Empowering the fruitcakes

The Bear’s Lair: Empowering the fruitcakes [¹]
Click here for a link to complete article:

By Martin Hutchinson | 23 October 2007

The long world boom, driven by cheap money and resulting in high commodity prices, has had one overwhelming disadvantage: it has empowered a series of economic fruitcakes— national leaders and private sector investors who operate on principles that make no economic sense. Without Schumpeteran “creative destruction” there is no force separating the sound from the unsound, the valuable from the insane. The long term destruction of wealth through this process will be far greater than the short term profits such people think they are creating.

For example the Center for Economic Policy and Research on Wednesday presented the Bolivian Minister of Hydrocarbons and Energy, Carlos Villegas. Evo Morales, the President of Bolivia, is a follower of Venezuela’s Hugo Chavez, but appears to be considerably less of a thug than Chavez. He also claims to be the first person of indigenous ancestry elected President of Bolivia, which if true indeed shows that the country has been run in the 180 years since independence largely in the interests of the Hispanic-ancestry governing class. If so, they’ve done a lousy job, as Bolivia is the poorest country in Latin America, in spite of having considerable natural resources, which of course is a large part of the problem. As British prime ministers from Sir Robert Walpole to Lord Liverpool could have told you, it’s perfectly possible for an oligarchy to rule in the interests of the country as a whole and enrich everybody including themselves by doing so.

The most politically important example of an economically counterproductive regime cemented in power by high oil prices is Vladimir Putin’s government in Russia. Putin in his early years was economically reformist, instituting a 13% flat tax that brought massive economic growth. However his seizure of oil assets and harassment of foreign investors since 2003 must by now have had a major negative effect, had it not been for the continually soaring oil price. With high oil and gas prices, Putin can keep Russian business under political control, and can use Gazprom’s supply capabilities to harass both his near abroad in the former Soviet Union and the more distant but more economically powerful countries of Western Europe.

Once oil prices drop, it will be very interesting to see what happens to the Putin regime. My guess is that it will descend into pure autocracy, as it will no longer be able to win elections or pursue an activist foreign policy through building up its military power. But as the old Soviet Union showed, economically sclerotic autocracies can last a remarkably long time.

The political consequences of low interest rates and high commodity prices have been seen within the US as well as overseas. The subsidies for producing ethanol from corn, an environmentally damaging and entropically futile effort, are encouraged by the high price and scarcity of petroleum. The house price boom of 2002-05 was entirely caused by low interest rates; it is now having its inevitable effect in producing calls for bailouts of foolish subprime homebuyers. Most damaging and subtle of all, the continual rise of asset prices has convinced middle-class Americans both that they don’t need to save and that the old paradigm of near-lifetime employment, good pensions and subsidized healthcare was in some way inefficient and can be replaced by workforce turnover and stock option grants.

In the private sector, bull markets always encourage speculators and this has happened with additional force in this cycle. In the late 1990s, analysts who didn’t analyze combined with accountants who didn’t audit and day traders who knew nothing about fundamentals to produce short term profits for some and long term costs for the economy. Since 2002, the mortgage banking industry has been built up on a series of intellectually untenable theories. [For example, it assumes that for mortgage banks and their ilk: ]

• Risk in a mortgage transaction can be removed and cost lessened by selling it, slicing it up and re-selling it in 'tranches' to German and Chinese investors.


• Financing long term assets through short term paper is financially sound, provided that the short term paper is issued by "conduits" so everyone can pretend it’s off their balance sheets.


• In order to buy a house it is not necessary to have a steady income large enough to meet the mortgage payments; creative mortgage brokers [and creative mortgages] remove this requirement.


• House prices will continue rising forever, with an eternally active buyer market, even if you go on building houses like madmen


• If, as a local government you encourage massive amounts of house-building using illegal immigrant labor, you need not worry about the difficult future social problem of unemployed illegal immigrants, nor about future water shortages and overcrowded schools and roads, as your infrastructure fails to keep up with the overdevelopment.

A decade of loose money and rising asset prices has also made the financial services industry economically illiterate, at least at its margins. Hedge funds, in particular have engaged in a wide variety of short term games that must consume them in the long run. The "carry trade" borrowing in yen and lending in other currencies, for example, is not a viable long term business strategy.

The assumption that Value At Risk models manage risk adequately, and remain equally adequate however arcane the derivatives being managed is also a nonsense that would have been quickly quashed in a normal market. The private equity business, that has landed the banking sector with $200-$300 billion of "bridge financing" with no opposite pier to the bridge in sight, would also have been brought back to earth quickly with tighter money, as it was after the RJR Nabisco debacle in 1988. In the 1980s, Mike Milken’s creative usage of junk bonds to finance ever more speculative transactions lasted less than a decade before producing bankruptcy for his firm and imprisonment for him. Equivalent follies have lasted far longer this time around; it is not a good thing.

Bear markets and recessions are unpleasant. However a period of loose money lasting over a decade, with accompanying bull market, rising commodity prices and apparently easy roads to wealth lowers the world’s collective IQ by a substantial percentage.


  M O R E. . .

Normxxx    
______________

The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.