A Measured View of a Difficult Week and the Markets

By Michael E. Lewitt, Special Contributor, Money Morning

January 11, 2015

France's 9-11 should remind investors that the world sits atop a precarious geopolitical perch. Madmen with guns have the ability to wreak enormous damage on the fabric of society, which in turn places the stability of markets at risk.

Last week's tragic events in Paris are likely to impose significantly greater security costs on Western societies while leading them to question the open borders that feed immigration and trade, two keys to the future economic growth that will be necessary to dig out of the deepening debt hole they have dug themselves.

Depending on the response, jihadists could win a bigger victory than they imagine if Western governments surrender to their worst fears…

What the Fed Hasn't Learned About Keynes

Markets ran in a parallel universe while events unfolded in France during the week. That universe was one in which central bankers continued to act as the puppeteers and stock market investors jigged and jagged as former tenured economics professors yanked the strings. If the first full trading week of the year was any indication of things to come, investors are in for a wild ride in 2015. The January 7 release of the minutes of the December FOMC meeting led to a bout of frenzied buying that ended four straight days of selling going back to December 30.

While there was little of note in the minutes, markets took the absence of any warnings of imminent rate increases as permission to pile back into stocks despite further oil price declines and more bad economic news from Europe, China and Japan.

Then, on January 8, Chicago Fed President Charles Evans, who would probably never raise interest rates again if he had his way, declared that an interest rate hike would be "catastrophic" – he actually used that word, "catastrophic" – because "official" inflation was running at only about 1.5% rather than at the Fed's 2% target.

One has to wonder what qualifies an individual to become a Fed governor. Perhaps it is a belief in the ability of a group of academics to micromanage the most complex economy that has ever existed in the history of mankind. Or perhaps it is the ability to ignore the fact that the Fed has rarely if ever accurately forecasted the path of the economy or any of its key components such as GDP growth or inflation.

Certainly it must include the ability to forget that only a decade ago the Fed led the economy down precisely the same path it is leading it down today when it left interest rates too low for too long, allowing a housing bubble to form that nearly destroyed the global economy.

Whatever Mr. Evans' credentials and those of his colleagues, their performance demonstrates beyond a shadow of a doubt that they are uniquely unqualified for the task at hand, are far behind the curve, have no clue what is happening in the real world in terms of the market bubbles that have formed, and are leading us straight to another crisis.

We don't need cowards with guns who call themselves jihadists to destroy us. Central bankers are doing the job on their own. As John Maynard Keynes wrote, "there is no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction and does it in a manner which not man in a million is able to diagnose."

He learned that, by the way, from a terrorist – Lenin. If the jihadists really want to destroy the West, they should stop reading the Quran and start studying The General Theory of Employment, Interest and Money. Stock market investors haven't figured out what's going on yet, however, so they are only too happy to follow Mrs. Yellen & Co. over the cliff while Wall Street strategists who are paid to lie are urging them to pile in for what they think is going to be another year of gains. If the market is to go up, it will do so in the face of a global economic slowdown, plunging commodity prices, a highly deflationary dollar rally, and increasing geopolitical risks. Unless you are a trader who is in a position to get out of your positions quickly or someone who has hedged your positions against a sharp correction or a bear market, you are playing with fire.

By the Numbers

Last week, the Dow Jones Industrial Average lost 96 points or 0.5% to close at 17,737.37 while the S&P 500 dropped 13 points or 0.65% to end the week at 2,044.81. The Nasdaq Composite Index, which seems hell-bent on breaking its Internet Bubble era record in the Social Media era, shed 23 points to 4704.47. The most sustainable market moves came in bonds where the yield on the benchmark 10-year Treasury dropped below 2% to close at 1.975%. The yield curve is continuing to flatten, a sure sign that the U.S. economy is likely to struggle in the year ahead.

The government may be churning out strong GDP numbers, but those numbers are statistical manipulations that belie underlying weakness in demand, a growing inequality gap, trumped-up corporate earnings, and the ever-increasing weight of public and private sector debt that is suffocating growth.

As low as bond yields are in the U.S., they are virtually microscopic in the rest of the world.

Most of Europe's short-term yields (2-5 years) have moved into negative territory while Germany's 10-year yields closed the week at 0.49%. Spanish and Italian yields finished at 1.71% and 1.87%, respectively. In Japan, where the sun is the only thing that is rising, 10-year yields are down to 0.26%. A 1.975% U.S. 10-year yield looks rich in comparison and will continue to draw buyers until it is driven much lower.

Even a BRIC nation like Brazil, which has serious problems, has a 10-year yield of only 4.17%.

This is the outcome of Ben Bernanke's and now Janet Yellen's unprecedented experiment in monetary policy to drive down interest rates to the point where the only thing investors can do with their money is lose it by investing it in risk assets.

That leaves the S&P 500 with a total capitalization-to-GDP ratio of almost 2.0x the mean (1.27 versus a mean of 0.65) and a Shiller/CAPE P/E ratio of 27x versus a mean of 16.6x against the backdrop of a flattening yield curve and a Fed likely to start raising short interest rates by the middle of the year (and if it doesn't, what does that say about the state of the economy?).

The Fed is in a straitjacket of its own creation. The December jobs report showed that the economy keeps creating 250,000 jobs a month and that the unemployment rate is now down to 5.6% (just 0.3% away from the Fed's 2015 year-end target of 5.3%) while U6, the all-in rate, fell to 11.2%. Of course, these numbers were flattered by a further drop in the labor participation rate to 62.7%, the lowest since 1977, but Fed policy can do nothing about that.

Obviously the numbers have not yet seen an impact from job losses in the oil and gas sector, but they will come soon enough. Originally the Fed had set 6.5% as the target at which it would start considering raising rates, but who are we to quibble? One disappointing statistic was a 0.2% drop in average hourly earnings as income inequality continues to widen.

Central Banks Can't Pilot a Smooth Landing

The refusal of the Fed to begin normalizing interest rates suggests either that it truly believes it can micromanage the economy to a smooth landing (which experience dictates it cannot) or it is terrified (as Charles Evans suggested) about the effects of higher rates on the economy.

With respect to the latter point, the economy can likely sustain 100-200 basis points of higher rates without much negative effect. Markets, however, are another matter. If stock markets are going to skyrocket every time the Fed hints at a delay in raising rates, as it did in mid-December and again last week, one has to wonder how hard it will sell off when the fateful day finally arrives and the Fed announces its first 25 basis point hike in the Fed funds rate. Despite all the brave talk by the Happy Faces on CNBC that such a move would indicate economic recovery and confidence in the future on the part of the Fed, stock market investors could well interpret the news as a sign that the party is over.

With stocks trading at levels only seen before prior market crashes, this may be what Mr. Evans was really trying to say when he said that an interest rate increase would be "catastrophic." But it is time for the Fed to stop protecting the stock market from itself and let free markets reign.

There may, after all, be some smart jihadist out there who understand what Keynes (and Lenin) were saying and are enjoying watching us destroy ourselves. Maybe their attacks only accentuate the real war that we are waging on ourselves.

Up and Down Wall Street

Fed Versus the Market: Which Is Right About Inflation?

FOMC deems oil price plunge “transitory” while slide in longer-term Treasury yields suggests something more enduring.

By Randall W. Forsyth   

January 8, 2015

Whom are you going to believe? The markets or the Federal Reserve?
Minutes of the Dec. 16-17 meeting of the Federal Open Market Committee released Wednesday suggest the policy-setting panel has greater confidence in its forecasts of inflation than that of the markets. That’s even though the Fed has consistently overestimated the strength of the economy and price pressures.
Specifically, the FOMC contrasted the plunge in market-based measures of future inflation expectations with those derived from surveys and econometric models. Since the markets’ determination contradicted that of the surveys and models, the committee discounted the former and concluded it would take more time and study to determine which was right.
Participants in the confab attempted to hash out whether the drop in anticipated inflation was real or an artifact of markets that are supposed to provide a window into expectations. The most prominent is that for Treasury Inflation Protected Securities, or TIPS.
As the economist Irving Fisher posited more than a century ago that interest rates consisted of a “real” return plus a compensation for the effect of future inflation. The real and inflation components of interest rates used to be discernable only in retrospect after gauges such as the consumer price index were calculated and published.
That changed with the introduction of inflation-indexed securities. The U.S. was relatively late to offer TIPS in the late 1990s, more than a decade after the U.K. and other sovereigns had started selling their versions. TIPS pay a real interest rate with their principal adjusted for the rise in the CPI.
Thus, the real and inflation components of Treasury yields could be deconstructed. By subtracting the real yield on TIPS from that of comparable-maturity regular Treasury securities, one could infer the market’s expectation of the inflation component of long-term interest rate from what came to be called the “TIPS spread.”
The FOMC cast doubt that it was an apples-to-apples comparison, however. Despite both TIPS and regular Treasuries being full faith and credit obligations of the U.S. Government, the latter have unique attributes, notably being the single most liquid and accepted financial instrument on earth.
That is worth a premium price, which lowers Treasuries’ yields a few basis points (hundredths of a percentage point.) In turn, that shrinks the TIPS spread correspondingly, and thus reduces the implied inflation premium.
But that effect is trivial compared to the collapse in inflationary expectations in the past half year.

That time span, not coincidentally, encompasses the time since crude oil prices have collapsed by half, from over $100 a barrel to under $50.
Back in mid-June, when oil peaked, the 10-year TIPS spread --representing the implied inflation forecast for the next decade -- was around 2.2%. That could be discerned from the 10-year T-note yielding about 2.60% and the comparable TIPS yielding about 0.40%.
By Wednesday’s close, the benchmark 10-year Treasury yielded 1.99% while corresponding TIP yielded 0.39%. That gives a TIPS spread of 1.6%, suggesting a sharp drop of 60 basis points in longer-run inflation expectations.
The FOMC doesn’t believe it. That’s because forecasts derived from consumer surveys and mathematical surveys don’t corroborate the decline that drop in inflation actually will happen.
That 1.6% inflation forecast also is significantly below the Fed’s target of 2%. Granted, the Fed’s favored measure isn’t the headline CPI but the personal consumption expenditures deflator. Leaving aside the mind-numbing differences between the two gauges, the important thing is the PCE deflator tends to run a few tenths of a percentage point lower than the CPI.
And the Fed focuses on “core” prices, which omit food and energy prices. Consistent with that, the FOMC minutes emphasized the impact of the drop in the cost of oil and gas was expected to be “transitory.”
What that means isn’t entirely clear. Does it imply that, if crude still is down around $50 a year from now, the annual change in energy costs will be nil? Or does it mean oil and gas prices are apt to rebound, if not all the way back to their peaks, then maybe half-way?
Whatever the case, the consumer surveys and models say the current low prices won’t last and inflation will revert to 2%-plus. That’s the Fed’s forecast and FOMC members’ expectations that the fed funds rate will rise to 3.75% in the long-term. The target federal-fund’s rate is now zero-0.25%.
Mr. Market avers. Not only does he see lower inflation ahead, he also sees a much more subdued liftoff in the fed funds rate.
According to the Chicago Mercantile Exchange’s Fed Watch web site, the fed-funds futures market was giving just under even-money odds of a hike to 0.50% by the July 29 FOMC meeting. The more likely timing of the initial hike is the Sept. 17 get-together, to which the futures gave a probability of 63%.
That’s also the timing seen by the Goldman Sachs economics team led by Jan Hatzius. Their forecast for a later liftoff than seen by the consensus reflects the chance inflation will fall significantly lower, perhaps as low as 1% on the core PCE, the Goldman economists write. That could delay the first rate hike until 2016, they conclude.
The Goldman team point out their forecast for inflation is well below the consensus and the FOMC. But it is in line with that of the market.
So, whom are you going to believe? The determination of the market, which is the distillation of millions of opinions of players who have put money on the line? Or survey respondents, for whom talk literally is cheap, or the Fed’s impersonal computer models?
The market has surprised the best and the brightest in bringing down interest rates and inflation expectations. That includes the Fed.

Europe’s Lapse of Reason

Joseph E. Stiglitz

JAN 8, 2015

Angela Merkel and Andonis Samaras

NEW YORK – At long last, the United States is showing signs of recovery from the crisis that erupted at the end of President George W. Bush’s administration, when the near-implosion of its financial system sent shock waves around the world. But it is not a strong recovery; at best, the gap between where the economy would have been and where it is today is not widening. If it is closing, it is doing so very slowly; the damage wrought by the crisis appears to be long term.

Then again, it could be worse. Across the Atlantic, there are few signs of even a modest US-style recovery: The gap between where Europe is and where it would have been in the absence of the crisis continues to grow. In most European Union countries, per capita GDP is less than it was before the crisis. A lost half-decade is quickly turning into a whole one. Behind the cold statistics, lives are being ruined, dreams are being dashed, and families are falling apart (or not being formed) as stagnation – depression in some places – runs on year after year.

The EU has highly talented, highly educated people. Its member countries have strong legal frameworks and well-functioning societies. Before the crisis, most even had well-functioning economies. In some places, productivity per hour – or the rate of its growth – was among the highest in the world.

But Europe is not a victim. Yes, America mismanaged its economy; but, no, the US did not somehow manage to impose the brunt of the global fallout on Europe. The EU’s malaise is self-inflicted, owing to an unprecedented succession of bad economic decisions, beginning with the creation of the euro. Though intended to unite Europe, in the end the euro has divided it; and, in the absence of the political will to create the institutions that would enable a single currency to work, the damage is not being undone.

The current mess stems partly from adherence to a long-discredited belief in well-functioning markets without imperfections of information and competition. Hubris has also played a role. How else to explain the fact that, year after year, European officials’ forecasts of their policies’ consequences have been consistently wrong?

These forecasts have been wrong not because EU countries failed to implement the prescribed policies, but because the models upon which those policies relied were so badly flawed. In Greece, for example, measures intended to lower the debt burden have in fact left the country more burdened than it was in 2010: the debt-to-GDP ratio has increased, owing to the bruising impact of fiscal austerity on output. At least the International Monetary Fund has owned up to these intellectual and policy failures.

Europe’s leaders remain convinced that structural reform must be their top priority. But the problems they point to were apparent in the years before the crisis, and they were not stopping growth then. What Europe needs more than structural reform within member countries is reform of the structure of the eurozone itself, and a reversal of austerity policies, which have failed time and again to reignite economic growth.

Those who thought that the euro could not survive have been repeatedly proven wrong. But the critics have been right about one thing: unless the structure of the eurozone is reformed, and austerity reversed, Europe will not recover.

The drama in Europe is far from over. One of the EU’s strengths is the vitality of its democracies. But the euro took away from citizens – especially in the crisis countries – any say over their economic destiny. Repeatedly, voters have thrown out incumbents, dissatisfied with the direction of the economy – only to have the new government continue on the same course dictated from Brussels, Frankfurt, and Berlin.

But for how long can this continue? And how will voters react? Throughout Europe, we have seen the alarming growth of extreme nationalist parties, running counter to the Enlightenment values that have made Europe so successful. In some places, large separatist movements are rising.

Now Greece is posing yet another test for Europe. The decline in Greek GDP since 2010 is far worse than that which confronted America during the Great Depression of the 1930s. Youth unemployment is over 50%. Prime Minister Antonis Samaras’s government has failed, and now, owing to the parliament’s inability to choose a new Greek president, an early general election will be held on January 25.

The left opposition Syriza party, which is committed to renegotiating the terms of Greece’s EU bailout, is ahead in opinion polls. If Syriza wins but does not take power, a principal reason will be fear of how the EU will respond. Fear is not the noblest of emotions, and it will not give rise to the kind of national consensus that Greece needs in order to move forward.

The issue is not Greece. It is Europe. If Europe does not change its ways – if it does not reform the eurozone and repeal austerity – a popular backlash will become inevitable. Greece may stay the course this time. But this economic madness cannot continue forever. Democracy will not permit it. But how much more pain will Europe have to endure before reason is restored?

Read more at http://www.project-syndicate.org/commentary/european-union-austerity-backlash-by-joseph-e--stiglitz-2015-01#v9vCEWxdbvj11Wvy.99


The Chinese Empire’s Burning Peripheries

Crackdowns in Hong Kong and Xinjiang threaten Taiwan—and regional peace.

By David Feith

Jan. 6, 2015 1:19 p.m. ET

Hong Kong democrats with yellow umbrellas in January 2014.  Hong Kong democrats with yellow umbrellas in January 2014. HongKong/Reuters

China’s paramount leader Xi Jinping frequently says that China is pursuing “peaceful development.” On a trip to France last year, he described his country as “peaceful, pleasant and civilized.” But 2014 saw the rhetoric of peace wearing thin.

That’s not only because Beijing is muscling for territory as far afield as Malaysia and Indonesia. Closer to home, the discontents of Chinese empire are mounting and its peripheries are burning.

China’s leaders have decisions to make in every direction, and recent evidence suggests they may not choose compromise anywhere. Which means that fear and loathing of Beijing will likely increase among tens of millions of people, that the Communist Party will face growing challenges to its reputation for “harmonious” and prosperous rule, and that after years of quiet the Taiwan Strait may become the world’s most dangerous flashpoint.

Start with Hong Kong. After police tear-gassed peaceful pro-democracy protesters in September, 200,000 people flooded into the streets. For 75 days, umbrella-wielding demonstrators occupied downtown streets to defend the liberties and institutions that China promised they could keep after British rule ended in 1997.

Unless Chinese leaders reverse course and grant Hong Kong the universal suffrage that was promised, China’s most international city—and still its leading financial center—faces a future of raucous protest and paralyzed government. Beijing may prefer that outcome to allowing seven million Chinese subjects to pick their own leaders. But it entails risks, from democracy advocates on the mainland drawing inspiration from Hong Kong’s struggle, to foreign investors losing trust in the city’s courts and regulators.

The gravest implications concern Taiwan, the democratic island that is growing more determined never to live under Beijing’s authoritarian control. China has claimed sovereignty over Taiwan since 1949 and tied its fate to Hong Kong’s since the 1980s, when Chinese supremo Deng Xiaoping promised that both territories would keep their freedoms under Beijing’s rule.

“We have proposed to solve the Hong Kong and Taiwan problems by allowing two systems to coexist in one country,” he said.

This formula has failed to protect civil liberties in Hong Kong—which helps explain why Taiwan last year experienced its own anti-China political earthquake. In March the so-called Sunflower Movement blocked a trade deal with China by bringing 600,000 people into the streets and occupying the legislature for 24 days. Protesters said the deal wasn’t transparent and would make Taiwan’s economy dangerously dependent on China.

In November, midterm elections handed the Beijing-friendly ruling party its worst-ever defeat, a powerful verdict against six years of increasing economic integration with China. The opposition, which has previously called for formal independence from China and is hated in Beijing, is expected to win the presidency in January 2016.

That would end the calm that has prevailed across the Taiwan Strait since 2008. Gaining control of Taiwan is the chief item of business left unfinished from Mao’s revolution and remains the focus of Chinese military modernization. China would prefer for Taiwan’s 23 million people to unify voluntarily, but Beijing regularly warns that it “will not abandon the possibility of using force,” as retired Gen. Liu Jingsong said last month. Xi Jinping said in 2013 that “these issues cannot be passed on from generation to generation.”

If Beijing responds to the rise of Taiwan’s opposition by trying to intimidate Taiwanese voters economically or militarily, China would threaten peace in East Asia. Given those stakes, it’s concerning to see how Beijing treats other perceived domestic irritants thousands of miles away in China’s western borderlands.

Though it barely registers on international radar, the northwestern region of Xinjiang is twice the size of France and could become China’s Chechnya. The homeland of roughly 10 million Turkic Muslims known as Uighurs, Xinjiang is a battleground between a central government intent on control and a native population seeking to preserve distinct traditions. In recent decades Beijing has flooded the region with Han Chinese, discouraged or criminalized Muslim worship, and treated Uighur activists as separatists or terrorists.

This repression radicalizes Uighur discontent, which now appears to have spawned the terrorism Beijing always feared. In the past 15 months, explosions and knife attacks have killed scores of people in train stations, markets and even Beijing’s Tiananmen Square. Clashes involving Xinjiang police have killed more than 100.

Beijing’s response is tougher and broader repression in Xinjiang. More bans on Muslim veils and beards in public, more closures of Uighur-language schools, more limits on Uighur travel.

More family-planning restrictions and forced abortions. More discrimination against Uighurs seeking work in local government or state energy firms (Xinjiang has China’s largest coal reserves and 20% of its oil).

In September a Beijing court sentenced Prof. Ilham Tohti, the country’s most prominent Uighur spokesman, to life in prison on separatism charges for which no evidence has been publicly presented. Seven of his students were imprisoned for shorter terms on the same charges.

Tighten the screws, refuse compromise, destroy moderates, alienate the next generation: While the implementation in Xinjiang is far more severe, this is the same playbook Beijing is using in Hong Kong, and it’s typical of the authoritarianism that makes Taiwan hold tight to self-rule.

Such tactics have often fostered fury at the edges of empires, making them more volatile than they appear. The past year is a warning that China is no exception.

Mr. Feith is a Journal editorial writer based in Hong Kong.

January 9, 2015 4:48 pm

Europe’s deflation risk leaves no option but quantitative easing

The ECB must now go full speed ahead to prevent the slide in prices

Long time exposure photo shows a tram passing by the Euro sculpture in front of the European Central Bank in Frankfurt, Germany, Monday, Oct. 27, 2014. (AP Photo/Michael Probst)©AP
Inflation data for the eurozone confirmed this week what we already know. Even abstracting from the effects of oil, the core rate of price rises remains perilously close to zero — and inflation expectations remain frighteningly low. In this context, it is more urgent than ever that the European Central Bank pushes ahead with the strongest form of quantitative easing it can muster.
That will not be easy. As well as continued scepticism from the Bundesbank and the German government, the ECB is facing the prospect of a ruling next week from the European Court of Justice that may restrict its ability to purchase sovereign debt outright. Mario Draghi, the ECB’s president, is having a tricky enough time with the economics and politics of QE without having to tiptoe round the constitutional law. Nonetheless, he should aim to use whatever freedom of manoeuvre he has to expand outright purchases of government bonds.

True, QE is by no means guaranteed to produce growth and stable positive inflation. There are good reasons to think that an operation in the eurozone will have more difficulty getting traction than in the US or the UK. QE is already priced into the market, suggesting that any plan will have to be spectacular to jolt expectations of inflation and growth upwards.

Moreover, buying eurozone government bonds with their low yields may have a limited effect on private willingness to borrow and spend. If the ECB is forced to delegate the bond purchases to the individual national central banks, fears about their future solvency could increase rather than decrease risks in the periphery.

What the ECB should be doing is financing a fiscal expansion, not pushing valiantly on what may turn out to be a monetary policy string. Those rock-bottom bond yields (with the exception of Greece) are practically begging governments to borrow and spend. The position of the German economic establishment is indefensible: it refuses to undertake a fiscal expansion itself while trying to hamstring a less effective central banking substitute.

The eurozone has been faced with two big challenges over the past five years and, thanks to the poor design of the currency union, it has responded with the wrong tool each time.

The response to the sovereign debt crisis in the periphery between 2010 and 2012 should have included the central bank clearly standing behind government borrowing across the eurozone.

Instead, governments, the EU and the International Monetary Fund painfully pieced together a clumsy crisis lending operation which responded slowly and weakly. Only when Mr Draghi took over as ECB president in 2011 and issued his famous plea to do “whatever it takes” the following year did the risk of eurozone-wide contagion recede.

With the threat having now shifted to deflation, the position has been reversed, and the ECB is forced to try to make up for the shortcomings of its fiscal counterparts. Given his limited options, Mr Draghi is right to push ahead with QE. The balance of risks strongly argues for trying tool after tool until finding one that works. But it should not necessarily be regarded as the ECB’s fault if it fails to jump-start the economy.

The eurozone cannot go on as it is. Growth is weak to non-existent; there is a chronic deficiency of demand which is turning acute; the risk of pervasive and persistent deflation only continues to grow.

The ECB is one of the few institutions in Europe that seems willing to try to arrest the slide. It should go full speed ahead.

January 8, 2015 3:28 pm

Blame the rise of the plutocrats on politics not capitalism

Put simply, the economy is run by the rich for the rich, writes Paul Marshall

It is easy to complain about modern capitalism. It is not so easy to offer a real alternative — and when critics of the western economic order, from Thomas Piketty to comedian-turned-revolutionary Russell Brand, fail to do so they are often dismissed. Perhaps we (or they) have been asking the wrong question.
There may be no proven alternative to capitalism writ large. But there are stark choices, nonetheless, for there are different kinds of capitalism. What makes many people uneasy is that Anglo-Saxon capitalism is heading towards a plutocratic model. The economy is run by the rich for the rich.

It is corporate executives — not sports people, celebrities or creatives — who dominate the ranks of the top earners. In 2013, the average chief executive in the US earned $11.7m, 331 times the average US worker.

They are big winners from the rigging of the financial markets. In the past five years the US Federal Reserve has pumped more than $3.5tn into bond markets, driving down the benchmark rate and increasing the price of many other assets. Across the world, equity market capitalisation has risen by more than $18tn. Quantitative easing may have been a necessary evil, but the way it was done favoured a small cadre. For a corporate executive, awarding yourself a generous option scheme has been a lucrative no-brainer. Asset managers and hedge funds have benefited too.
The windfall gains in income and wealth could have been offset by fiscal measures, as they have been to a degree in the UK. But there seems little danger of that in the US, where corporate lobbyists have captured Congress.

Education ought to be the great leveller. But in the US it too is run for the rich. Schools are funded through local taxation, so well-heeled neighbourhoods get well-heeled schools, while poor ones are left behind. University places can be assured through timely “donations”.

The corrosion of US capitalism matters enormously because the US is still the lodestar of the world economy. It is hard for other western countries to resist US trends in taxation or pay.
Joseph Schumpeter, an Austrian émigré to the US, foresaw much of this. He shared with Karl Marx the insight that capitalism would eventually be the victim of its own success. Marx called it the “principle of infinite accumulation”. As successful companies became monopolies and wealth disparities widened, the bourgeoisie would become their own gravediggers. Schumpeter saw the problem more in terms of the stifling of innovation, as large companies became too dominant and vested interests prevented the process of “creative destruction”. Marx sought the demise of capitalism, but Schumpeter was a believer. His warnings matter.

We live in an age when, thanks to the power of the in­ternet and technology, Schumpeter’s ideal of disruptive capitalism has never been closer to realisation. Yet this disruptive age coincides with a consolidation of privilege, which risks undermining the legitimacy on which the system depends.

The fact that the plutocratic version of capitalism has gained ground is not a failure of capitalism but a failure of politics. Monopoly and privilege need to be challenged. US president Theodore Roosevelt may have been the last politician to understand this and act on it. He took on the wealthy and powerful.

Former UK prime ministers Tony Blair and Gordon Brown were bamboozled by bankers. US presidents have been reluctant to take on Wall Street or big business. George Osborne, the British chancellor, understands the importance of an enterprise economy but has a blind spot when it comes to the privileges of inherited wealth.

Ed Miliband, leader of the opposition Labour party, is much more interested in Marx than Schumpeter. What British and American capitalism needs, if it is to remain credible in the 21st century, is more of the Austrian, not the German.

The writer is chairman of Marshall Wace, a London-based hedge fund

A 2014 Gold Investors Year In Review: Cracks In The International Order Appear

  • We think 2014 will be remembered for major events that are breaking down the current international order.
  • US and Russian relations hit their lowest point since the Cold War and there is no sign of improvement.
  • In the Middle East, ISIS threatens the status quo even as oil plummets and savages oil-producer revenues.
  • Populist groups in Europe are emerging, with the most notable event being the upcoming Greek elections that could break up the European Union.
  • Despite gold not doing much in terms of price in 2014, investors will want to own gold in 2015 if we see further turmoil.
"It is historians who retrospectively portray the process of imperial dissolution as slow-acting, with multiple over determining causes. Rather, empires behave like all complex adaptive systems. They function in apparent equilibrium for some unknowable period. And then, quite abruptly, they collapse."
-Historian Niall Ferguson Complexity and Collapse: Empires on the Edge of Chaos
While many analysts and prognosticators may remember 2014 as the year that the Fed ended its massive quantitative easing program without consequences to the markets (it didn't as the Fed is still reinvesting its balance sheet), or the global economy continued its slow recovery process as the US surged, or that stock markets continued their climb to all-time highs, or even that Ali Baba (NYSE:BABA) opened itself up to the world. We think that 2014 will best be remembered as the year that the international order that we've had since the fall of the Soviet Union, started to crack.

Investors do not need to look hard to see major political events that seem to be breaking up the status quo and separating nations. The quote we opened this article with from Harvard professor and historian Niall Ferguson, suggests that if we're correct then we can see a break-down in the international order much sooner than anybody expects.

Of course this should interest all market participants as the implications of a major change in the global system will affect all kinds of investments, but for gold investors it is even more important. Gold is the currency and investment that one makes in times of financial chaos as it is the only currency (if held in physical form) that is not dependent on any other counter-party. Investors should remember that gold was one of the only assets that increased in value in 2007 and 2008 during the financial crisis.

Looking back on 2014 we think it will be remembered as the beginning of the end of the current international order. While this doesn't mean that we'll be living in caves and eating canned beans, it does mean that some major changes are coming in 2015 and years ahead, which investors should be prepared for and will get into later in this piece.

In terms of price action, we didn't see much from gold in 2014 as it essentially treading water for the year and ended the year with a slight 2% loss (though it certainly was volatile).

Though we do note that gold actually did extremely well when compared to other currencies.

Source: US Global Investors

But as we stated earlier, the significance of the year was in the nature of the geopolitical events that we saw around the world. In our opinion, these events are showing that our world is becoming more fractured and split - the opposite of the globalization and integration that we've seen over the past few decades.

The Ukrainian Civil War and Demonization of Russia

First and foremost, we cannot cover 2014 without mentioning the collapse of the Ukrainian government. While Ukraine in itself is a non-relevant player on the global scene, the collapse of the Ukrainian government was really the escalation in the proxy war between Russian and the United States. The results of this led to the capture/liberation (depending on your politics) of Crimea and then the escalating sanctions by the US and Europe on Russia.

These events were probably the greatest in terms of future impact to the world order as it now actively pits Russia against the US - each will actively work to destabilize the other and use proxies and alliances all over the world to do so. In our weekly gold investment letter we covered a very interesting recent visit by STRATFOR's George Friedman into Russia that covered many of these issues based on the Russian point of view. There are many takeaways but maybe the most important is that Russians believe that this is clearly US aggression and that Putin is much more secure than the West believes - we don't think there will be any backing down here despite the weak economic conditions in Russia.

Neither do we see the US backing down, so this is a formula for a continued downward spiral in these relations - leading to competition across the globe to weaken the other. Investors should remember that the greatest attack that Russia can make against the US is to attack the US Dollar - and we think that is what they have been doing and will continue to do. The more deterioration in the Russian economy, the more incentive that Russia has to do something rash - after all there isn't much for them to lose.

This brings us to…

Oil, ISIS, and the Middle East

Sometimes it is hard to take an unbiased look back and remember how obscure something was that isn't obscure today. The Islamic State group ("ISIS") fits perfectly into that category.

As investors can see from a Google Trends search term popularity graph, at the beginning of 2014 there really was very little interest or knowledge about ISIS. Obviously, throughout the year that changed.

ISIS was another major event of 2014, which we think reflects more cracks in the international order. It is our belief that ISIS is not the cause of the problem, but rather, a symptom. It wasn't very long ago (2010-2011) that we saw the "Arab Spring" in the Middle East change the political landscape as many ordinary citizens revolted against years of oppressive regimes. Well, that Arab Spring ended with quite a thud as most of the countries have returned to a status quo of dictatorships, with some even more (such as Egypt) more brutal than ever.

But it's tough to bottle backup freedom after it has been released, and that's where radical groups like ISIS come in - they appeal to the frustration of the masses and offer an approach of violence as the only alternative to win back freedom. That's why we say ISIS is a symptom of a greater problem and not the cause, and this is extremely relevant because if it is a symptom than that means that even if ISIS is destroyed or falls apart, another similar group will take its place until the cause is removed.

Geopolitically that means that change will come as regimes are brought down. To further that prediction, the collapse in oil prices to around $50, will lead to more budgetary havoc in the Middle East, further radicalizing people and weakening the strangleholds on power that these regimes hold. Doubleline's Jeff Gundlach expressed his concerns in a recent interview:
Oil is incredibly important right now. If oil falls to around $40 a barrel then I think the yield on ten year treasury note is going to 1%. I hope it does not go to $40 because then something is very, very wrong with the world, not just the economy. The geopolitical consequences could be - to put it bluntly - terrifying.
We don't think it has to go to $40 to have terrifying consequences, unless we see a miraculous rise in oil (which would have its own possibly negative consequences) we think it is too late - the dominoes for oil-dependent producers have already begun to fall.

Finally, to further emphasize that changes in the Middle East are coming fast, in December the 90 year-old king of Saudi Arabia fell ill and was hospitalized and many don't expect him to live much longer. What is even worse for Saudi's stability, is that all his successors are in their mid to late-70's - not really facilitating long-term political ambitions. You don't have to be a "Game of Thrones" fanatic to know that when it comes to succession that things can get pretty messy - and getting messy in Saudi Arabia would have implications that would go way beyond the oil price.

Let us also not forget that right next door we have ISIS that has ambitions to create an Islamic state spanning the Middle East and what better way to do this than to take control of the holiest city of Islam - Mecca?

A collapse in revenues, a young radicalized and jaded population, an old dying monarchy, and a new and powerful group willing to do anything it takes to rewrite decades old borders and completely change the status quo. We're about to see some real fireworks in the Middle East…

Populist Parties Gaining Strength in Europe

Across Europe we're seeing populist parties gather strength as they rail against the status quo.

Source: Goldman Sachs via ZeroHedge

As investors can see, parties across Europe in Italy, Spain, France, Germany, and even in non-EU countries like the UK and Sweden have seen their poll numbers rise consistently as the European economy treads water.

Many of these populist parties don't want to see minor changes - they want a complete change in the current approach, with many of them desiring an exit from the Euro if the EU does not give in to their demands. This is a big change from what we've seen over the last two decades as Europe has gradually moved to unite - now we're seeing the opposite as Europe is moving back towards sovereign empowerment.

From an American's perspective, this has some similarities with the US Civil War as national interests diverged from the independent state interests. But unlike the Civil War, in Europe there is a much weaker non-complete union between nations (rather than states) and the growing success of populist parties is only increasing the divide between nations. If the European Union is going to survive then nations will have to come closer together and make the union stronger - it can't be a pseudo-union with national interests trumping shared, joint interests or it will collapse.

What is the kicker? A very busy European election calendar in 2015.

Source: Goldman Sachs via ZeroHedge

There are plenty of events here where Europeans can express their dissatisfaction with the status quo.

Not a bad time to transition to possibly the most important event not on that calendar - the Greek January 25th general election.

The Greek Elections

I don't think there are many more fitting ways than to have 2014 close with the third failure of the Greek president Antonis Samaras to win enough votes to elect a new president. The final failed vote was on December 29th and the results mean that Greeks have to head to the polls on January 25th to vote on the country's leadership.

The trouble, at least for markets, is that the anti-austerity Syriza party leads in polls and has adamantly insisted that there will be no more austerity. As Bloomberg reports:
Samaras has warned the election will determine Greece's euro membership and raised the specter of default in case of a victory by Tsipras, who advocates higher wages and a write-off of some Greek debt. 
"Additionally, as to markets perception, the issue of debt negotiation is fundamentally important," Tsipras told Teodoro Andreadis Synghellakis in the question-and-answer style book. Syriza vows to write down most of the nominal value of Greece's debt once elected. "That's what was done for Germany in 1953, it should be done for Greece in 2015," Tsipras said in a speech in Athens Jan. 3.
If I were a Greek citizen I would probably vote for Syriza and Alexis Tsipras as well - so I understand where the popularity stems from.

The problem here is that if Syriza wins and Greece holds firm to its demand of debt forgiveness, then the ECB and the EU will have to decide whether or not Greece should remain in the Euro. A few years ago, Greece was considered a systemic risk capable of bringing down the whole Euro, but now some are saying that it no longer is of much importance to the stability of the system.

The Federal Reserve and United States regulators thought the same thing when Lehman Brothers collapsed (and we know how that turned out), and we think this may be even greater as it's almost impossible to know what dominoes will fall as a result. What happens to European periphery bonds which are now paying interest rates at all-time low yields? What if a big move in bonds (up or down) causes one of the counter-parties of the trillions in CDS derivatives to default? What if the ECB doesn't implement some QE program before Greek elections? Will Russia come to Greece's aid and what would be those implications? What if the uncertainty leads countries to start selling Euros and the currency begins to collapse?

The only thing we know is that nobody really knows what will happen here.

Conclusion for Gold Investors

We haven't gone over a number of other events across the world that we saw in 2014 such as the increase in violence and regime change in Africa, Chinese and Japanese saber rattling over the Senkaku islands, and the potential of major currency and economic collapses in a number of South American nations.

All of this speaks to the instability in the world that we believe is due to the declining US influence on the international order. Even during the financial crisis of 2007, we saw much more in terms of world unity, as nations and central banks across the world tried to stem and control the impact of the US crisis - if we had a similar crisis today, we think we would see nothing close to that unity.

Financial market chaos, potential currency collapses, distrust on the international stage, and disruptive changes across the world are exactly why an investor should own gold. After all, it is the only currency that is not dependent on any other counter-party and as former Federal Reserve Chairman Alan Greenspan recently stated:
Gold is a currency. It is still, by all evidence, a premier currency. No fiat currency, including the dollar, can match it…
Yet gold lingers at around $1200 per ounce and most gold stocks are down 50-90% over the past few years - is there a better contrarian, yet fundamentally sound buy?

Thus we think this is a great opportunity for investors to accumulate physical gold and the gold ETFs (SPDR Gold Shares (NYSEARCA:GLD), SGOL, PHYS, and CEF) - though be very careful as ETFs work well in certain circumstances, but in others physical gold is much more desirable and investors should own both. For investors looking for higher leverage to the gold price, they may want to consider miners such as Goldcorp (NYSE:GG), Newmont Mining (NYSE:NEM), Agnico Eagle Mines (NYSE:AEM), or even some of the explorers and silver miners such as First Majestic (NYSE:AG) or Pan-American Silver (NASDAQ:PAAS). We're not suggesting these companies specifically (though we did recently issue a piece detailing our top five gold picks for 2015) - only suggesting them for further investor research. Investors interested in the miners may be interested in taking a look at some of our investment thesis detailing some of the rules we're currently looking for in a gold miner.

Finally, we think the real opportunities will be in the gold explorers, as their valuations are much lower than the miners and the fact of the matter is that these gold miners will be looking to expand reserves and buying out the quality explorers, so we'd suggest investors be aggressively investing in these quality explorers. For those interested in explorers or investors interested in keeping up with the gold market on a consistent basis consider following us (clicking the "Follow" button next to my name) or join our free email list where we send out a weekly email summarizing all the important events in the gold and silver industry, including all of our latest articles and research - it's a great way to keep up with the gold and precious metals market whether you are an individual investor or economist and its completely free.

We don't know what will happen in 2015, but we expect to see many more cracks in the international order as events speed up. Do not forget Professor Ferguson's reminder about complex systems, "and then, quite abruptly, they collapse." Investors should ask themselves what assets they want to own if things in the current international order break down further - we don't think there is any better investment than gold.

Business World

We Can Protect Ourselves

The Charlie Hebdo attack and the Boston Marathon bombings point to the solution: better surveillance.

By Holman W. Jenkins, Jr.

Jan. 9, 2015 6:46 p.m. ET

In the past few years, you could walk into certain office buildings in New York and not pass a security barrier on the way to the elevators. Not at big, brand-name companies, but in buildings housing smaller companies, a noticeable re-relaxation of security was taking hold.

That will change with the Charlie Hebdo attack, which raises the question, as did the Sony hack, of where private security leaves off and police responsibility begins.

Charlie Hebdo and Sony Pictures have two things in common; they were in the business of offending (for Hebdo it was a full-time business) and their security measures, while not trivial, failed to envision the threat that beset them.

The good news is that deterrence works. Many security experts and even former homeland-security chiefs who should know better have been heard lately declaring that defenders have to be right 99 times and terrorists have to be right only once. That’s the wrong way of analyzing the challenge.

Terrorists aren’t looking to play roulette with our security measures. The 9/11 attacks worked because the terrorists did things we let them do. We let them bring box-cutters on planes. We instructed air crews to cooperate with hijackers. We can deter things we want to deter.

Much remains to be disclosed about the Paris attack, but the Charlie Hebdo assault likely wouldn’t have been attempted if the attackers had not been able to assure themselves access to the satirical magazine’s premises. An arriving employee, a Kalashnikov waved in her face, opened the door from the outside via a keypad. It’s no great insight to see that antiterror security requires a door controlled from inside.

In the Sony case, any business whose network must be usable by thousands of employees and millions of customers will be breachable with a stolen password. But a hacker ends up stealing nothing if the data he steals is properly encrypted, which Sony’s wasn’t.

And both companies had reason to suspect they were special targets for attack. That’s not a reason to avoid mocking Islamic extremism or satirizing North Korea (if more people did so, it would render terrorist attacks futile from the terrorist perspective); but it’s a reason to engage in adequate self-defense.

Still, the question of foreign sponsorship looms over all. Despite the fear of lone-wolf activities, lone wolves haven’t been up to mounting the kind of attacks that meet terrorist objectives for impact and intimidation, which the Paris attacks certainly did. As horrible as the French attacks were, they show our security steps are on the right track.

Notice certain parallels to the 2013 Boston Marathon attack. The Tsarnaev brothers may have been radicalized by watching Anwar al-Awlaki videos, but dead-brother Tamerlan made a murky sojourn in 2012 to Dagestan and Chechnya where he may well have received bomb-making skills and terrorist training. Tamerlan was known to U.S. authorities. He figured on U.S. no-fly and terrorist watch-lists.

The suspected leader of the French attacks, Said Kouachi, was known to French police. He served three years in prison for illegally seeking to emigrate to Iraq in order to fight the U.S. He was a student of Anwar al-Awlaki. He is known to have visited Yemen for al Qaeda training. He also featured on U.S. no-fly and terrorist watch-lists.

Which shouts that surveillance is a solution, and could have forestalled both attacks, if we could just improve its efficiency.

People who assert jihadist sympathies and cross borders in search of terrorist training and backing are enemy agents, deserving of being carefully tracked. We have the tools. U.S. privacy concerns are overblown. One word: EZPass. The U.S. government and private businesses already hold information on all of us—our health, our finances, our movements—that would be infinitely more distressing if leaked or misused.

Ridiculous, then, is our angst about phone metadata, which allows law enforcement quickly to connect phone numbers used by terrorist and criminal suspects (though not to monitor their calls).

Let’s face it, the potential risks of phone-metadata abuse are so much less than the potential risk of abuse of the vastly more sensitive data that government and businesses protect on our behalf. So let’s grow up and move on.

miércoles, enero 14, 2015



India’s economy

The Gujarat model

How Modi-nomics was forged in one of India’s most business-friendly states

Jan 10th 2015


BILLBOARD images of Narendra Modi loom over visitors to Ahmedabad, the main city of Gujarat, at almost every turn. The big-brother omnipresence of India’s prime minister is part of the build-up to a big trade fair held in neighbouring Gandhinagar, a showcase for the business-friendly state initiated in 2003 by Mr Modi when he was its chief minister. The 2015 Vibrant Gujarat summit, the seventh such event, will run for three days from January 11th, when Mr Modi will make a speaking appearance. It will be a vast affair with visitors from 125 countries. A fleet of golf buggies, with plastic wrap still on the seats, stands ready to ferry visiting dignitaries, including John Kerry, America’s secretary of state, between the hangar-sized exhibition halls.

Gujarat is richer, enjoys faster GDP growth and a greater intensity of jobs and industry than India as a whole. Mr Modi’s reputation for clean government and economic competence rests on his record here. When Indians voted for him in great numbers last May, it was in large part because they wanted the country run as Gujarat is. His impact on the state is nevertheless contested. It is helpful, say Mr Modi’s critics, that he built a platform for a career in national politics in a state that already had deep roots in commerce (the Mafatlal textile plant, an hour’s drive south of Ahmedabad, for instance, recently celebrated its centenary). What is clearer is that Mr Modi’s time in Gujarat offers a guide to his approach to the bigger job of fixing India’s economy.

Start with the record, which shows that Gujarat punches above its weight. With just 5% of India’s population and 6% of its land mass, it accounts for 7.6% of its GDP, almost a tenth of its workforce, and 22% of its exports. Climate and geography pushed it towards commerce.

Poor rainfall made it hard to scratch out a living in farming; a long coastline favoured international trade. Today a quarter of India’s sea cargo passes through its ports. Even if Mr Modi cannot claim much credit for Gujarat’s natural endowments, the state’s annual GDP growth under his watch from 2001 until 2012 averaged almost 10%, a faster rate than India as a whole (see chart). Other exporting states, such as Maharashtra and Tamil Nadu, also did well. But sustaining rapid growth in any of India’s richer states is not a feat to be sniffed at.

Where Gujarat noticeably came up short is in poverty reduction, reckons Reuben Abraham, of the IDFC Institute, a think-tank. Other states of similar rank made greater inroads into cutting poverty rates between 1993 and 2012, he finds, though only three can boast a lower level of poverty. Mr Modi’s biggest feats were tangible, says Mr Abraham, the kind of improvements that migrant workers tend to notice, and report back to their relatives. The roads through and around Ahmedabad are excellent. The state has moved from a deficit in electricity generation, in 2002, to a surplus, despite the energy demands of a booming economy. Its 18,000 rural villages are connected to the grid. Water supply is abundant.

This emphasis on basic infrastructure, a hallmark of the Gujarat model, extends to making land easily available for commercial development. In 2008 Tata Motors switched the site for the plant to make the Nano, a small car, from West Bengal to Sanand in Gujarat after Ratan Tata, boss of the conglomerate parent, received an SMS message from Mr Modi offering him a factory-ready plot for the firm and its suppliers. Bogged down in messy land disputes at its initial choice of site, Tata Motors readily made the switch. Others have since followed. Ford is opening a plant in Sanand later this year.

India sits a lowly 142nd out of 189 countries in the World Bank’s “ease of doing business” rankings. But in Gujarat factories spring up more readily because permits, licences and environmental clearances are granted quickly. This predates Mr Modi’s time in office. Apollo, a big tyre manufacturer, opted in 1990 to build a plant in Gujarat in part because clearances were less painful than elsewhere. Mr Modi added his own twist. He saw that e-governance, the application of IT to the provision of government services, could make civil servants more accountable and cut corruption.

“He thought of it as synonymous with good governance,” says S.J. Haider, secretary of IT for the government of Gujarat. Tata Consultancy Services, an IT-services firm, designed systems for tracking state finances, documents within government offices and value-added tax payments. Other states are now looking at adopting similar platforms.

A focus on basic infrastructure and public goods; a drive to make civil servants honest and accountable; a penchant for IT; a flair for marketing to business investors. The elements of Mr Modi’s brand of economics are not obviously those of Margaret Thatcher or Ronald Reagan, to whom he has been compared by some commentators. Thatcher wanted a small state. Reagan is held to have said that “the nine most terrifying words in the English language are: ‘I’m from the government and I’m here to help.’” Mr Modi, by contrast, believes government can be made to work better.

“The Gujarat model is more about ideologically-neutral good governance than the sort of big-bang reforms seen in 1980s Britain and America,” says Vivek Dehejia, an economist. What sets Mr Modi apart from many of his predecessors is his ability to make a decision and be held accountable for it. But his record suggests those hoping for big privatisations or bold labour reforms are likely to be disappointed.