other than dollars, most currencies held in foreign hands are in relative short supply.

	Global reserve currencies (from Wikipedia)

For the Brazilian Real to become a world trading currency, the government of Brazil would have to remove economic protection from local industries — so that foreign goods would become competitive on the local market.

At the same time, the Brazilian government would have to somehow find a way to convince foreign suppliers to receive payment in Brazilian currency. (if you know how this could be done, please leave a comment on this article.)

The Anti-Gresham’s Law of global currency

	Sir Thomas Gresham

Sir Thomas Gresham stated in the time of Tudor England that “Bad money drives out the good”. But this is only true if both currencies are required to be accepted as legal tender at a fixed ratio.

There is no “legal tender” in international trade that binds exporters to accept a certain currency that importers may offer in payment.

Instead, there is a free market in which exporters prefer to be paid in what they perceive as the “best” currency, not the weakest.

Electing the “best” currency

Exporters elect the “best” currency based on their own practical experience, observance of the market, and commonsense:

• In how many other countries will exporters accept a certain currency?
• How safe are bank deposits in the country that issues this currency?

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• How well do the laws of the country that issues this currency protect the property rights of foreigners?
• For how many decades has this currency been widely accepted in international commerce?
• Over the last few decades, how well has the central bank of the issuing country protected the value of this currency, compared to other currencies?
• If the exporter (due to problems in his own country) were to move to the country of the other currency, how well would he be received? Would he and his family be comfortable living there? How well does the issuing country receive foreigners?
• How stable is the political and economic system of the issuing country relative to alternatives?

Try to answer each of these question, not in absolute terms, but in terms relative to other currencies — remembering that the currency selected must be issued by a country that is large enough to run a substantial trade deficit to supply enough currency to be relevant in the world economy — without putting the issuing country at risk.

So far, there are only two issuers of currency that even come close to meeting these requirements, the United States and Euroland — and Euroland doesn’t want to run a trade deficit.

How about the International Monetary Fund?

So far, there have been no serious suggestions that the IMF issue legal tender meant to be accepted by exporters throughout the world and that would be widely available in bank checking accounts or by credit card.

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Instead, we have various suggestions that only are relevant to dealings between central banks.

An importer can’t pay an exporters in a check issued in SDRs, nor can the exporter uses this “currency” to pay for a trip to Disneyland.

Professor Jeffrey Sachs (in the above-mentioned article) seemed to like the Chinese proposal for “a more symetrical monetary system, in which nations peg their currencies to a representative basket of others rather than the dollar alone”.

However, this would require abandoning the free market, ignoring the “votes” of real-world importers and exporters, and surrendering national sovereignty to a small international body of over-paid, non-elected economists.

Not very likely to happen any time soon.

Too soon to give up on the dollar

The Crash of 2008 was undoubtedly a world-changing event that severely shook the position of the US dollar.

It also brought about the inauguration of one of the least inspiring (in economic terms) governments since Jimmy Carter.

With wild, irrational spending by the Pelosi-Reid Congress combined with quasi-nationalization of the US auto industry and proposals for massive tax increases to fund medical nirvana and a mystical green, “carbon-free” environment — it is not surprising that the Chinese, Brazilians, and other holders of dollar reserves are nervous — but so are a large and growing segment of the US population.

Moreover, US history suggests that the road forward may not be as dismal as it now seems.

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1. The US holds Congressional elections every two years, and Presidential elections every four years. President Obama is spending his political capital almost as fast as he is spending taxpayer money. Opposition is growing faster than one would have expected. The genius of American Democracy is the ability to “turn the rascals out”. It seems likely that the Obama administration will become weaker with each passing day.
2. The US financial system will probably emerge from the debacle stronger than ever. Capitalism is all about “creative destruction” and the process is already well underway. Things will be different, but not necessarily worse.

Already there are signs that Americans are saving more, credit card use is being cut, lending to the non-credit-worthy is no longer in fashion, leverage is being reduced, stock buybacks are ending … the system is healing itself.

New leaders will come forward.

We’ll see.

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However, this need not be so.

The Congress may reverse course on spending or give the Federal Reserve extraordinary powers to control inflation.

Basically, it comes down to politics — and these are times in which the course of government may change rapidly and unexpectedly — creating great uncertainty.

This heightened uncertainty is bound to be reflected in erratic behavior of the stock and bond markets.

Classic cures for monetary inflation

The type of inflation being ginned up by the Obama administration will be the result of the money supply increasing much faster than the supply of goods and services.

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Note: Even this is uncertain, since with a global economy, in a sense, the supply of goods and services relative to a specific country is much greater than within restricted national borders. As long as the dollar remains the world reserve currency, the US may avoid the worst effects of inflation. However, a profligate US administration is already endangering the dollar’s reputation as a safe haven. Without a strong dollar, the benefits which Americans have seen for the last three generations may fade away.

When people have more money relative to the amount of available goods and services, prices rise and inflation gets underway.

If the amount of money continues to rise faster than the supply of goods and services, inflation becomes endemic.

The cure of inflation is either to increase the supply of goods and services faster than the supply of money, or to reduce the volume of money relative to the supply of goods and services.

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When the government has approved government spending on an order of magnitude far greater than any conceivable increase in the supply of goods and services (as in the case of the Obama Administration), the only way to avoid inflation would seem to be to reduce the supply of money.

There are three ways to do this (which can be done in any combination):

1. Increase taxes.
2. Remove money from circulation by selling government bonds.
3. Increase bank reserve requirements.

The last item I call the “Nuclear Option”.

How government spending creates inflation

When the Pelosi-Reid Congress approved government spending in amounts greater than government income through taxation, the foundation was laid for increased inflation.

The steps to inflation are easy to understand:

1. Congress approves the disbursement of funds for some purpose (war expense, help for homeless children, a “shovel-ready” spending project, etc. — the “worthiness” of the project is irrelevant);
2. Based on Congressional approval, the Treasury Department makes a disbursement of funds by sending a check to the beneficiary (say, the contractor on a “shovel-ready” project);
3. The recipient of the government check (or it could be a money transfer), deposits the funds in a bank account;

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4. The bank clears the check, which goes to the Federal Reserve, creating funds in the bank’s account with the Federal Reserve (Federal Funds);
5. The money supply has now been increased by the amount of the payment made by the Treasury. However, as the beneficiary withdraws funds from the bank account to pay others, who in turn deposit the same funds in their bank accounts, and as the new money circulates throughout the economy, and as these banks, in turn, make loans based on these deposits, eventually there are more bank account balances than the original payment made by the Treasury. (The Multiplier Effect).

Brain surgery with a blunt instrument

The cures for inflation all involve removing money from circulation.

However, the three most likely options are difficult to calibrate.

If too much money is removed, deflation will result; if not enough, inflation will persist. Each option also has unpleasant political and economic side-effects.

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Take taxes, for example.

In the United States, only about half of the population pays income taxes. Those that create jobs are among that portion of the population that pay most taxes. Consequently, to increase taxes not only fails to remove money from those who don’t pay taxes, but tends to discourage those that create jobs — thereby increasing unemployment.

The result is stagflation.

The possibility of removing money from circulation by selling government bonds is limited by the number of investors that actually have money available for such a purpose.

If government spending is sufficiently excessive (as in the case of the Obama administration), the potential for inflation reduces the appeal of investment in government bonds (fear of inflation), while the shortage of funds available for this purpose, leads to higher and higher interest rates, which, in turn, acts as a brake on business expansion.

Again, the result may be stagflation

The Nuclear Option: Increasing bank reserve requirements

Finally, we have the Nuclear Option — increasing bank reserve requirements — which is essentially a way to limit banks’ ability to earn money on bank deposits, decreasing bank profits while impacting the availability of credit.

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The Federal Reserve has the power to require banks and depositary institutions to increase or decrease the percent of various classifications of liabilities that must be deposited as cash with the Federal Reserve in a non-interest-bearing account.

(Recently, the Fed was given power to pay interest on such accounts).

Congress has the power to increase or decrease the limits for reserve requirements that may be set by the Federal Reserve, and also to re-define the institutions that may be required to maintain reserves with the central bank.

(For example, Congress could pass a law requiring money market funds to maintain deposits with the Federal Reserve Bank.)

Prior governments that had economic policies similar to those of the Obama administration — the Roosevelt government of the Great Depression and the Jimmy Carter Presidency — both took measures allowing higher bank reserve requirements.

	Jimmy Carter signing the Monetary Control Act of 1980

In both the administrations of Jimmy Carter and Franklin Roosevelt, bank reserve requirements were modified during economic hard times.

In the case of Jimmy Carter, the country passed through a period of stagflation.

In the case of FDR,bank reserve requirements were increased during the Great Depression, resulting in deflation and a prolongation of hard times long after the rest of the world had recovered.

See: Reserve Requirements: History, Current Practices, and Potential Reform.

Undoubtedly, if bank reserve requirements were set high enough and applied to enough institutions (banks, broker-dealers, money market funds, foreign bank branches, etc.), it might be possible not only to stop inflation dead in its tracks, but also to eliminate interest costs that future generations might have to bear for Congressional profligacy.

Political limits on fighting inflation

The best defense against inflation is for Congress not to spend too much in the first place.

Once excessive spending has been authorized and inflation gains the upper hand, governments often fall.

It often takes a change of government to stop bad behavior — however, this usually occurs only when economic conditions read the nadir — and the US is not there yet.

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In the United States, Congress has greater control of the economy than the Federal Reserve.

Only Congress can authorize excessive spending or grant the Federal Reserve sufficient powers to control inflation once the economy gets out of hand.

Chairman Bernanke doesn’t have a Wizard Hat that will allow him to wave a wand and cure the economic sickness caused by a bad Congress.

It would be unusual for the same Congress that had approved spending that led to inflation to change course and either cancel appropriations already authorized or to give sufficient powers to the Federal Reserve to risk cutting off recovery, in order to control inflation.

Under current legislation, the Fed’s powers to exercise the Nuclear Option (increasing reserve requirements) are limited by the fact that money is able to flow into non-bank lending institutions, such as money market funds, that are not subject to bank reserve requirements.

Inflation seems the most likely outcome

Although the popularity of President Obama has been falling, the decline has not been fast or steep enough to reasonably expect that the Democrats might lose control of Congress in 2010 or that President Obama might not be reelected in 2012.

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Without a change in government in the near term,it seems highly unlikely that the United States will be able escape the logical inflationary consequences of profligate Pelosi-Reid Congress and the Obama administration.

The worst period of inflation can be expected to start soon after funds appropriated under the various stimulus packages begin to result in large bills actually being paid by the US Treasury Department, the logical consequence of current appropriations.