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At Arm's Length: 07.28.05

No doubt, you have heard about all you want to hear about housing bubbles. All the major media concerns have alerted folks to the unreasonable costs for homes but have failed to offer any real reason why this is a problem.

The full article.

Today's Commentary: 07.25.05
Mr.G.: Care to reconsider?

On Wednesday last week, Alan Greenspan, Federal Reserve Board Chairman made his last appearance before the House Financial Services Committee. His rosy estimates of the economy, one where investors are paid for the risks they take, seemed to greet the news with a sigh of relief. The knowledge that he will continue to raise rates for the remainder of the year, something the markets anticipated, will allow the Greenspan gamblers to pursue a much riskier stance especially with the near term surprise effectively removed from the picture.

The Fed chief is scheduled to retire in January of next year leaving a legacy of mixed successes, unpredictable policy swings, and two orchestrated bubbles, one supposedly still enabled. Testifying before Congress, he showed why he has the market's ear. And apparently the market liked what it heard.

His assessment of the economy unfortunately could not be farther from the truth as he travels dangerously closer to exuberance than anyone, including the markets, should like. When Mr. Greenspan speaks, he also has the attention of the global investor as well.

Increasingly, the ripple effects of the United State's policy towards deficits and trade, currencies and commodities, has met with equally strong return currents not only from China, but the world as well. The two biggest players on the global stage are now teetering, one with the weight of success and runaway growth, the other with mounting deficits and sluggish growth. Whichever way they fall, so goes the rest of the world.

In the case of the United States, an economy whose fortunes ride on the current political wave and the indefatigable capitalist belief in free markets, does not operate at its best when it is hampered by huge deficits on both the trade and budgetary fronts. Granted, economies can be nudged along with the right alignment of loose money and accommodative spending, something that has become the norm over the last five years, but it will do nothing more than limp.

China on the other hand has a problem of acceleration on its hands and may not have the wherewithal to grasp the beast at the exact moment it needs to be harnessed. With a large amount of the companies in China not only hitched to the government policies at the proverbial hip - the Sino connection with the business structure goes far beyond just policy and into outright ownership, at least in part - they also have a growing crisis in their banking system because of it. Even with rampant growth, the Chinese banking system is loaning money at a far greater rate than payments received.

The interrelationship between these two behemoths has a direct effect on the economy of the United States, which leaves me to wonder how Greenspan could offer such a sunny estimate of the future.

For now though, we have to wonder how could he have arrived at his current vision of the economy. He has taken the bond market to task suggesting that their belief in long term market stability or more precisely, Greenspan's predictable increases in rates has forced fixed income investors into riskier offerings. Nothing unsettles a bond investor like the inability to call the next move. Scold away, Mr. G., you are partly to blame for those low yields you wonder aloud about.

The housing bubble, which he almost acknowledged, is an understandable concern for the nation's top banker even if his ability to control the growth in this particular corner of the market may be slightly out of his reach - but not out of his influence. The architect of the stock market bubble knows how to cover his tracks and may manage to dodge the historical blame for his mishandling of the housing markets.

Housing he believes, has grown into a considerable risk to the stability of the economy but not enough to try and talk it down from its ledge. Almost as a footnote he added that oil is also a concern.

The housing market, whose "frothiness" seems to be part of a generally wry observation rather than something of a major concern. Unless you have been living under a rock, there is an abnormal interest in what used to be considered a long term investment. Our lawmakers needed to be warned - because they are living under rocks - and he failed to do so.

Through no fault of our own, we were also led to believe that economic stability which would come gift wrapped in manageable interest rates creating a world where mortgage rates would never rise. Housing is an exuberance all its own and even if the so-called bubble really is just regional, the effects of a significant adjustment - read burst - will be felt nationwide.

"Long periods of relative stability often engender unrealistic expectations... and, at times, may lead to financial excess and economic stress." Do ya think, Mr.G.?

So the dollar slipped significantly and the bond market reacted in kind largely because Greenspan failed to be at least cautious. Instead, he leaned toward the optimistic. The conservative investor in Greenspan's vision of the world now has no place to put their money.

His upcoming retirement should make the markets more jittery than they currently are. The now almost affirmed rate of 4% at year's end should have investors worried. Greenspan has relied less on a firm policy than on his ability to pull the purse strings whenever necessary even if he was late in beginning to tighten. His successor however may not be as nimble as he was and this might be a cause for concern among Washington policy wonks. They are not alone. Greenspan's methodology should not be repeated by his successor and that should have most long term investors somewhat worried.

Following that testimony and before he appeared before the Senate, China announced the devaluation of the Yuan leaving most of the markets wondering how this would effect the global economy. Of course the administration was front and center with their assessment. Coming just short of "mission accomplished", Treasury Secretary John Snow saw it as a move in the right direction for the global economy.

Speaking before the Senate Banking Committee on Thursday in the wake of the Chinese news, Greenspan reiterated what he said on Wednesday before the House about his outlook for the economy and his interest rate plans. He also assessed the Chinese move as admirable. But he might want to reconsider his position.

It is important to understand two things. China is not a trade partner in the sense that there is an even exchange of goods and the Chinese economy is not as easy to read as the global economy would like to believe - or hope.

Devaluing the currency has effectively made operations of their industries much easier. With commodities tied to the dollar, the raw materials needed to keep these enterprises churning at full capacity have effectively become cheaper. This will not make products imported into the United States cheaper nor on the flip side, will the Chinese suddenly have an appetite for US manufactured goods.

"This is certainly a good first step" the Fed chief suggested saying that is would be "the type of step you'd want to take when you've had a decade-long fixed structure. I think they've been cautious, and I think admirably so, but I look at it as a first step in a number of further adjustments as they invariably increase their participation in the world trading market."

Mr. G. might need to reassess how much of partner China needs to be along with how good of a customer we should remain.

In a simplified form, here is the best explanation of why both China and the US could bring the rest of the world tumbling down with the wrong move and how words like Greenspan's do more harm than good.

The United States as I mentioned earlier uses its nation status to promote its companies. It often does this at the risk of shooting itself in the foot. The more trade that exists between global companies - operations that are based here in the US but systematically moved overseas where labor is cheap, productivity is high and the US policy for such actions is encouraged - that simply comprise of shifting materials amongst themselves, the greater the chances that the trade deficit will grow. The US policy of capitalism does not have, despite whatever comes out of Washington, a very democratic effect on the job front here at home.

As jobs shift, so does the economic base and without a readily available source of cash, Americans borrow against their homes. As interest rates begin to rise and Greenspan confirmed this, the appetite for spending will slow.

The Chinese understand the fragile relationship they have with the US, the customer of last resort. They don't want to see that particular base dry up anytime soon but they are also worried about our debtor nation status. They are beginning to reassess their part in the continued rise in the deficit and have backed off significantly in their purchases of that debt.

Instead of painting a blue sky with green lights as far as he is able to see, Mr. Greenspan should be worried that those deficits, funded by his accommodative policies. Those shortfalls will further balloon and are predicted to hit 50% of GDP by the end of this decade. This cannot continue to be ignored.

Greenspan cannot wave away the problem just as Congress cannot keep ignoring the growing schism between real earning power - which has stagnated and is beginning to decline - and productivity - hailed as the cure-all for all economic woes. The Fed chairman could have taken a long term approach and warned, in his sternest voice, about these scenarios but he didn't, leaving a golden opportunity missed.

The playing field, as many initially assumed, will not be leveled by the Chinese move to devalue its currency.

While neither side may win this economic battle of diplomacy and wits, you can count on one thing: the worker will ultimately be the one who pays for any failed policy. And that is worth re-considering.

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