Page 2 of 2 Widgets and wrecks
By Julian Delasantellis
But even disappearing banking sector profits should not be enough to hit tech
in the way it was hit last week. For that, one must look deeper, to the basic
financial dysfunction that is stalking almost all equities, from computer
software ( Oracle, down 15% last week) to even cat food. ( Nestle SA, parent
company of Purina, down 3% last week).
Going back to Cisco; Cisco makes networking equipment, specifically, Internet
routers. I sort of know what that is; but,
remember, I'm an economics teacher, we think of and describe all products in
terms of widgets.
"What's a widget?" down-to-earth heart-of-gold millionaire late middle-age
college freshman Thornton Mellon (Rodney Dangerfield) asks his business
professor, the uber snooty Dr Philip Barbay, (Paxton Whitehead) on the first
day of class in the 1986 movie Back to School.
"It's a fictional product, it doesn't matter." Barbay responds.
"Fictional product, tell that to the bank."
Cisco's routers are not fictional products; they're very real, and, I imagine,
very good. However, if there exists a dysfunction in the banking and financial
sectors, if the banks can't or won't extend sufficient finance to the real
economy, it means that there'll be less money being directed towards this
previously thriving enterprise, whether as operating finance or to its
customers as loans to buy Cisco's products.
Cisco will then have to drop prices or curtail production, probably both. That
means less prosperity for Cisco, its suppliers, employees, stockholders, all
the company's stakeholders. In much the same way that HIV morphed and "jumped"
from simians to humans, by potentially not having sufficient capital to lend
out, the subprime contagion is jumping from the financial species to the rest
of the economy.
Subprimes and SIVs weren't the only thing worrying Wall Street last week. The
collapsing US dollar was also a concern. With the British pound at $2.11, that
currency is at its highest level against the US$ since 1979 ( as is gold); the
newer euro reached another record high, to be worth $1.4750. Since August 16,
the dollar has fallen 10% against the common European currency.
Of course, at its core, the dollar's most recent fall is directly attributable
to the subprime crisis as well. August 16 was the day before the US Federal
Reserve, reacting to August's subprime-generated turmoil in the markets,
commenced the current series of interest rate reductions with its opening 50
basis point cut in the discount rate.
The selling that has followed in the US dollar, as illustrated by August's US
Treasury International Capital data series, represents foreign investors and
central banks' rejection of a country that refuses to maintain the value of the
currency in which their investments are denominated. (See
US rate cuts: Like a blow to the head Asia Times Online, September 20,
2007.)
The markets are also nervous regarding US consumers' continued willingness, or
even ability, to shop till they drop in the face of the withering challenge of
crude oil nearing $100 a barrel; that's up almost $30 barrel since August.
Crude nearly always rises in price as the US$ falls; following the linkage back
to its source, it can be seen that here too lies another fearsome manifestation
of the crisis in the subprimes.
Anecdotal reports that US consumer spending fell off a cliff in October also
weighed heavy on the markets. We'll find out soon enough if that was true, as
for now, we do see that the stocks that comprise the RTH retail index have
fallen 12% since mid-October.
There is another subprime factor besides crude oil weighing on consumers'
continued ability to support the retail markets. Crude oil has essentially
doubled this year, and it has risen five-fold since 2002 ( as of now, it does
not look like the Iraq war selling point of the conflict leading to lower crude
oil prices is going to work out, does it?) All during that time, economists
have marveled at US consumers' continued ability and willingness to burn
through their credit cards until they were smoking like a drag racer's tires
under the starter's lights.
We are now beginning to see where all that spendable cash was coming from. With
this decade's tremendous growth in US home valuations, US consumers have been
well able to pull the increased equity value out of their homes through
aggressively promoted home equity loans and lines of credit; in essence, for
much of this decade, US home ownership included an implied money printing press
along with the eight-burner platinum stoves and 29-cubic-foot refrigerators.
However, home equity loans and lines of credit are only readily available when
home values are rising; there's no new equity to pull out of houses if you've
already borrowed against and thus extracted the old equity and the real estate
market is no longer producing the rising prices needed to generate any new
equity. In other words, besides all the other bad things the subprime crisis is
doing, it's also breaking the American homeowner's piggy bank. Now, $100 a
barrel oil is going to hurt.
Outside of the financial press, last week's events in the markets received some
coverage in the general press, but not nearly as much as another critical issue
for the future of American democracy, namely, the heated controversy over
whether Senator Hillary Clinton's allegedly poor performance at the October 30
Democratic Party presidential debate in Philadelphia was attributable to
pre-menstrual or post menopausal syndrome. Perhaps the most important
development, and issue for the markets going forward, went almost entirely
unnoticed.
The core method by which the US Federal Reserve influences interest rates in
the short-term money markets is through transactions in these markets called
repurchase agreements. This is the way the Fed either raises or lowers the key
short-term money market rate, called the Federal Funds interest rate, until the
market rate falls into line with the Federal Reserve's target policy rate,
currently at 4.50%. (See
When the big guns fail, call in China Asia Times Online, August 21,
2007.)
For the past two weeks, the Fed has been loosening a virtual fire hose of money
onto the short-term money markets; November 1 saw the largest intervention, at
$41 billion, since attempts to stabilize the markets after September 11, 2001.
These interventions continued, albeit at a reduced rate, every day last week.
These actions would have been understandable had the Federal Funds market rate
been trending above the target rate, but that was not the case. For much of the
week, the market rate was actually trading below the target rate, indicating
that, to achieve the policy objective of hitting the target rate, the
interventions were not necessary.
So why the interventions? Market observers are puzzled. It could be that the
Fed was trying to accomplish the sometimes difficult task of keeping the money
markets of a country with a rapidly declining currency well lubricated; that
can sometimes be like trying to keep a leaky bucket filled with water. But that
explanation does not really fit in with a Federal Funds market rate under
target; if so much money was being drained from the money markets through
capital flight out of the greenback, the resulting money shortage should have
shown up in a rising Federal Funds rate.
Some observers are suggesting that the Fed is, instead of dealing with events
in the present, trying to prepare the markets for a very negative upcoming
event, perhaps the insolvency of a major financial institution, in the near
future. I have no idea whether that is true. All I know is that Friday's Dow
Jones Index market action, with the market's selling off, stabilizing, and then
selling off hard again into the close to settle just above 13,000, indicates
that a lot of prudent people felt it was just too risky to see Sunday night and
Monday morning arrive with the amount of long stock positions they then had.
At its core, economics is a very simple discipline. In much the same way that
aeronautics is about gravity and medicine is about life, economics is about, of
course, money. Before the subprime crisis broke, the private financial system,
aided and abetted by the US Federal Reserve, had established, and was
maintaining, a very effective system for creating money, through the borrowing,
lending and leveraging up of securitized assets such as subprime mortgage
paper. The money that these instruments created drove up the prices of real
estate and just about all other traded financial instruments.
But much of the wealth created solely out of the new money was not real, was
not backed by anything whose traded value corresponded with its real value.
That's why gold has been rising and the US$ falling even before the crises that
commenced in summer and have now resumed; gold has more than tripled since
2002.
But no financial mania lasts forever, and the one associated with US real
estate is now clearly over. In that the continued operation of the financial
sector's money creation machine was always ultimately dependent on
ever-increasing rising asset prices, now that prices are going down, the great
machine is going in reverse, and wealth is being destroyed.
So the basic question here is, who and what is going to replace it? The private
sector? The failure of the M-LEC superfund is indicative of what economists
call the "free rider" problem; instead of ponying up the requisite cash to
reliquify the markets, the companies of the private sector seem to be enamored
of the prospect of sitting back, letting other companies fix the problem so
that then the "free riders" can once again reap the benefits of a fully
restored financial system.
If it's not going to be the private sector then it has to be the public sector,
namely government. There is precedent for this; in 1989, the Democratic
Congress and Republican president George H W Bush came together to create the
Resolution Trust Corporation, the public/private partnership that solved the US
Savings and Loans crisis.
But that was a long time ago, in a far less polarized time. There is every
indication that today US conservative Republicans are more than willing to see
the entire US financial system sink like a stone rather than compromise on
their free market anti-government principles; as for the Democrats, why resolve
an issue today that could be an absolute landslide for them in the presidential
election now a mere 51 weeks away?
But even if the current financial crisis now requires a government solution,
that does not mean that it has to be an American government solution. I've
written before how I believe that this crisis will ultimately be resolved by
the world's newly created Sovereign Wealth Funds (SWFs), foreign
government-owned investment pools created out of the massive trade surpluses of
countries that have stoked the debt-driven US consumer rage of this decade, in
particular China.
I have been looking for a SWF rescue of the US financial system since at least
August. It has not happened yet; maybe it won't, maybe it's just that the
Chinese are waiting for even cheaper asset prices, and more desperate Americans
to be made forever indebted and grateful to China, before swooping in to save
the day; perhaps I should not be looking at this with my impatient Western
eyes.
All I know is that the SIVs now dragging down the balance sheets and financial
structure of the capitalist world are proving themselves to be every much of a
"fictional product" as Dr Barbay's widgets.
"Fictional product, tell that to the bank."
That's the problem, Mr Mellon. Somebody did, and the bank bought it.
Julian Delasantellis is a management consultant, private investor and
educator in international business in the US state of Washington. He can be
reached at juliandelasantellis@yahoo.com.
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