Page 2 of 5 Liquidity boom and
looming
crisis By Henry C K Liu
to
support rising share prices pushed up by too many
dollars chasing after a dwindling supply of shares
caused by corporate share-buyback programs paid
for with low-interest loans.
Further, the
wealth effect from the equity bubble has not been
broadly distributed, resulting in a boom in the
luxury consumer market catering to the
beneficiaries of capital gain while the broad
consumer market catering to
wage earners stalls. The newly rich in the
financial sectors are buying multimillion-dollar
first and second and even third homes, while
average workers are buying cheap T-shirts and
shoes made in China. The highest-paid hedge-fund
manager took home US$1.7 billion in 2006, while
the average US worker's annual pay was $28,000.
The minimum wage was $5.15 per hour. If the
minimum wage had risen at the same rate as chief
executive officers' pay, it would have been $22.61
per hour in 2006.
Wages decline while
returns on capital soar Another troubling
bit of economic news came from the US Labor
Department, that while the DJIA rose 5.9% in Q1
2007 with inflation at 2.2 %, wages and benefits
grew by only 0.8%, down slightly from the low 0.9%
increase in Q4 2006. Wages and salaries went up
1.1%, the fastest since 2001, but benefit costs
edged up only 0.1%, the slowest since Q1 1999
despite rising medical costs, reflecting a trend
by companies to maximize their earnings by
abdicating their social responsibilities to their
workers and to society.
Labor's share of
the US GDP growth of 1.3% amounted to
negative-2.6% after a 3.4% inflation adjustment,
while capital's share was positive 2.5%. If
labor's share of GDP growth were to be kept
neutral after inflation, capital's share would
register negative-0.1%. This is not good news to
anyone except the Fed, which views rising wages as
inflation. And if labor's share of GDP growth
remains negative, companies will not be able to
sell their products and will be forced to lay off
workers to maintain profit margins, thus slowing
economic growth still further.
Jobless
expansion US consumer spending rose at a
3.8% pace in Q1 2007, slightly weaker than the
4.2% growth rate logged in Q4 2006. This signals
the depletion of the wealth effect from asset
inflation.
US job creation slowed to its
weakest pace in more than two years in April as
layoffs extended beyond manufacturing and
construction to retail trade. Unemployment rose to
4.5% in April from 4.4% in March, with only 88,000
new jobs created in April, compared with an
increase of 177,000 in March.
The slowdown
in job creation reflects recent economic weakness
but is likely to be viewed perversely by the
Federal Reserve as a welcome sign that wage
inflation pressures are easing. Heavy job losses
in the retail sector were a sign of a "broad-based
deceleration" in employment in the service sector,
underlining fears about the resilience of consumer
spending. The retail sector shed 26,000 workers,
while house builders cut 11,000 positions and
manufacturers eliminated 19,000.
In April,
US private-sector jobs registered the weakest
growth in four years, increasing by only 64,000.
Service firms added 106,000 jobs, goods producers
cut 42,000; small businesses created 45,000 jobs
and about 24,000 government jobs were added,
adding up to a job growth of 88,000, lower than
the 100,000 forecast. Unit labor costs, a
much-watched inflation signal, rose at only 0.6%
annualized, way below expectations of 2.1%. In the
manufacturing sector, while jobs continued to
decline, the cost figures were higher:
productivity was up 2.7% while unit labor costs
grew as well at 2.7%, reflecting growth in
high-tech, big-ticket manufacturing such as
commercial aircraft where the US still commands
global competitiveness.
This jobless
recovery is still 6.7 million private-sector jobs
short of the typical recovery 67 months after a
previous business-cycle peak.
New
geometry of debt securitization The
mortgage sector before the age of securitization
was shaped like a cylinder in which risk was
evenly spread throughout the entire sector, thus
all mortgages share the aggregate cost of default.
This even spread of risk premium is viewed as
market inefficiency.
Securitization
through collateralized debt obligations (CDO)
permits the unbundling of generalized risk
embedded in all debt instruments into tranches of
escalating risk levels with compensatory higher
returns, and in the process squeezes additional
value out of the same mortgage pool by maximizing
risk/return efficiency.
The geometry of
CDO securitization transforms the cylinder shape
of the mortgage sector to a pyramid shape, with
the least risky tranches at the top and the more
risky tranches with commensurate premiums toward
the bottom, so that a greater aggregate risk
premium can be squeezed out by the security
packagers and investors as profit. This extra
value, when siphoned off repeatedly from the
overall mortgage pool, requires an ever larger
base of subprime mortgages in the new pyramid
shape, thus increasing the systemic risk further.
Subprime borrowers are no longer just
low-income borrowers. They include high-income
borrowers whose incomes and collateral value do
not provide sufficient reserve for sudden changes
in market conditions. A subprime borrower is one
who over-borrows beyond prudent standards. The
extra risk-premium value thus taken out of the
mortgage sector contributes to the increase in
liquidity to feed the debt market further, pushing
the low credit standard of subprime lending
further down. Once prime-credit customers have
borrowed to their full credit limits, growth can
only come from lowering credit standards, turning
more prime borrowers into subprime borrowers.
This is the structural unsustainability of
CDO securitization, irrespective of the state of
the economy, since risk of default is shifted from
the state of the market to the direction of the
market. Any slight turn in market direction will
set off a downward-spiral crisis. The initial
upward phase of this cycle is euphoric, like any
addiction, but the pain will come as surely as the
sun will set in the downward phase.
Not
many economists or regulators have yet focused on
this structural defect of CDO securitization. The
recent congressional hearings on subprime
mortgages completely missed this obvious
structural flaw.
China's foreign
reserve mirage China's latest foreign-reserves
data showed that there is as much as $73 billion
in unexplained new reserves. The People's Bank of
China (PBoC), the central bank, now holds more
than $1.2 trillion in foreign reserves, the most
among the world's central banks, except the US
Federal Reserve, which can create dollars at will
and therefore needs not hold any foreign reserves.
The Wall Street Journal explained the
Chinese foreign-exchange puzzle by suggesting that
the "leading suspect is a possible series of
foreign-currency swaps by Chinese banks". The
Journal reported that foreign-exchange trading
among Chinese banks in 2006 was "more active than
widely known".
The PBoC did not provide
any comments or an explanation. The question is
whether the funds were in fact swaps, which would
mean only minor implications for the broader
economy, or if they
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