Sunday, May 31, 2009

Why is Small Beautiful?


I was reading something on microsatellites which got me thinking about how in the new era of investing, bigger does not always mean better.

When I was looking for work in Montreal, I stumbled across a group of prop traders that really impressed me. They work for themselves, put up their own capital and trade in and out of futures contracts all day long.

A few of these guys are extremely successful at this style of trading. When I inquired as to how they trade, they told me they move ahead of the big hedgies and big institutions and are able to be nimble and pick their spots.

It's not foolproof and they don't always make money but they got me thinking. I could never trade the way they do and their strategy is not very scalable for institutions to replicate. Moreover, I find it excruciatingly boring going in and out of the futures market hundreds of times a day.

But if you understand the constraints of prop traders, portfolio managers, hedge fund managers and institutional investors, you can use this information to your advantage in your own personal portfolio.

Let me explain. A hedge fund manager or portfolio manager at some pension fund or mutual fund has limits on how much they can invest in one company or sector. For example, they might limit and individual position to 3% of their portfolio and a sector to 10% of their portfolio.

Now, if you know this, you also know that they will start bidding up stocks in sectors that are outperforming and the trend can last longer than you think. Unlike them, you are not constrained by some tight risk rules or stop losses, allowing you to place a higher weighting on some stocks or sectors in your portfolio.

Let me take a step back here to go over my approach to looking at the stock market. In my comment on the investment labyrinth, I wrote that I use a thematic approach which combines top-down analysis with bottom-up technical and fundamental analysis.

I wrote that I track the following funds from MFFAIS website (data is lagged but fairly recent and based on 13-F filings):

AQR Capital Management

Artis Capital Management

Atticus Capital

Bamco

Barclays Global Investor

Berkshire Hathaway

Brevan Howard Asset Management

Bridgewater Associates

Bridgeway Capital Management

Cascade Investments

Caxton Associates

Citadel LP

Clarium Capital Management

DE Shaw and Co

Eton Park Capital Management

Farallon Capital Management

Fortress Investment Group

Fox Point Capital Management

Greenlight Capital Inc

Golden Tree Asset Management

Goldman Sachs Group

Grantham Mayo Van Otterloo and Co

HBK Investments

Highbridge Capital Management

Hussman Strategic Growth Fund

Ionic Capital Management

Jabre Capital Partners

JP Morgan Chase Co

Legg Mason Capital Management

Letko Brosseau and Associates

Leuthold Core Investment Fund

Leuthold Grizzly Short Fund

LSV Asset Management

Morgan Stanley

Kingdon Capital Management

Lone Pine Capital

Maverick Capital

Millenium Management Llc

Moore Capital Management

Paulson and Co Inc.

Pequot Capital Management

Pershing Square Capital Management

Quantum Capital Management

Renaissance Technologies Corp.

Soros Fund Management

Spinnaker Capital LP

Sprott Asset Management


Tiger Global Management

Traxis Partners

Tremblant Capital Group

Tudor Investment Corp.

Viking Global Investors LP


[Note: I added a few funds. Another good source of information on what hedge funds are buying and selling is Seeking Alpha's comments on hedge fund activity.]

The reason I track what top funds are buying instead of what analysts are touting is that actions speak louder than words. You can recommend a stock to me but if I know you are putting your money where your mouth is, then I know you have conviction behind your recommendations.

When I told my friends to buy energy stocks in Q2, especially solar stocks, I was not just saying it, I was putting my money where my mouth is and I warned them it is a very volatile sector but when it moves up, it moves up very quickly.

[Note: Read an earlier comment on solar stocks from last August and more recent articles on the Chinese solar index taking top spot, alternative energy cost parity within reach, and falling silicon prices pressure thin-film solar]

I know because I got nailed buying some of these companies after what I perceived to be an inordinate and steep drop in Q4 2008. But I understood the mechanics behind this decline so I kept buying as much as possible all the way into early March.

There are times to cut your losses and move on, and there are other times when you should be forgetting these trader rules and keep doubling down. That was one of those times.

Let's look at a specific example of a solar stock that I track but did not invest in. Look at this one-year chart of Trina Solar (TSL). If you check out the summary, you'll see a 52-week range of 5.61 - 49.63 in its price.

Why all this volatility? Hedge funds were long but as they delveraged to meet redemptions, they were forced to sell stocks. Long-short hedge funds are typically long small cap stocks and short large cap stocks, so it wasn't surprising to see small cap stocks get decimated in Q1 of this year.

But all stocks got clobbered in Q1. Now, there are currently 1,483 stocks in the Russell 3,000 that are up year to date, 134 are up more than 100%, and 38 are up more than 200%.

Getting back to Trina Solar, you'll see some of the major holders at the end of Q1 were Citadel and DE Shaw, two well known hedge funds. You will see the stock hit a double-bottom (one in November, one in March) and has been trending up ever since.

Let's say you were lucky enough to buy it a $7 and it doubled. Would you have sold? Most people would have sold but as long as a stock makes higher highs and higher lows on a weekly basis, you should be riding it up.

Specifically, for short to intermediate trends, focus on the 10-day EMA being above the 50-day EMA and for longer trends, focus on the 50-day EMA being above the 200-day EMA.

You should be looking at these moving-average trends, weekly high, low, close and volume very carefully. I look at them as a gauge and not just for individual stocks, but for general markets like the Nasdaq and S&P 500.

If you are not comfortable investing in individual stocks, learn all you can about ETFs and ETF trends. Lots of people out there are getting raped on fees by mutual funds that consistently under-perform the markets. WHY?

My final comment in this small post is to tell you that I agree with Toro's Running of the Bulls Market Blog, when the yield curve is this steep, it is usually a good time to invest in stocks. Treasuries could make a comeback or range trade for a long time.

For now, risk trades are back on: long commodities, long commodity currencies, long emerging markets, long high yield bonds, long, LONG, LONG! How much longer will it last? Who knows? As long as they keep buying the dips, this rally has legs.

My thoughts are that all that liquidity is drowning the meaning of inflation but showing up in speculative pockets like oil. And guess who is back buying oil futures? Who else? Pension funds and other speculators are back buying these indexes and now U.S. Senator Bernie Sanders has asked the federal futures market regulator to crack down on speculators whom he blamed for pushing up crude oil and gasoline prices.

But the tidal wave of liquidity has been unleashed. The genie is out of the bottle and to navigate these treacherous markets, individual investors need to use their nimbleness and lack of constraints wisely, increasing sectoral positions when opportunities arise and not be afraid to ride these trends up knowing that liquidity is very favorable.

One final piece of advice: do not be afraid to short pension funds and go long hedge funds. The best hedge funds are typically ahead of the curve and the former are typically late to the game. Interestingly, public pension funds have not invested in solar stocks while the best hedge funds have.

But as I mentioned above, hedge funds and institutional funds have position and sector limits - an extra constraint that you do not have. Use this to your advantage, be nimble, study their portfolio moves and do not be afraid to take on more risk when opportunities arise.

And above all remember that everyone's risk profile is different. If you are not comfortable with investments, consult a few experts and ask some tough questions on fees and their thoughts on markets going forward. Never be afraid to ask as many questions as you need to, after all, it's your money.

Saturday, May 30, 2009

Street Fighters and Their Pension Clients


Please take the time to read my update at the end of my last comment on CPPIB as the backlash is building to give back those outrageous bonuses.

One word of advice to the politicians in Ottawa. I know how hard it is to be a politician because my stepfather survived over 20 years in Quebec politics. It's easy to be cynical but being a politician is no barrel of fun, especially in difficult economic times like these.

But I hope politicians will stick to their principles and share some of the moral outrage that is being voiced out there concerning the payment of these bonuses. It's utterly ridiculous to pay anyone millions based on some four-year rolling return (which is based on questionable benchmarks) after a fund loses $24 billion in one year.

I know they will tell you to attract and retain "the best and brightest" we need to compensate them or else they will go to the private sector. I say let them go to the private sector because I guarantee you they will never find any private firm paying them based on a four-year rolling return. In the private sector, you do not perform, you are fired. Period.

Greed has permeated every facet of the financial industry, including public pension funds. This brings me to this weekend's topic.

A few weeks ago, I received a complimentary copy of Kate Kelly's new book, Street Fighters, which discusses the last 72 hours at Bear Stearns.

The book is a quick read and it is well documented. I enjoyed reading these accounts, but having worked on the sell-side and buy-side, I can't say I was surprised reading about the egos involved.

But Kelly's book is well worth reading, especially for those regulators who are trying to regulate these firms and every day investors trying to figure out what goes on behind closed doors. Unless they understand the culture of greed that permeates the financial world, they will always remain vulnerable to these sharks.

The L.A. Times' Tim Rutten wrote this review on Kelly's book:
A little more than a year ago, the fabled investment banking house of Bear Stearns was one of the pillars not only of Wall Street, but also of the global economy, widely admired for its daring innovations in managing and marketing new generations of asset-backed securities.

Today, to the extent Bear is remembered at all, it is for its collapse and forced sale to JPMorgan Chase, the first rock to fall in the risk management avalanche that triggered the current global financial crisis. As a reporter for the Wall Street Journal, Kate Kelly was the best of the financial journalists covering Bears' once-unthinkable descent into oblivion. Her admirably detailed three-part narrative of the firm's ultimate failure and dissolution was an important source for another account of the debacle, William D. Cohan's "House of Cards," which was published in March.

In "Street Fighters: The Last 72 Hours of Bear Stearns, the Toughest Firm on Wall Street," Kelly has elected to undertake an hour-by-hour reconstruction of the three days in March of 2008 when Bear Stearns first realized it was collapsing, fought to save itself and, ultimately, agreed to a humiliating sale to JPMorgan. It overstates nothing to call Kelly's book brilliantly reported, and her narrative is grippingly propulsive and peopled with fascinatingly drawn characters. Notable among them are Bear's Hamlet-like CEO, Alan Schwartz, who wept in line at the nearby Starbucks on the morning he had to announce the sale, and Jimmy Cayne, the erratic and wildly eccentric cigar-smoking chairman, whose real passions appear to have been bridge and golf. There are terrific walk-on appearances by Warren Buffett; Bear's legendary ex-chairman, Ace Greenberg; Lloyd Blankfein (the Goldman Sachs honcho); and Chris Flowers, the engaging private equity investor who made a spirited run at Bear.

Kelly's meticulous reporting amply demonstrates that the locus of Bear Stearns' fundamental problems derived from the unique interplay of its distinctive internal culture with the deeply flawed and, often, unfortunately idiosyncratic men who ran the place in those last years. The result seemed to be an institution that -- at all levels -- was quick to display bare knuckles to the outside world, while behind its own closed doors a lot of sharp elbows were swinging. Perhaps the most telling of the interlocking portraits Kelly sketches so well is that of Bear's upper echelons, where executives were fiercely territorial and oddly inattentive to even critical operational questions. Bear Stearns was, in the end, an institution where denial was the executive suites' emotion of first resort.

Even so, the breadth of Kelly's reconstruction opens doors on other, structural questions. It's clear from her account that at some of the most critical junctures during the three days in which Bear Stearns writhed in extremis, the intervention of federal officials was critical. The deal with JPMorgan would have collapsed at the 11th hour had then-New York Fed Chairman Timothy Geithner, now secretary of the Treasury, not jumped in and proposed a federal guarantee of Bear's most problematic real estate-linked assets. The humiliating $2-a-share stock price at which the firm initially was sold was set by then-Treasury Secretary Henry Paulson, who reportedly felt Bear Stearns deserved to be punished for its recklessness. Similarly, if Paulson had elected to open the Fed's discount window -- which loans money to banks -- to investment banking houses just a day or two sooner, Bear might have been able to remain in business, at least for some time.

In her epilogue, Kelly reports on how most of the key characters in her drama have fared since Bear's Stearns' collapse. It will surprise only the catatonic that most landed firmly on their feet, that those who wanted to find other employment in their field quickly found it and that even most of those who remain traumatized and unhappy over their firm's fate mourn in considerable comfort.

At one point, Kelly catalogs the variety of implausible conspiracy theories that have been spun around Bear's fall. Then, she notes:

"Regulators may never know what really happened. But one thing is clear: Once confidence in a company falls away on such a grand scale, it can never recover. Bear started that week with more than $18 billion in capital, its largest cash position ever. Three days later, negative headlines, a stock drop, lender reticence and big withdrawals from client accounts had cut those capital levels in half. Eight hours later, it was nearly dead."

The tsunami-like pace of onrushing financial disaster was impressive, indeed. The introductory sentence to that paragraph, however, is deeply chilling and bears repeating -- "Regulators may never know what really happened." Yet this was a situation so threatening to the fabric and substance of global finance that Federal Reserve Chairman Ben Bernanke would subsequently insist that, absent government intervention to essentially force the deal with JPMorgan, Bear would have gone into bankruptcy, causing a "chaotic unwinding" of investments in all the American markets.

Yet regulators may never know what really happened.

That's the intolerable fact of public policy on which this whole mess turns, along with all the pain it set rippling through the nation's human economy, the one where ordinary people struggle to pay the deceptive mortgages that backed all those derivatives and where women and men who've lost jobs as a consequence of this calamity now scratch to find new livings.

There are timeless human failings to ponder anew in Kelly's artful narrative journalism -- ego, hubris, venality and folly, the whole sad crew. They, unfortunately, will always be with us, consequences of our fallen nature. What we need not tolerate is a federal regulatory structure that is blind to the operations of those who wheel and deal at the very center of the global economy and federal officials who are so uncertain of their aims and prerogatives that they fumble in the face of crisis.

By the way, many pension funds were investing these exotic derivatives based on shaky mortgages (CDOs) and some were selling insurance on CDOs (CDS) just like AIG.

I can also share with you that ego, hubris, venality and folly are still alive and thriving in the sell-side and buy-side. There is a pathological and symbiotic relationship between the sharks on Wall Street and their institutional clients. I was often disgusted watching individuals stroke each others egos as they figured out ways of profiting for themselves.

Not everyone in finance is ruthless and looking out for themselves, but having worked in this industry for a good part of my life, I can tell you that I have never seen so many hopelessly insecure and ruthless people with no sense of morality, and many of them are running these powerful institutions.

Finally, please take the time to listen to Kate Kelly's interview on CBC radio as well as her recent appearance on the Charlie Rose show along with William Cohan, author of House of Cards: A tale of Hubris and Wretched Excesses on Wall Street. (Note: you can read a review of Mr. Cohan's book here.)

I will come back tomorrow and write about why I think in the new era of investing, small is beautiful. Enjoy your weekend.

Wednesday, May 27, 2009

The Incredibly Uneven Recovery?


The Dow Jones industrial average fell almost 175 points Wednesday, erasing most of the previous day's rally as a jump in government bond yields fanned concerns that higher interest rates will sap strength from the economy:

A steep drop in the price of the benchmark 10-year Treasury note pushed its yield up to 3.75 percent from 3.55 percent late Tuesday and to the highest level since November. Bond investors were selling on concerns that the huge amount of debt the government is selling to fund its bailout programs will ultimately keep Treasury prices down.

Along with increasing borrowing costs for the government, rising yields on Treasury debt could hamper an economic recovery since they are used as benchmarks for home mortgages and other kinds of loans. Higher mortgage rates could delay a recovery in the battered housing market.

"The equity market is getting worried about the 'green shoots.' I think the deer have nipped off a few and I think a few turned out to be weeds," said Hank Herrmann, chief executive of Waddell & Reed. Herrmann was referring to early positive signs in the economy that Federal Reserve Chairman Ben Bernanke has called "green shoots."

While Wall Street has been rallying for most of the past three months on those early signs of recovery, it has also been vulnerable to unexpected turns such as the jump in Treasury yields.

"Stocks are following bonds," said John Brady, senior vice president of global interest rate products at MF Global. "Will the economy grow and expand vigorously in the face of sustained higher interest rates?"

Late today, the WSJ reported that Pequot Capital Management -- a pioneering and well-connected hedge fund that gained fame for racking up years of strong returns -- is shutting its doors amid a revived insider-trading probe.

[Note: Talk of a major hedge fund shutting its door always spooks the market as people fear liquidation. Watch to see if traders buy this dip.]

In other news, the National Association of Business Economists (NABE) came out on Wednesday to say that the US economy is poised to emerge from recession in the second half of the year:

The National Association for Business Economics said a survey of 45 professional forecasters found that the consensus believed the end of the prolonged recession that began in December 2007 was finally was in sight.

"While the overall tone remains soft, there are emerging signs that the economy is stabilizing," according to NABE's latest survey and its president, Chris Varvares.

"The survey found that business economists look for the recession to end soon, but that the economic recovery is likely to be considerably more moderate than those typically experienced following steep declines," said Varvares, who is president of Macroeconomic Advisers.

The NABE outlook showed that panelists expected gross domestic product (GDP) -- the country's goods and services output -- to shrink by 1.8 percent in the second quarter.

But the NABE panel, in the survey taken between April 27 and May 11, downgraded the outlook for the next several quarters.

The panelists said a sharp pullback in business investment was stoking near-term weakness, and cited rising government spending as a "vital support" to the ailing economy.

The consensus forecast continued to see a "modest" rebound in the second half, beginning in the third quarter, "followed by steady improvement," NABE said.

But overall the lackluster rebound was expected to post a meager 1.2 percent annual pace, "well below trend," in the second half of the year.

That would include growth of 1.0 percent in the third quarter and 2.1 percent in the fourth quarter.

For 2010, meanwhile, the NABE pegged average growth at just 2.0 percent, down from its earlier projection of 2.4 percent growth.

NABE said the key downside risks continued to loom large: steep job losses, extremely tight credit conditions and falling home prices.

"These same forces are causing consumers to remain cautious, a feature that NABE panelists think is here to stay," the association said.

Consumer spending is considered key to economic recovery since it represents about two-thirds of US output.

The NABE panel predicted that labor market conditions would deteriorate further, but the pace of job losses would decline through the rest of the year.

"A total of roughly 4.5 million jobs are expected to be lost in 2009, driving the unemployment rate to 9.8 percent by year-end," NABE said.

The panelist projected "modest" job gains in 2010 that would trim the unemployment rate to 9.3 percent by the end of next year.

[Note: To view the NABE US Outlook Survey click on these Slides].


Another prominent economist, Martin Feldstein, told Reuters on Tuesday that there will not be a sustainable recovery in the United States before next year even if there is positive growth in the second quarter:

"I still hold the view that a sustainable recovery in the United States will start in 2010, if we are lucky," said Feldstein, a Harvard University professor who sits on U.S. President Barack Obama's Economic Recovery Advisory Board.

"We may see some positive growth in the second quarter but it will not be the beginning of a sustainable recovery," he said on the sidelines of an economic conference in the Greek capital.

Feldstein is a member of the panel of experts tapped by Obama to help shape his response to the economic crisis.

"I think the fundamentals are for the dollar to come down. We have an enormous trade deficit," he said. "I don't think inflation is a problem in 2009 and probably not in 2010. The big problem now is how to get the economy growing again."

"The dollar's (decline) will certainly weaken economic recovery in Europe. And this has to be seen by European officials as a long term problem," he said.

Mr. Feldstein is right to be concerned. According to the OECD, Gross domestic product (GDP) in the OECD area fell by 2.1% in the first quarter of 2009, the largest fall since OECD records began in 1960, according to preliminary estimates, and followed a fall of 2.0% of GDP in the previous quarter.

And Mr. Feldstein is right, the dollar's decline will weaken the economic recovery in Europe, which is a downer for world economic recovery:

Nine months into the worst economic downturn since the Great Depression, the free-fall in the United States appears to be giving way to a more measured decline, but economists are struggling to find a steady pulse in European and other industrialized nations, such as Japan, where the world's second-largest economy is also slowing the global recovery. These countries' recessions are shaping up to be both deeper and longer than the one in the United States, where the pace of job losses has eased and there are fresh signs of life in financial markets.

There are hints of stabilization in the Old World -- in Germany, for instance, investor sentiment is up amid indications that factory orders are stabilizing after months of sharp drops. But many economists now say Europe will trail the United States in pulling out of recession by at least three months.

Critics charge that this is partly because Europe is still moving slowly to roll out government stimulus programs and right its own ailing financial system. Some countries, like Ireland, are so cash-strapped that they've raised taxes in the middle of a deep recession, making things worse. In addition, European leaders have only recently signaled their willingness to conduct broad, systematic stress tests on their financial institutions, similar to the ones on major U.S. banks already concluded by the Treasury Department.

Indications are that they need such tests, and fast. While U.S. banks have already written down about half the estimated $1.1 trillion in troubled loans and toxic assets on their books, Europe's financial institutions have thus far written down less than 25% of their $1.4 trillion in bad debts related to the crisis, according to a report from the International Monetary Fund. Many major Western European banks are also heavily invested in hard-hit Eastern Europe, where the risk of a fresh wave of corporate and consumer defaults is considerable.

"Recovery here depends on recovery abroad," U.S. Treasury Secretary Timothy F. Geithner told a House Appropriations subcommittee last week. "Our financial reform effort in the United States must be matched by similarly strong efforts elsewhere in order to succeed." In the face of congressional criticism of Europe, however, he defended the actions taken by its governments thus far, saying they were "better than you think."

Nevertheless, Europe's troubles are bad news for a global recovery. The 27-nation European Union accounts for almost a quarter of the world's economic activity, and its sluggish emergence from the crisis is likely to slow any rebound in world trade and foreign investment.

"The net effect is that Europe will not be an engine in a global recovery; in fact, it will be quite the opposite," said Eswar Prasad, senior fellow at the Brookings Institution and professor of trade policy at Cornell University. "Europe is going to be a drag on the world economy for the next one to two years."

Bloomberg reports that the U.K. recession probably will end in the second half of this year, according to strategists in Edinburgh at fund managers overseeing 237 billion pounds ($378 billion). Then growth may stall again over the next two years.

[Note: Read my comment on the W-recovery.]

The Guardian reports that Nouriel Roubini on Wednesday said the end of the global recession is likely to occur at the end of the year rather than the middle, and that U.S. growth will remain below potential afterward:

"We are not yet at the bottom of the U.S. and the global recession," said Roubini. "The contraction is still occurring and the recession is going to be over more toward the end of the year rather than in the middle of the year."

"There is still too much optimism that a recovery is just around the corner," said Roubini, a professor at New York University's Stern School of Business and chairman of RGE Monitor, an independent economic research firm.

Roubini, who is widely credited for predicting the current economic turmoil, was speaking at the Seoul Digital Forum.

"A more sober analysis suggests we're closer to the bottom; there is light at the end of the tunnel, but it's going to take a while longer, and the recovery is going to be weaker than otherwise expected."

Once the recession ends, "U.S. economic growth is going to be below potential for at least two years," he said, amid multiple imbalances in the housing sector and the financial system, and the rise of public debt.

Roubini said the outlook for Asia was more positive than for Europe, Japan and the United States, thanks to stronger fundamentals.

"The latest economic indicators from Korea ... suggest there is the beginning of an economic recovery, and growth might be already positive in the second quarter."
The downside risk, Roubini said, was if advanced countries did not recover fast enough and if China's rate of growth started to slow again.

Roubini predicted China would post a 6 percent growth rate this year, a "hard landing" considering it grew by 10 percent for a decade.
A robust recovery in Korean, China and other countries in the region would depend upon relying less on external demand and export-led growth and relying more on domestic growth, he said.

Reuters reports that the People's Bank of China said on Wednesday that China's economy has seen signs of improvement but still faces considerable downward pressure:

The central bank said in a report on region-by-region financial conditions that the global economic crisis was still spreading and that China's recovery to date was not yet on solid ground.

It sounded an optimistic note about China's longer-term development, saying that growth was spreading more strongly to less-developed inland provinces, a process that could become a driving force for the economy in coming years.

In the short term, though, the export outlook remained bleak and local governments needed to adjust their policies to provide more support for exporters, the central bank said.

It added that financial institutions should also extend more credit to exporting firms hit hard by the slowdown in external demand.

"Although our economy is showing some positive signs, the foundation is still not solid and downward pressure on the economy remains quite strong," the central bank said.

It appealed to local governments throughout China to implement Beijing's crisis-fighting strategy of stimulating domestic demand, stabilising external demand and promoting "stable and quite fast" economic growth.

Turning to how different regions should position themselves, the central bank said that the east coast, the wealthiest part of China, should try to expand links with international markets while also developing its service, high-tech and advanced manufacturing sectors.

It said that China's poorer central and western regions should focus on improving their basic infrastructure and reducing bottlenecks.

"Our country's interregional economic development is becoming better balanced, more complementary and more sustainable," the report said. "Regional economic development will become a new bright spot of economic growth."
Clearly global economic recovery is tenuous at best. There are signs of stabilization, but no indication that a sustained recovery in underway.

Moreover, I agree with the folks at Merrill Lynch who in a recent report state that surging global liquidity of the kind we’re seeing now, could result in another bubble — very possibly in energy. That in turn, could potentially put a quick stop to any impending global recovery — or make the current downturn worse.

Finally, take the time to read the Digital Rules blog comment on the incredibly uneven recovery:

Prior to this recession, the most notable feature of the late 20th/early 21st century economy was its volatility. The silicon chip, the Internet and globalism were accelerants to the renaissance of entrepreneurial capitalism that began in the late 1970s. Around the world, the storyline was familiar. New products, services, distribution paths and business models would appear out of nowhere and cause damage to the old and slow.

The global consultant, McKinsey & Co., summarized this effect in a famous 2005 paper called "Extreme Competition" (published in McKinsey Quarterly). "Extreme Competition" said top companies, across all industries, faced a 20% to 30% probability of falling out of leadership in a five-year period. The chance of toppling from the top ranks had tripled in a generation.

Will this pace of disruption and churn continue during the recession and recovery? I think so. It is tempting to see a recession as a yellow caution flag that slows all cars in the field. But in fact, recessions tend to shake out the old, slow and bloated that masked their decline in flusher times.

The 1973-74, 1980 and 1982 recessions dealt death blows to the incoherent conglomerates created during the 1960s. The 1990-91 recession killed off the minicomputer industry and nearly did in IBM. The recession of 2007-09 has shredded the Michigan auto industry. Big city dailies are falling everywhere. Were they killed by the recession or Craigslist? (By both.)

Recovery from this recession is likely to be weak. Rising oil prices amidst increasing supply and falling demand is proof of U.S. dollar weakness and portends stagflation. Real growth for the American economy when recovery starts will be in the 1% to 2% range, instead of the usual 3%. It will be the 1970s again.

But remember: GDP growth is an aggregate number. Peel back this pedestrian top line figure, and what you'll see is a jagged landscape of booms and busts. Some companies, industries, cities, regions and skill sets were never hurt much and will experience a robust recovery. Others will be mired in permanent depression.

As one example, the New York Times columnist, Bob Herbert, points out the disproportionate problems of uneducated young males:

"The Center for Labor Market Studies is at Northeastern University in Boston. A memo that I received a few days ago from the center's director, Andrew Sum, notes that 'no immediate recovery of jobs' is anticipated, even if the recession officially ends, as some have projected, by next fall

The memo said: 'Since unemployment cannot begin to fall until payroll growth hits about 1%--and payroll growth will not hit 1% until [gross domestic product] growth hits at least 2.5% to 3%--we may not see any substantive payroll growth until late 2010 or 2011, and unemployment could rise until that time.'

"We've already lost nearly 5.7 million jobs in this recession. Those losses, the center says, 'have been overwhelmingly concentrated among male workers, especially among men under 35.'"

As another example, today's Wall Street Journal has a fascinating tale of two Michigan cities, Ann Arbor and Warren:

"The divide between Ann Arbor, with a population of 116,000, and Warren, population 126,000, is large and widening. Ann Arbor's unemployment rate of 8.5% in March trailed the nationwide rate of 9% and was well below Michigan's overall rate of 13.4%, based on nonseasonally adjusted figures. By contrast, Warren's unemployment rate of 17.3% is among the highest in the state. The average family income in Ann Arbor was $106,599 in 2007, compared with $69,193 nationally and $60,813 in Warren.

"That economic gulf wasn't always there. In 1979, the average family in Warren made $28,538 annually, not much below Ann Arbor's average of $29,840. But in the past 30 years, the U.S. economy has undergone a sweeping transformation that has benefited cities like Ann Arbor and hurt manufacturing hubs like Warren.

"Warren is suffering from its reliance on the auto industry.

"As transportation and communication costs fell, and countries like Japan and, now, China, increased their manufacturing capability, Michigan's advantages have faded. Those same forces of globalization benefited educated workers--an area where Michigan largely fell short.

The science fiction writer, William Gibson, likes to say: "The future is already here--it is just unevenly distributed."

Likewise, the economic recovery has already started. But its distribution will be highly uneven.

In my opinion, the distributional effects of this recovery will ultimately determine its sustainability. If policymakers don't figure out ways to counterbalance these uneven distributional effects, we risk heading into a protracted period of subpar growth.

Tuesday, May 26, 2009

Liquidity Drowning the Meaning of Inflation?


On Monday, Sheldon Filger wrote an article in the London Telegraph stating that the U.S. economy risks the dire prospect of hyperinflation:

... though not downgrading the danger of deflation, I believe policymakers are ignoring other factors regarding this economic and financial condition. Furthermore, the U.S. government and Federal Reserve in particular, are taking steps to "cure" deflation that will inevitably lead to hyperinflation, which in the long-term may prove far more destructive to the long-term health of the U.S. economy.

History demonstrates that deflation is not a permanent condition. Market forces, unencumbered by fiscal and monetary intervention, eventually restore pricing equilibrium. At a certain point prices of major durables such as homes are low enough to encourage new categories of consumers to enter the marketplace. As demand is restored, prices stabilize and then resume their upward ascent. It is all a question of time. However, key decision-makers in the United States are not paragons of patience. They want deflation cured immediately, which explains why the U.S. Treasury and Federal Reserve are hell-bent on policies that are guaranteed to be inflationary. The question is how bad will inflation ultimately be.

Massive quantitative easing by the Fed is pouring trillions of U.S. dollars into the money supply, essentially conjured out of thin air. This is being done without transparency, the rationale being that frozen credit markets require a vast expansion of the money supply in an attempt to get the arteries of commerce flowing again. Similarly, the U.S. government is spending vast amounts of money it does not have, with the Treasury Department selling unprecedented levels of government debt in a frantic effort to fund the wildly expanding U.S. deficit. These two forces, quantitative easing and multi-trillion dollar deficits, are the core ingredients of an explosive fiscal cocktail that I believe will ultimately lead to hyperinflation.

What exactly is hyperinflation? Economists disagree on a common definition, so I will offer one myself. Double-digit inflation extending over a period of at least two years would arguably be a hyperinflationary period. It can get much worse, witness Weimar Germany in the early 1920's and Zimbabwe at present. The most recent experience the United States had with this unstable economic condition was in 1981, when the annual CPI rate exceeded 13%. The cure was draconian; Federal Reserve Chairman Paul Volcker engineered a severe economic recession that created the highest level of U.S. unemployment since the Great Depression -- until now. The federal funds rate, currently near zero, rose to above 20% under Volcker's harsh discipline. Eventually high inflation was purged out of the system and economic growth was restored, however the monetary regimen was punitive for several years.

The current monetary and fiscal policies being enacted by the key economic decision-makers in the United States are laying the groundwork for a far more dangerous inflationary environment than anything encountered by Paul Volcker.

The explosive growth in the money supply and government debt is simply unsustainable without severe inflation. It must be kept in mind that the Federal government is not the only public authority engaged in massive deficit spending.

Throughout America, state, county and municipal governments are faced with imploding tax revenues and lack the ability or political flexibility to cut services to a level commensurate with revenue flows. Both the Fed and the public sector are engaging in a reckless gamble; borrow like crazy in the hope that this overdose of economic stimulation will restore growth to the economy and normal tax revenues, leading to a decreased and sustainable level of public sector indebtedness.

If one believes that the policymakers running the Federal Reserve, Treasury and Federal government, the same architects of the Global Economic Crisis, are smart enough to now get everything right, perhaps we may escape the worst consequences of their turbo-charged fiscal and monetary policies. However, there are growing indications that global investors and the broader market are beginning to reach a far more sobering assessment.

In an interview with Bloomberg News, Bill Gross, co-chief investment officer of PIMCO (Pacific Investment Management Company) suggested that the coveted AAA credit rating U.S. government debt now benefits from will eventually be downgraded. "The markets are beginning to anticipate the possibility of a downgrade," Gross said.

China, the major purchaser of Treasuries and holder of $1 trillion of U.S. government debt, is already on record as expressing concern for the integrity of its American investments, and has begun actively exploring alternatives to the U.S. dollar as the primary global reserve currency. These moves by China are not based on fears of expropriation of its U.S. assets, but focuses on the specter of hyperinflation destroying much of the value of assets denominated in U.S. dollars. No doubt China's economic experts are well aware of the growing number of economists who are convinced that the U.S. will be unable to service its rapidly expanding debt burden without significant inflation. Inflation in monetary terms means the erosion of the intrinsic value of the American dollar.

What is most frightening about the policy moves being enacted by the Fed and Treasury is that their actions may not be a reckless gamble after all. They may have come to the conclusion that only hyperinflation will enable the United Sates to avoid national insolvency. In effect, they may be pursuing the exact opposite course undertaken by Paul Volcker in the early 1980's. If that is their prescription for the dire economic crisis confronting the U.S., then one must conclude that Ben Bernanke, Timothy Geithner and Larry Summers have learned nothing from history. Once the spigot of hyperinflation is tuned on, it becomes a cascading torrent that is almost impossible to switch off, and which in its wake inflicts inconceivable levels of economic, political and social devastation. Before it is too late, President Obama should put the brakes on his economic team's dangerous gamble with the haunting specter of hyperinflation. If he fails to act in time, a hellish prospect may be his economic and political legacy.


On Tuesday, the Telegraph's Ambrose Evans-Pritchard reports that China has warned a top member of the US Federal Reserve that it is increasingly disturbed by the Fed's direct purchase of US Treasury bonds:

Richard Fisher, president of the Dallas Federal Reserve Bank, said: "Senior officials of the Chinese government grilled me about whether or not we are going to monetise the actions of our legislature."

"I must have been asked about that a hundred times in China. I was asked at every single meeting about our purchases of Treasuries. That seemed to be the principal preoccupation of those that were invested with their surpluses mostly in the United States," he told the Wall Street Journal.

His recent trip to the Far East appears to have been a stark reminder that Asia's "Confucian" culture of right action does not look kindly on the insouciant policy of printing money by Anglo-Saxons.

Mr Fisher, the Fed's leading hawk, was a fierce opponent of the original decision to buy Treasury debt, fearing that it would lead to a blurring of the line between fiscal and monetary policy – and could all too easily degenerate into Argentine-style financing of uncontrolled spending.

However, he agreed that the Fed was forced to take emergency action after the financial system "literally fell apart".

Nor, he added was there much risk of inflation taking off yet. The Dallas Fed uses a "trim mean" method based on 180 prices that excludes extreme moves and is widely admired for accuracy.

"You've got some mild deflation here," he said.

The Oxford-educated Mr Fisher, an outspoken free-marketer and believer in the Schumpeterian process of "creative destruction", has been running a fervent campaign to alert Americans to the "very big hole" in unfunded pension and health-care liabilities built up by a careless political class over the years.

"We at the Dallas Fed believe the total is over $99 trillion," he said in February.

"This situation is of your own creation. When you berate your representatives or senators or presidents for the mess we are in, you are really berating yourself. You elect them," he said.

His warning comes amid growing fears that America could lose its AAA sovereign rating.

I doubt America will lose its AAA sovereign rating, but $99 trillion of unfunded liabilities can bring the world's biggest economy closer to that day of reckoning.

But not all Fed presidents fear inflation. Last Thursday, Boston Federal Reserve Bank President Eric Rosengren said the risk of deflation is currently more of a concern than inflation:

Between inflation and deflation, my concerns are currently more weighted toward deflation," Rosengren said in response to audience questions after giving a speech to the Worcester Economic Club.

He added that the size of the Fed's balance sheet -- which has more than doubled in the financial crisis -- was "not a situation we want to be in, it's a situation we need to be in" given the severity of the crisis.

Answering a separate question, Rosengren said that due to the global nature of the crisis "in the short-run it will be hard to have export-led growth."

Rosengren is not a voter in 2009 on the Federal Open Market Committee, the Fed's policy-setting panel.

Indeed, if you look around the world, you see that Japan, the U.K. , and other countries are grappling with deflation.

So why is the U.S. bond market on edge? Isn't all this talk of hyperinflation absurd? The Financial Ninja is back and he writes that with each interest ticker higher, another "green shoot" dies:

"There isn't enough capital in the world to buy the new sovereign issuance required to finance the giant fiscal deficits that countries are so intent on running. There is simply not enough money out there," -Kyle Bass

FN: Giddy talk of "green shoots" has completely drowned out a more sober and rational assessment of the global situation. Random statistical noise in various minor economic indicators have over the past two months resulted in wild exclamations of "the worst is definitely over".

It most certainly is not.

With every major economy in the world attempting to solve this economic crisis with both loose monetary and fiscal policy, it was only a matter of time before the global credit markets would reach their limits.

These limits have almost been reached.

The long end of every curve of every major economy has been steadily climbing. The rate of change has now accelerated and interest rates on these important benchmarks have now reached "pre-crisis" levels. In a ZIRP world this is definitely a bad sign. Formerly respectable governments from the US to the UK have gone the "banana republic" route and started monetizing their debts in a desperate attempt to prevent long rates from rising, to no avail. A veritable tsunami of debit issuance now sits just over the horizon, waiting to dumped on a crippled and saturated global debt market.

The UK will eventually lose it's coveted triple 'AAA' rating and the US cannot be far behind. Rising rates will drag everything from mortgage rates to credit card rates higher. Everything from residential and commercial real estate to businesses will feel the pain of higher borrowing costs. The central banks of the world have no more real options left. They've lowered the rates they control to zero and have flooded the financial system with liquidity. Their balance sheets are now swollen with toxic assets and outright debt monetization won't bring rates down.
The ECONOMPICDATA blog asks, Can we inflate ourselves out of this mess?, and concludes

Thus, the concern I have is that inflation won't be driven through via wage increases (where at least workers salaries are keeping up), but by a spike in the price of commodities. If inflation concerns = dollar concerns = commodity spike, then that impossible stagflation may be possible once again.

We may be in the early stages of asset inflation in stocks and commodities. It's too early to tell, but it is worth keeping in mind that asset inflation can transpire as liquidity makes its way through the financial system.

Finally, writing in the Asia Times, Henry C K Liu writes that liquidity is drowning the meaning of 'inflation':

The conventional terms of inflation and deflation are no longer adequate for describing the overall monetary effect of excess liquidity recently released by the US Federal Reserve, the nation's central bank, to deal with the year-long credit crunch.

This is because the approach adopted by the Treasury and the Fed to deal with a financial crisis of unsustainable debt created by excess liquidity is to inject more liquidity in the form of both new public debt and newly created money into the economy and to channel it to debt-laden institutions to reflate a burst debt-driven asset price bubble.

The Treasury does not have any power to create new money. It has to borrow from the credit market, thus shifting private debt into public debt. The Fed has the authority to create new money. Unfortunately, the Fed's new money has not been going to consumers in the form of full employment with rising wages to restore fallen demand, but instead is going only to debt-infested distressed institutions to allow them to deleverage from toxic debt. Thus deflation in the equity market (falling share prices) has been cushioned by newly issued money, while aggregate wage income continues to fall to further reduce aggregate demand.

Falling demand deflates commodity prices, but not enough to restore demand because aggregate wages are falling faster. When financial institutions deleverage with free money from the central bank, the creditors receive the money while the Fed assumes the toxic liability by expanding its balance sheet. Deleverage reduces financial costs while increasing cash flow to allow zombie financial institutions to return to nominal profitability with unearned income and while laying off workers to cut operational cost. Thus we have financial profit inflation with price deflation in a shrinking economy.

What we will have going forward is not Weimar Republic-type price hyperinflation, but a financial profit inflation in which zombie financial institutions turn nominally profitable in a collapsing economy. The danger is that this unearned nominal financial profit is mistaken as a sign of economic recovery, inducing the public to invest what remaining wealth they still hold, only to lose more of it at the next market meltdown, which will come when the profit bubble bursts.

Hyperinflation is fatal because hedging against it causes market failures to destroy wealth. Normally, when markets are functioning, unhedged inflation favors debtors by reducing the value of liabilities they owe to creditors. Instead of destroying wealth, unhedged inflation merely transfers wealth from creditors to debtors. But with government intervention in the financial market, both debtors and creditors are the taxpayers. In such circumstances, even moderate inflation destroys wealth because there are no winning parties.

Debt denominated in fiat currency is borrowed wealth to be repaid later with wealth stored in money protected by monetary policy. Bank deleveraging with Fed new money cancels private debt at full face value with money that has not been earned by anyone, that is with no stored wealth. That kind of money is toxic in that the more valuable it is (with increased purchasing power to buy more as prices deflate), the more it degrades wealth because no wealth has been put into the money to be stored, thus negating the fundamental prerequisite of money as a storer of value.

This is not demand destruction because decline in demand is temporarily slowed by the new money. Rather, it is money destruction as a restorer of value while it produces a misleading and confusing effect on aggregate demand.

Thinking about the value of any real asset (gold, oil, and so forth) in money (dollar) terms is misleading. The correct way is to think about the value of the money (dollars) in asset (gold, oil) terms, because assets (gold, oil, and so on) are wealth. The Fed can create money, but it cannot create wealth.

Central bankers are savvy enough to know that while they can create money, they cannot create wealth. To bind money to wealth, central bankers must fight inflation as if it were a financial plague. But the first law of growth economics states that to create wealth through growth, some inflation needs to be tolerated.

The solution then is to make the working poor pay for the pain of inflation by giving the rich a bigger share of the monetized wealth created via inflation, so that the loss of purchasing power from inflation is mostly borne by the low-wage working poor and not by the owners of capital, the monetary value of which is protected from inflation through low wages. Thus the working poor loses in both boom times and bust times.

Inflation is deemed benign by monetarism as long as wages rise at a slower pace than asset prices. The monetarist iron law of wages worked in the industrial age, with the resultant excess capacity absorbed by conspicuous consumption of the moneyed class, although it eventually heralded in the age of revolutions. But the iron law of wages no longer works in the post-industrial age in which growth can only come from mass demand management because overcapacity has grown beyond the ability of conspicuous consumption of a few to absorb in an economic democracy.

That has been the basic problem of the global economy for the past three decades. Low wages even in boom times have landed the world in its current sorry state of overcapacity masked by unsustainable demand created by a debt bubble that finally imploded in July 2007. The whole world is now producing goods and services made by low-wage workers who cannot afford to buy what they make except by taking on debt on which they eventually will default because their low income cannot service it.

All the stimulus spending by all governments perpetuates this dysfunctionality. There will be no recovery from this dysfunctional financial system. Only reform toward full employment with rising wages will save this severely impaired economy.

How can that be done? Simple. Make the cost of wage increases deductible from corporate income tax and make the savings from layoffs taxable as corporate income.
I agree with Henry Liu, unless we get wage increases across all OECD nations, I wouldn't count on a sustained global economic recovery, or on the hyperinflation we've seen in the past.

But asset bubbles and another market meltdown look inevitable as excess liquidity finds its way into the global financial system. When this happens, don't say nobody predicted it. You've been warned.

Pension Terminators?


I just came back from the movies where I saw Terminator Salvation. Not bad, but nowhere near as good as Terminator 2 - Judgment Day, which was a classic in this series.

But far away from Hollywood, real life pension terminators are hard at work. Canadian Auto Workers (CAW) members voted 86 percent in favor of a cost-cutting deal with General Motors Corp.'s Canadian unit as the automaker bids to qualify for more government loans and assure its future in Canada:

According to the CAW, the tentative deal with GM Canada provides that the starting pay rate for new hires will be 70 percent of the established rate with increases of 5 percent per year for six years. New hires will be entitled to the same retiree health benefits, funded either through a new Health Care Trust or by the company.

The deal freezes pensions until 2015, eliminates semi-private hospital coverage and ends tuition assistance for workers joining the company after Jan. 1, 2010. The CAW also said a $3,500 vacation compensation payment has been cut to offset other costs, including pensions.

Under the contract, the union and the company have committed to negotiate a Health Care Trust agreement to provide retiree health care benefits in the future, much like the automaker's terms with U.S. workers. GM Canada also agreed to restructure its underfunded pension plan within a year and move to funding the plan on a solvency basis comparable to the plans at Ford and Chrysler.

Bloomberg reported that Canada’s federal government won’t finance pension benefits retained in a tentative labor accord with GM.

On May 10th, USA Today reported that more companies are freezing pensions:

The number of companies that have frozen their traditional pension plans has accelerated sharply this year, a trend that will likely continue as companies wrestle with declining profits and poor investment returns.

At least 16 companies have announced plans to freeze their pensions so far this year, vs. 18 for all of 2008. Last week, Wells Fargo told its employees that their pension plans will stop accruing benefits July 1.

When a pension is frozen, employees get to keep the benefits they've already earned, but the company usually won't contribute any more money. Older employees are particularly hard hit because they have less time to make up for the loss, says Nancy Hwa, spokeswoman for the Pension Rights Center.

Severe investment losses in 2008 shrank the assets of the nation's largest pension plans to 79% of projected liabilities, down from 109% at the end of 2007, according to an analysis by Watson Wyatt. Companies, already hurting in the weak economy, have to increase contributions to make up the difference, and are facing stricter federal requirements about funding the plans.

More companies will freeze their pension plans unless Congress temporarily relaxes the funding requirements, says Dena Battle, director of tax policy for the National Association of Manufacturers. "When your funding obligations triple and you don't have the cash to deal with that and you don't get relief from Congress, you have to make hard choices," she says.

Pension-rights advocates and some lawmakers support giving relief only to companies that agree not to freeze their plans.

"Congress will be hesitant to provide pension fund relief without assurance that employers would protect benefits of rank-and-file employees and not divert funding relief to other uses," such as corporate bonuses, says Sandra Salstrom, a spokeswoman for Rep. Earl Pomeroy, D-N.D., who is drafting a pension relief bill.

Battle says many plan sponsors would reject relief on those terms. The employer-sponsored retirement system, "has always been voluntary," she says. "We work very hard to preserve that."

Many companies, including Cigna, Gencorp, Fujitsu, and others have frozen their pensions or cut them altogether in an effort to cut costs.

And it's not just companies. In a move that some Republican senators in Connecticut warned was fiscally irresponsible, the Senate voted 29 to 6 last Thursday to exempt cash-strapped Bridgeport from paying any money for three fiscal years into its pension fund.

In the U.K., the FT reports that the CBI employers body is calling for sweeping changes to the framework for regulating and accounting for pensions:

The employers group wants to ease the burden on businesses that are already suffering through the most severe recession in the postwar period.

In an eight-point plan released on Tuesday, the CBI says it believes “it is time to take clear, decisive action to preserve pension schemes and protect sponsors”, particularly those now at a disadvantage because they created a scheme while competitors did not.

The CBI’s plan contains several elements that have already been rejected by the pensions regulator or ministers because they pose too many risks to members’ benefits. But the document highlights the issues that the government might need to consider in an increasingly painful trade-off between the desire to protect retirement benefits and the wish to aid businesses through the recession.

First, the CBI wants the regulator automatically to allow companies to stretch out the time frame, from 10 to 15 years, over which deficits are repaired without special scrutiny, a request that the regulator has considered and rejected.

Although the regulator has said it is prepared to see deficit repair schemes stretched out much longer, it does not believe that it is prudent to skip special scrutiny of even more schemes during a recession.

Furthermore, the CBI is calling on accounting bodies to rethink rules under which liabilities are “marked to market”, giving far greater clarity to how much a company owes its pension scheme. If schemes are heavily invested in assets such as equities that do not move in line with liabilities, pension obligations can appear very volatile.

However, analysts and shareholders have been pressing for more, not less, clarity on pension costs for years. In a recent note, Peter Elwin, head of accounting and valuation analysis at Cazenove and a member of the Corporate Reporting Users Forum, described such pleas as a “let’s turn the telescope round because it makes the elephant look less worrying” approach, which he said “has lost all credibility as a potential solution”.

The CBI wants government to compensate companies more fairly for obligations they have taken on that would otherwise have to be paid under the government’s own Serps scheme, and to reconsider proposed taxation of employers’ contributions for higher earners.

It also wants a commitment to freeze levies that employers must pay to the safety net for the underfunded schemes of insolvent employers.

The Globe and Mail's editorial on Monday discussed pensions for the pensionless:

In a series of recent speeches, the heads of several of Canada's largest pension plans have warned that a steadily increasing number of Canadians do not have workplace pension plans, and that most are not saving enough on their own to provide an adequate retirement income. And their message has gone beyond hand-wringing.

The pension leaders are proposing bold solutions, debating designs for some form of innovative government-sponsored pension plan that would manage money for the 75 per cent of Canadian workers who do not have a company plan. But while the "super-fund" proposals have garnered much attention in the world of pension managers and actuaries, they remain virtually unknown to the broader public. That must change.

As Jim Leech, head of the Ontario Teachers Pension Plan, observed last week, we'd all love to be rich, but what we really don't want to be is poor. But a C.D. Howe Institute report has concluded that only one-third of Canadian households are saving enough to meet their projected basic household expenses by 2030, leaving two-thirds of the population not saving enough to cover their non-discretionary costs in the future. Beyond the personal toll, Mr. Leech says this will also create a broader economic drag, as a growing portion of the population becomes unable to contribute meaningfully to growth.

This failure of Canadians to save adequately is not a new story, but is becoming more critical as a increasing percentage of them find themselves without a workplace pension plan. The problem has been spurred on in recent years by the decline in union membership and rampant job cuts in the manufacturing sector - both traditionally associated with pension-plan coverage. It has also been worsened by large numbers of companies cancelling their traditional pension plans or closing them to new employees, arguing that the cost of the obligation is too onerous or the volatility of funding demands too risky. But while the costs can be high for plan sponsors, pension-fund managers are now voicing a compelling counterargument that there is still no more efficient way for workers to save for retirement. Traditional pension plans are cheaper to operate, with administration costs typically only a fraction of the fees paid on personal savings vehicles such as mutual funds, and managers can take advantage of long time horizons and scale across a broad population, in order to save most efficiently for generations of retirees.

Two wide-ranging recent reports on pension-fund coverage - one commissioned by the Ontario government and the other jointly commissioned by the governments of Alberta and British Columbia - have urged the creation of new types of pension plans to ease the funding burden on companies, while greatly expanding the reach of retirement coverage to more workers. The Alberta/B.C. report, for example, proposes creating a new arm's-length agency to provide pensions to the 80 per cent of the workers in the two provinces without a workplace plan. It would be available on a voluntary basis to employers, individual employees or self-employed workers, and would provide pension levels that would vary depending on investment returns. While the provinces would finance the start-up costs, they would not be expected to bear any continuing costs or liabilities.

Others have proposed a federal pension plan, similar in structure to the Canada Pension Plan, with some advocates suggesting it should be mandatory to all workers who lack a company plan, and others arguing it should be voluntary, just for those who wish to join. Some models propose a traditional plan with a guaranteed payout level at retirement; others suggest a more contemporary one with no guaranteed payout amount and pensions based on the fund's investment returns. Still others suggest a hybrid of the two, with a minimum guaranteed floor of payments plus extra payments based on investment returns. Around the world, in countries such as Britain, the Netherlands and Australia, various reforms and new models are being tested, all with the aim of creating universal pension coverage for workers.

It is time for Canada to begin mulling on its own best solution, but that will require an appetite for reform. The first step is to win broader public recognition that there is a looming pension crisis that must be dealt with now, decades before today's younger workers retire without adequate incomes. As Mr. Leech warned in his speech, it is easy for politicians to ignore a problem so distant in the future, but that this is the reckless behaviour of "credit-card junkies who can charge the bill to our kids." Across Canada, provinces and the federal government have recently unveiled short-term solutions to help companies facing pension-funding problems, offering companies more time to make up shortfalls in their plans.

The relief is needed, but it does not answer the questions about the longer-term viability of pension plans, and does little to convince companies to maintain traditional pension plans or to create new ones.

Broader solutions are now beginning to emerge, and pension experts are growing excited by the possibilities. But there must be political support before major reforms can be enacted, and the pension crisis should be front and centre in the next federal election. The issue needs a high-profile champion willing to lead the effort to create a new institution that could be as important to Canadians as the Canada Pension Plan. With many workers still shocked by the financial devastation to their retirement nest eggs from the market's collapse last year, there should be strong support for the right solution.

And now Ontario is spearheading an effort at Monday's meeting of Canada's finance ministers to get Jim Flaherty, Canada's Minister of Finance, to turn his attention to concerns that Canadians are ill-prepared for retirement as the recession erodes savings:

Ontario Finance Minister Dwight Duncan will push for a national summit on pensions during the meeting – asking Ottawa to take a leading role in a debate over whether governments need to take steps to help Canadians' bolster their retirement nest eggs.

Last year, an Ontario commission on pension reform called for governments to investigate expanding the Canada Pension Plan or creating a comparable program to enhance coverage for workers.

I say now is the time to hold a national summit on pensions and perhaps even an international summit on pensions, because what is happening in Canada, is happening all around the world.

[Witness Australian reaction to a decision to raise the pension eligibility age which has mirrored the UK experience and is being heavily criticized.]

When it comes to pensions, governments and companies can't just keep saying "I'll be back".

Finally, Monday was Memorial Day in the U.S. and made me think of the young men and women fighting abroad, as well as those that were killed or wounded in battle. Please take the time to watch this CBS news report on a remarkable U.S. Navy SEAL.

When it comes to heroes, nothing compares to the ones in real life. Their humility and dedication is truly inspiring.

***Update***

Here are some more stories for you to read:

The financial position of the Pension Benefit Guaranty Corp. again is rapidly deteriorating, triggering fears that a taxpayer-funded bailout may be needed to shore up the government's pension plan insurer.

Half of UK adults aged between 20 and 60 are not putting aside any funds into a pension, a survey commissioned by the BBC suggests.Half of UK adults aged between 20 and 60 are not putting aside any funds into a pension, a survey commissioned by the BBC suggests.

More and more Canadians are relying upon defined-contribution pension plans for their retirement, according to a new study released by Statistics Canada Tuesday.

Financial Planning reports that the downturn is accelerating the demise of the traditional pension.

Sunday, May 24, 2009

On the Inherent Unpredictability of Life


Federal Reserve Chairman, Ben S. Bernanke, addressed graduates at the the 2009 commencement of the Boston College School of Law on Friday:

I am very pleased to have the opportunity to address the graduates of the Boston College Law School today. I realized with some chagrin that this is the third year in a row that I have given a commencement address here in the First Federal Reserve District, which is headquartered at the Federal Reserve Bank of Boston. This part of the country certainly has a remarkable number of fine universities. I will have to make it up to the other 11 Districts somehow.

Along those lines, last spring I was nearby in Cambridge, speaking at Harvard University's Class Day. The speaker at the main event, the Harvard graduation the next day, was J. K. Rowling, author of the Harry Potter books. Before my remarks, the student who introduced me took note of the fact that the senior class had chosen as their speakers Ben Bernanke and J. K. Rowling, or, as he put it, "two of the great masters of children's fantasy fiction." I will say that I am perfectly happy to be associated, even in such a tenuous way, with Ms. Rowling, who has done more for children's literacy than any government program I know of.

I get a number of invitations to speak at commencements, which I find a bit puzzling. A practitioner, like me, of the dismal science of economics--and it is even more dismal than usual these days--is not usually the first choice for providing inspiration and uplift. I will do my best, though, and in that spirit I will take a more personal perspective than usual in my remarks today. The business reporters should go get coffee or something, because I am not going to say anything about the markets or monetary policy.

Instead, I'd like to offer a few thoughts today about the inherent unpredictability of our individual lives and how one might go about dealing with that reality.

As an economist and policymaker, I have plenty of experience in trying to foretell the future, because policy decisions inevitably involve projections of how alternative policy choices will influence the future course of the economy. The Federal Reserve, therefore, devotes substantial resources to economic forecasting. Likewise, individual investors and businesses have strong financial incentives to try to anticipate how the economy will evolve.

With so much at stake, you will not be surprised to know that, over the years, many very smart people have applied the most sophisticated statistical and modeling tools available to try to better divine the economic future. But the results, unfortunately, have more often than not been underwhelming. Like weather forecasters, economic forecasters must deal with a system that is extraordinarily complex, that is subject to random shocks, and about which our data and understanding will always be imperfect.

In some ways, predicting the economy is even more difficult than forecasting the weather, because an economy is not made up of molecules whose behavior is subject to the laws of physics, but rather of human beings who are themselves thinking about the future and whose behavior may be influenced by the forecasts that they or others make. To be sure, historical relationships and regularities can help economists, as well as weather forecasters, gain some insight into the future, but these must be used with considerable caution and healthy skepticism.

In planning our own individual lives, we all have a strong psychological need to believe that we can control, or at least anticipate, much of what will happen to us. But the social and physical environments in which we live, and indeed, we ourselves, are complex systems, if you will, subject to diverse and unforeseen influences. Scientists and mathematicians have discussed the so-called butterfly effect, which holds that, in a sufficiently complex system, a small cause--the flapping of a butterfly's wings in Brazil--might conceivably have a disproportionately large effect--a typhoon in the Pacific.

All this is to put a scientific gloss on what you probably know from everyday life or from reading good literature: Life is much less predictable than we would wish. As John Lennon once said, "Life is what happens to you while you are busy making other plans."

Our lack of control over what happens to us might be grounds for an attitude of resignation or fatalism, but I would urge you to take a very different lesson. You may have limited control over the challenges and opportunities you will face, or the good fortune and trials that you will experience. You have considerably more control, however, over how well prepared and open you are, personally and professionally, to make the most of the opportunities that life provides you.

Any time that you challenge yourself to undertake something worthwhile but difficult, a little out of your comfort zone--or any time that you put yourself in a position that challenges your preconceived sense of your own limits--you increase your capacity to make the most of the unexpected opportunities with which you will inevitably be presented. Or, to borrow another aphorism, this one from Louis Pasteur: "Chance favors the prepared mind."

When I look back at my own life, at least from one perspective, I see a sequence of accidents and unforeseeable events. I grew up in a small town in South Carolina and went to the public schools there. My father and my uncle were the town pharmacists, and my mother, who had been a teacher, worked part-time in the store. I was a good student in high school and expected to go to college, but I didn't see myself going very far from home, and I had little notion of what I wanted to do in the future.

Chance intervened, however, as it so often does. I had a slightly older friend named Ken Manning, whom I knew because his family shopped regularly at our drugstore. Ken's story is quite interesting, and a bit improbable, in itself. An African American, raised in a small Southern town during the days of racial segregation, Ken nevertheless found his way to Harvard for both a B.A. and a Ph.D., and he is now a professor at MIT, not too far from here. Needless to say, he is an exceptional individual, in his character and determination as well as his remarkable intellectual gifts.

Anyway, for reasons that have never been entirely clear to me, Ken made it his personal mission to get me to come to Harvard also. I had never even considered such a possibility--where was Harvard, exactly? Up North, I thought--but Ken's example and arguments were persuasive, and I was (finally) persuaded. Fortunately, I got in. It probably helped that Harvard was not at the time getting lots of applications from South Carolina.

We all have moments we will never forget. One of mine occurred when I entered Harvard Yard for the first time, a 17-year-old freshman. It was late on Saturday night, I had had a grueling trip, and as I entered the Yard, I put down my two suitcases with a thump. I looked around at the historic old brick buildings, covered with ivy. Parties were going on, students were calling to each other across the Yard, stereos were blasting out of dorm windows. I took in the scene, so foreign to my experience, and I said to myself, "What have I done?"

At some level, I really had no idea what I had done, or what the consequences would be. All I knew was that I had chosen to abandon the known and comfortable for the unknown and challenging. But for me, at least, the expansion of horizons was exactly what I needed at that time in my life. I suspect that, for many of you, matriculation at the Boston College law school represented something similar--a leap into the unknown and new, with consequences and opportunities that you could hardly have guessed in advance.

But, in some important ways, leaving the known and comfortable was exactly the point of the exercise. Each of you is a different person than you were three years ago, not only more knowledgeable in the law, but also possessing a greater understanding of who you are--your weaknesses and strengths, your goals and aspirations. You will be learning more about the fundamental question of who you really are for the rest of your life.

After I arrived at college, unpredictable factors continued to shape my future. In college I chose to major in economics as a compromise between math and English, and because a senior economics professor liked a paper I wrote and offered me a summer job. In graduate school at MIT, I became interested in monetary and financial history when a professor gave me several books to read on the subject. I found historical accounts of financial crises particularly fascinating. I determined that I would learn more about the causes of financial crises, their effects on economic performance, and methods of addressing them. Little did I realize then how relevant that subject would become one day. Later I met my wife Anna, to whom I have been married now for 31 years, on a blind date.

After finishing graduate school, I began a career as an economics professor and researcher. I pursued my interests from graduate school by delving deeply into the causes of the Great Depression of the 1930s, along with many other topics in macroeconomics, monetary policy, and finance. During my time as a professor, I tried to resist the powerful forces pushing scholars to greater and greater specialization and instead did my best to keep as broad a perspective as possible. I read outside my field. I did empirical research, studied history, wrote theoretical papers, and established connections, usually in a research or advisory role, with the Fed and other central banks.

In the spring of 2002, I was asked by the Administration whether I might be interested in being appointed to the Federal Reserve's Board of Governors. I was not at all sure that I wanted to take the time from teaching and research. But this was soon after 9/11, and I felt keenly that I owed my country my service. Moreover, I told myself, the experience would be useful for my research when I returned to my post at Princeton. I decided to take a two-year leave to go to Washington. Well, once again, so much for foresight. I have now been in Washington nearly seven years, serving first as a Fed governor, then chairman of the President's Council of Economic Advisers. In the fall of 2005, President Bush appointed me to be Chairman of the Fed, effective with the retirement of Alan Greenspan at the end of January 2006.

You will not be surprised to hear that events since January 2006 have not been precisely as I anticipated, either.

My colleague, Bank of England Governor Mervyn King, has said that the object of central banks should be to make monetary policy as boring as possible. Unfortunately, by that metric we have not been successful. The financial crisis that began in August 2007 is the most severe since the Great Depression, and it has been the principal cause of the global recession that began last fall. Battling that crisis and trying to mitigate its effect on the U.S. and global economies has dominated my waking hours now for some 21 months. My colleagues at the Fed and I have been called on to take many tough decisions, including adopting extraordinary and unprecedented policy measures to address the crisis.

I think you will agree that the chain of events that began with my decision to go far from home for college and has culminated--so far--with the role I am playing today in U.S. economic policymaking is so unlikely that we could have safely ruled it out of consideration. Nevertheless, of course, it happened. Although I never could have prepared in advance for the specific events of the past 21 months, I believe that my efforts throughout my life to expand my horizons and to keep a broad perspective--for example, to study and write about economic and financial history, as well as more conventional topics in macroeconomics and monetary economics--have helped me better meet the challenges that have come my way.

At the same time, because I appreciate the role of chance and contingency in human events, I try to be appropriately realistic about my own capabilities. I know there is much that I don't know. I consequently try to be attentive to all points of view, to work collaboratively, and to involve as many smart people in policy decisions as possible.

Fortunately, my colleagues and the staff at the Federal Reserve are outstanding. And indeed, many of them have demonstrated their own breadth and flexibility, moving well beyond their previous training and experience to tackle a wide range of novel and daunting issues, usually with great success.

Law is like economics in that, although it has its own esoterica known only to initiates, it is at bottom a craft whose value lies primarily in its practical application. You cannot know today what problems or challenges you will face in the course of your professional lives. Thus, I hope that, even as you continue to acquire expertise in specific and sometimes narrow aspects of the law, you will continue to maintain a broad perspective and willingness, indeed an eagerness, to expand the range of your knowledge and experience.

I have spoken a bit about the economic and financial challenges that we face. How do these challenges bear on the prospects of the graduates of 2009? The economic situation is a trying one, as you know. We are in a recession, and the labor market is weak. Many of you may not have gotten the job you wanted; some may have had offers rescinded or the start of employment delayed. I do not minimize those constraints and disappointments in any way. Restoring economic prosperity and maximizing economic opportunity are the central focus of our efforts at the Fed.

Nevertheless, you are in some ways very lucky. You have been trained in a field, law, that is exceptionally broad in its compass. At the Federal Reserve, lawyers are involved in every aspect of our policies and operations--not just because they know the legal niceties, but because they possess analytical tools that bear on almost any problem.

In law school you have honed your skills in reasoning, reading, and writing. Many of you have work experience or bring backgrounds to bear ranging from history to political science to the humanities to science. There will always be a need for people with your abilities and talents.

So, my advice to you is to stay optimistic. Things usually have a way of working out. My second piece of advice is to be flexible, even adventurous as you begin your careers. As I have tried to illustrate today, you are much less able than you think to foresee how your life, both professional and personal, will play out.

The world changes too fast, and too many accidents and unpredictable events occur. It will pay, therefore, to be creative and open-minded as you search for and consider professional opportunities. Look most carefully at those options that will give you a chance to learn new things, explore new areas, and grow as a person. Think of every job as a potential investment in yourself. Will it prepare your mind for the opportunities that chance will provide?

You are lucky also to be living and studying in the United States. There is a lot of pessimistic talk now about the future of America's economy and its role in the world. Such talk accompanies every period of economic weakness. The United States endured a decade-long Great Depression and returned to prosperity and global leadership.

When I graduated from college in 1975, and from graduate school in 1979, the economy was sputtering, gas prices and inflation were high, and pessimism--malaise, President Carter called it--was rampant. The U.S. economy subsequently entered more than two decades of growth and prosperity. The economy will recover--it has too many fundamental strengths to be kept down for too long--and the mood will brighten.

This is not to ignore real challenges. Our society is aging, implying higher health-care costs and fiscal burdens. We need to save more as a country, to reduce global imbalances in saving and investment, and to set the stage for continued growth. Our educational system is strong in some areas, including our university system, but does not serve everyone equally well, contributing to slower growth and greater income disparities. In the diverse capacities for which your training has prepared you, many of you will play a vital role in addressing these problems, both in the public and private spheres.

I conclude with congratulations to the graduates, your families, and friends. You have worked hard and accomplished much. You have a great deal to look forward to, as many interesting and gratifying opportunities await you. I hope that as you enter or re-enter the working world, you make sure to stay flexible and open-minded and to learn whenever you can. That's the best way to deal with the unpredictabilities that are inherent in life. I wish you the best of luck, with the proviso that luck is what you make of it.

And perhaps you will advise next year's class to invite J. K. Rowling.

No matter how critical you are of the way this Fed Chairman is handling the financial crisis, I think his address should be read by all.

Life is inherently unpredictable and we will all come across personal and professional challenges. At the age of 26, I was completing my Master's thesis in economics, critically reviewing the literature on growth empirics and convergence. I took a trip down to New York City with a buddy of mine and started feeling a pain under both my feet.

The pain was so excruciating that I couldn't walk or sleep and yet there were no visible signs of anything wrong with my feet. My buddy was very concerned so we took a flight out to head back to Montreal.

My father and brother are physicians. They told me to go do an MRI. My father took me to the emergency room and after an hour long MRI, I was diagnosed with Multiple Sclerosis as there were lesions in my brain which pointed to MS.

Needless to say, I was devastated. I thought my life was over, but I was wrong. With the support of my family and friends, I mustered the strength to regain my composure, finish my thesis (I even got an "A" on it), and slowly got on with living life.

Over the years, my bout with MS has not been easy. Like it or not, it is incredibly frustrating when you lose control over your body and are aware of it. I also faced very difficult periods dealing with challenges at work and in my personal life.

But no matter how hard life gets, I try to focus on what I can do today and worry a lot less about what I might not be able to do in the future. I simply do not care about what other people think of me. I am done worrying about what others think of me. Either they accept me for who I am or they don't.

The other thing I can share with you is that there is a beauty is in this inherent unpredictability of life. We are all here for a finite time, which is a gift in and of itself. What we do with our lives and how we cope with great obstacles is what ultimately defines each and every one of us.

I know that many people lost their job and are feeling the angst of the recession, but try to lead a healthy life, keep your focus and remember what's ultimately important is your health, your family and your friends. If you can, go volunteer some of your time to see what real misery exists out there.

I hope that the Boston College School of Law does invite J.K. Rowling to address their graduates next year. Her mom suffered from Multiple Sclerosis and with all due respect to the Fed Chairman, I find Ms. Rowling's life fascinating and the very epitome of the beauty of inherent unpredictability of life.

On that personal note, I am heading out to enjoy the beautiful weather in Montreal with my friends and will spend time with my family later today. I wish all of you in the U.S. a very nice long weekend.