The Accounting Crisis: Mark to market and the Destruction of the U.S. Banking System

Did you ever see the Stephen King movie The Happening, where people throughout New York City are committing suicide in mass? You see people literally turning on themselves to end their own lives as a result of some strange spore released into the air by plants protecting their existence. Well, if you think about it this is analogous to the current destruction underway in the financial system of the United States. Banks literally are turning the knife on themselves by sheepish lending practice while the accounting rule of mark to market is silently spreading to induce the massive death and destruction.

Mark to market is a rule whereby publicly traded companies must "mark," or declare, the value of their assets to what it would be worth if it was to be sold at that very moment. This rule, while widely used in valuing liquid assets such as securities was applied to nonliquid assets, such as real estate, after the Enron scandal. The general hypothesis towards applying the rule to nonliquid and liquid assets alike is to prevent companies from misleading investors by valuing its held assets at higher price than their "real" value.

The problem in the banking world is that banks are regulated stringently by the Federal Government and must maintain a certain ratio of assets to loans to be considered legally solvent. The result is that when a bank must mark its assets down according to the accounting rule, it is legally required to cover that write-down by adding another asset, usually cash, or decrease the number of loans it has outstanding. Since their is no practical way to call loans, banks must raise additional cash when the marketability of their assets fall regardless of whether those assets are performing perfectly.

Approximately 2.5-6% of home mortgages are in foreclosure. A staggering number, but not insurmountable. Now add that under 50% of Americans have a mortgage on their home. What do you come up with? Yes, you're right! The banking crisis has less to do with the foreclosures and more to do with arbitrary accounting rules. As infuriating as the truth is, the mark-to market accounting rule is forcing banks to value the homes that they hold mortgages on down to the values being received in foreclosure sales representing somewhere between 1.25%-3% of total homes!  Even if one intends to pay every last payment of one's mortgage with the paycheck from one's stable Federal government job, and that mortgage payment is less than 25% of one's take home pay, the bank has to value that home as if foreclosing on it today.  

The mark to market rule literally created the same bubble it is bursting.  When the market was trending to the moon in 2002-2005, banks were allowed to mark the assets up to the market price.  This increased the assets on their balance sheets and created more room for lending, thus pushing prices higher as more credit was made available.  This sinful consequence flew in the face of sound accounting where gains on illiquid assets are not to be realized until sold.  Subsequently, as prices began to fall, banks "marked" their assets lower limiting their ability to lend, which limited credit and prices fell further.  Once prices fell further, the banks had curtail lending more and guess what?-Prices fell further.  The sad reality is that the houses being sold determining this market value were not sold by choice, but rather as a result of foreclosure and therefore no true market existed.  Further, with buyers unable to access credit because of banks having to hoard cash to make up for falling values on assets (95-97% of which were performing) fewer transactions occurred to stabilize prices.

Here is the rub, foreclosures had very little to do with the financial crisis, accounting and fear were the culprits, and I can prove it.  If Bank A foreclosed on house 1 previously valued at $250,000, Bank A would not have to mark that asset down so long as they issued a new loan to the next Buyer at $250,000.  Even if the next buyer couldn't afford the house and would subsequently go bad on the loan in one year, the asset value by rule would be $250,000.  As a result, it was lenders unwillingness to lend that literally caused their inability to lend.

Clearly I understand that the moral hazard associated with the securitization of mortgages, relaxed standards by Freddie and Fannie and outright fraud caused much of the bubble of the housing market,  but the illogical extension of marking illiquid assets to the market amplified the problem from a rising market to a bubble and then from  a declining market to a catastrophe. 

 A great example of how the market rule amplifies itself occurred when Wamu was deemed insolvent by the FDIC and Chase Financial was given Federal assistance to take over the massive mortgage lender.  In taking over Wamu, Chase marked all of the acquired mortgages down to what Chase and regulators deemed a palatable level.  Regardless of whether or not the mortgages were performing, Chase marked them down as if they were to be sold that very day according to the accounting rule.  Almost immediately following this transaction Wachovia was on the brink of insolvency as a result of how Chase had discounted the assets.  All the experts agreed that there was no market for new homes and that the most difficult issue facing Wall St. and banks was how to put a value on them.  Wachovia was profitable.  Their loans were performing. Mark to market killed Wachovia because of how Chase valued the assets of Wamu in the forced sale.

Solution:  An illiquid asset is worth whatever it is originated at and at its sale, disposition, trade or disposal a gain or loss is to be recorded.  No matter what the system for valuing assets it will never be perfect, but surely it can be without unintended exaggeration.  After all accounting is supposed to illustrate reality, not create it. 

The stock market: Is it a trailing or leading indicator

Does the stock market predict things to come, or does it reflect things passed? Believe it or not, the answer is quite intuitive and simple. Stranger than that is that many financial planners, economists business leaders and stock analysts have it wrong. The answer is unavoidably that the stock market trails movement in the real economy.

How can this be? Everyday on the financial news it is taken as a given that the stock market is a predictor of the future of the economy and quite efficient in doing it. Such sources also tell us that the stock market is an efficient mechanism that reflects the true price of an asset or company based on the compilation of large sampling of peoples' opinions. Books such as The Wisdom of Crowds, by James Suroweiki, further state that large sample sizes of random guesses tend to better predict an unknown (such as an asset value or stock price) than an individual. Further, this school of thought has run a number of controlled tests that proved that a large sample size of random guesses is better at predicting an unknown than a small number of better equipped individuals (smarter or more experienced) who are collaborating to formulate a guess.

The fundamental premise is that information provided must be equal to all guessing.

It is a very small jump from this conclusion to state that markets best reflect the true value of an asset or company so long as information is freely available. People from this school of thought are most commonly referred to as Efficient Market Theorists (EMTs). Business programs predominately teach this method of market valuation to MBA students and the majority of players on the scene believe this to be true. So, if assuming EMT is correct, how can the market be a trailing indicator? Wouldn't it be a good predictor of the future?

Unfortunately not. The precipitous decline in the stock market in the fall of 2008 was clearly a reflection of the steady decline in the American economy beginning in the middle of 2007. The economy was sputtering in 2007, and financial analysts told the public nothing was wrong, and that if one separated the durables, autos, homes and mortgage business from the remainder of the economy everything was just fine. That was an incredible statement, and a terrible misrepresentation. It is common knowledge that durables, autos, and homes are the first indicator of a recession and as soon as they show declines, the entire economy shall follow. In fact, Alan Greenspan's company, prior to him becoming Federal Reserve Chairman, used to predict business cycles by simply tracking durables and automobile sales. That said, financial analysts, newscasters and government officials insisted that this was a "new" economy and such variables were no longer dispositive. Wrong. Funny how Greenspan, in his eighties nonetheless, predicted the recession within weeks.

The stock market continued on its upward trend throughout 2007 despite all prudent economists understanding a full blown recession would hit before the end of the year. Why was the market not reacting? The answer: denial and data.

1. Data

The first reason why the stock market is unable to predict future movements in the economy is that the prices are set by the purchase and sale of equities by analysts who base their decisions on data now known. The imperative here is that the prices are dependant on the reporting by companies of events that have already happened. Earnings, estimates and strategies released by companies are always released well after they have occurred. In other words, analysts, financial reporters, and traders receive data that has been processed by Board of Directors and executives for days, weeks and months. Therefore, it is an incontrovertible fact that stock prices trail real economic events. This reality is multiplied tenfold when the economy is recessing as companies will use deferrals and reserved profits from past expansions to buffer evidence of a slowdown in their business. The result, analysts and buyers are even further behind the curve of a bear market.

It is important to note that it isn't only business data that is slow to market, government data is painfully slow to market. One great example is jobless claims. First, one must admit that reducing capacity is one of the last cuts a business is to make. In most cases, businesses will begin cutting all areas that don't directly affect their ability to produce. As a result, necessary job cuts often come well too late in the business cycle as businesses must be sure demand won't rebound before diminishing capacity in the work force. The point is that the real economy has shifted and the financial news channels, traders, analysts and economists cannot see the shift. In other words, the government reports, which traders rely on to trade and invariably derive some picture of the future are more analogous to the wake than the boat.

In addition to equity reports and government reports lagging economic realities, commodity reports must be the least reliable of the bunch. A great example is OPEC. Cheating, overproducing and general market manipulation have created an environment where analysts and traders no longer trust forward announcements of OPEC. Analysts don't believe OPEC when they declare they will produce more oil to keep prices tolerable and they don't believe OPEC can restrain from producing at lower prices despite promises to do so to increase prices.

The net result is analysts, financial networks, and traders basing future decisions on inventory reports from the past. Worse yet, these reports are incapable of determining whether reserved supplies increased or decreased due to demand or supply. Regardless, players in this game determine how to bet based changes in the past.

In all fairness, I must state that many efficient market theorists would argue that traders, analysts and economists don't believe they are guessing at a future valuation of a company, but rather using the data to generate a prediction as to the present value of the company in real time. If that is the case, then the stock market is neither a trailing indicator or a leading indicator of the economy, but rather a barometer of the economy in that exact moment. That said, the general tendency of the market to wait for trends to emerge and the complimentary tendency to hesitate before declaring a change of trend leads to a conclusion that the stock market isn't even an efficient indicator of the current market.

2. Denial

The second reason why the stock market and asset prices always lag reality is because of momentum, or as I like to call it denial. Humans are creatures of habit. When things have been trending downward, people cannot imagine what it was like when things were growing. Vice-versa, when things are growing people cannot imagine a reversal as the common tendency is to believe "things are fundamentally different this time(commodity bubble, tech bubble, housing bubble, and soon to be the end of health care bubble)." As a result, analysts, brokers, traders and economists wait for a trend to emerge before declaring it safe to change direction.

That's right! Not only are these market participants basing decisions off of old data, once they see data signaling a change, such data is earmarked as an "aberration" until it duplicates itself. In the clearest sense people literally wait to buy once the real economics have turned more favorable and usually do so six to eight months after the company has realized the change in business.

The funniest part is that once the decision to purchase or sell is made, the real run of expansion or recession is well underway indicating that the reversal of that trend is closer than the market participants realize. As the price moves because of these transactions, it attracts more transactions in the same direction which most closely can be analogized to a stampede. This stampede always overshoots its target as the participants are watching old data and waiting in denial for trends. This creates the wild inefficiencies of markets in the short run, and also illuminates why 95% of the investing public ends up wrong all the time.

While I'm certain it is human nature to buy high and sell low because its the popular thing to do, its comical how we fear to act when the opportunity costs are low (prices are low because the majority are predicting further wealth destruction) and are so brave to act when the opposite is true. When the trend of past data is upward, indicative of a bull market, we as investors love to run directly off a cliff. Reminiscent of the old roadrunner cartoon, standing on nothing but air and filled with a false confidence by the reported data we believe to be a reliable prophecy of the future, there is no where to go but down.

The American Party

There are two invariable ends to any organization or association, it reinvents itself or it dies. The two parties now in existence, the Republicans and the Democrats, are at that presipas. These parties both attempt to speak to every issue in existence and in doing so speak to nothing. 

Don't agree? Think about a few of these mind benders objectively (if you are a partisan person, really try to be objective and you won't believe the conclusion you will come to):

1. Believes in the right to bear arms, but believes that the Country should observe or reflect Christian principles.

2. Believes in the unencumbering of personal freedoms, but believes in strict regulation of people's rights to use land, employ people and gun ownership.

3. Believes in strict land use restrictions for environmental protection and open spaces requirements (which drives up the cost of living and availability of affordable housing), but believes in making housing more affordable for all americans.

4. Believes in the death penalty, but is prolife

5. Against the death penalty, but is prochoice

6. Against a strong military, but for the combating of genocide around the globe

7. Against the first amendment when it comes to prayer in school, but for the first amendment when it comes to anti-American demonstrations in school

8. Against spending on foreign aid, but for spending on a military presence in countries of civil unrest.

9. For open borders and foreign owned ports , but believes in securing America against terrorism

10. Against open borders and foreign owned ports, but believes in providing health care to all regardless of national origin.

To be fair to both parties, they both are diabolical in their belief systems. Why? The best answer I can come up with is that they have tried to reach as many people as possible without directly contradicting themselves in ideological stances. Over the years, the desire to be in power has outweighed the desire to be "just, fair and correct." As a result, the parties now represent no cross section of our population.

Perhaps the issue is far deeper than stated above.  The issue may turn on the inherent fallibility of political parties in general. Our founding fathers didn't believe in political parties, rather they aligned themselves according to a stance on a particular issue or ideology as a faction. The enormous distinction between the two is that a faction supports a single frame of thought, as opposed to a stance on every issue. Modern day parties serve as the department store of ideologies. These parties offer such stances regardless of whether the ideologies offered on the subjects are in conflict. Our political parties literally decide for its partisans everything from prayer in school, to welfare, to social security, to defense spending.

In the formative years of our country, an issue such as Federalism divided the founding fathers. The important factor for our purposes is that the argument between Federalists and Antifederalists was a single issue. Arguments surrounded the need, or the imposition (depending on what side one took), of having a federal government as opposed to rule by the states as entities. The push and pull that occurred for decades to follow always followed the logical progression of deciding under what structure legislation and policy should be promulgated. What founders refused to do was meander into making decisions for every possible issue of their society.  That would have been ridiculous.

It was deemed by the founding fathers of the United States that factions were to liberty, what air was to fire. The sad reality is that under the current system, people cannot form an effective faction as the parties rule from the standpoint of power and not logical extension of an ideal or belief system. By brute force of office and manipulation of the election process elected officials are forced to pledge allegiance to a particular party. This transgression creates cynicism in the citizens as no party truly identifies with them. The end result is a feeling of government in spite of the people instead of for the people, by the people as it was intended.

With boyish hope, I believe that the tide may have finally shifted with the election of Barack Obama. January 19, 2009 Barack Obama held a dinner honoring Americans who exemplify bipartisanship in hopes of making the behavior more prevalent. One of the Americans honored, John McCain, the Republican who ran against him for the presidency.

Further, President Barack Obama proclaims that it is time to "renew the promise of America and create an America where we all support the common good." This concept, while hardly new, is quite novel in modern times. It reflects the emergence of a faction that deems Americans as its constituents. Obama states, "Native American, Mexican, Black, Asian, and Caucasian, gay and straight, disabled and not," are called upon to work together to fulfill the common good of all and "restore America's promise that every American can make it with hard work." He calls for an America where our children are able to reach higher than their parents in life.  Finally, Obama demands elected officials deny the bias of their party and put country first.

This message is fundamentally different from the gimmik rhetoric of "reaching across the aisle," this type of revolutionary talk marks an intent to eliminate the aisle altogether. Officials, dignitaries and government is to be judged by the merit of their ideas and their ability to perform, not the name of their party. The United States is asked to focus for the first time in a very, very long time on building a better nation through service and sacrifice. With this focus, factions about how to accomplish a more perfect union shall emerge, and the liberty once created by our founding fathers restored.

National Security and Balancing the Current Account Deficit

Believe it or not, most people under the age of 40 don't even know what the current account is, much less how dangerous carrying a deficit is to our personal safety and the safety of our country. The current account is very simply the difference between exports and imports into our country. In other words, when a country exports more than it imports, the country has a positive current account, or a net export. When its imports exceed its exports, the opposite is true.

Most people don't pay a lot of attention to where a good is produced, assembled and its parts originate. However, it is a massively important factor to the overall safety of a Nation. In fact, Bismarck was qouted as stating, "Free trade is the weapon of the strongest (Makers of Modern Strategy, from Machiavelli to the Nuclear Age pg 223)." When a good is traded, or exported from the producing nation for payment, a number of crucial items are captured, most significantly 1. Greater Purchasing Power for their Currency, 2. Jobs, 3. Production Capacity, 4. Control of Natural Resources, 5. The Deflating of the Purchasing Countries Currency, 5. A General Tactical Strengthening of their Position in the world.

First, the purchase of a widget by a citizen of the United States from a foreign country, for our example Foreignland, causes a boost to the currency of Foreignland. This boost is caused because the US citizen is foregiong dollars for a good. Since that good was originated in a foreign country, the dollars received as payment are traded for the currency of Foreignland to compensate its workers, managers and profit margins. This trading of dollars for Foreignland currency causes the demand for dollars to fall and the resulting demand for Foreignland currency to rise. This causes an appreciation in the currency of Foreignland relative to the dollar and thus gives residents of Foreignland greater purchasing power for goods in dollars (real estate, automobiles, clothing or DVDs). In a functioning free market trade, the appreciation in the currency of Foreignland from goods sold to the United States would eventually lead to a reverse in the money flow as dollars become cheap and therefore the jobs, manufacturing, and goods would soon be produced in the United States as it is now more cost effective to build those goods in the US.

No big deal right? Right. Except, once a country enjoys the jobs, production capacity, control of natural resources, and general tactical strength over the purchsing country they are reluctant to allow the natural reversion to occur. Instead, the exporting country does everything in its power to hold its currency low, thus capturing all the dollars from the trade, as well as, the jobs, natural resources, and tactical strength. A perfect example is China. China refuses to allow their currency to appreciate by refusing to allow its currency to be freely traded or exported out of the country. China represses the market further by demanding that any import or foreign corporation be partnered with a Chinese firm with no less than 50% ownership in order to do business within the country. This is neither a dishonest or dishonorable action, it is statesmanship, albeit at the expense of industrialized countries such as the U.S..

That said, such behavior is not conducive to a free market. It creates a manipulated market with the majority of the societal rewards of trade favoring the country willing to assert itself. The sad reality is that the United States over the passed two decades has taken measured steps to eradicate any governmental regulation on trade so as to proliferate such results. Whether a naive pipe dream of free marketeers, a calculated manipulation by the upper 3% of the United States population to enrich themselves off of artificially underpriced labor, or pure laziness this lack of oversight by the United States as an entity have allowed trade to hinder its citizens rather than enrich them.

Worst yet, because of the number of U.S. dollars the Chinese hold in reserve, China is a significant military threat to the United States and its empire. Twenty years ago, China had no capability to manuever in the world, no economic might to purchase modern military technology, and was little more than a decentralized region of impoverished people. China certainly was not militarily ambitous or sophisticated enough to shoot down United States' satellites as a show of force (which happened in the summer of 2008). The enrichment from the dollars of U.S. citizens, gave the Chinese this capability. The dollars have literally built a formidable threat on the global scene with its own identity, cares, interests and ambitions. With every additional dollar, they grow relatively stronger and the United States relatively weaker.

Jobs, are the second great benefit of being a net exporter. These jobs represent a standard of living and the general contentness of a population. It is a given that a population without work is one which is without stability. Ghandi once stated that, "Violence occurs when there is wealth and no work." Many others have highlighted that there is a general tendancy of the classes to war when the working class of that society is not sustainable in nature. The great growth of the United States from 1941-1990 was the result of a vibrant manufacturing base and an economy where those willing to work were always afforded that oppurtunity. Without the abundance and demand for work, a society will begin to destroy itself from within. Therefore, it is not an exaggeration to state that the ability to import unilaterily into a country, is the ability to poison it.

An importing country becomes enslaved by the exporting country as its population is literally dependant on those imports so that they can resell them for industry (see article "The Float," this blog) and consume them for their sustenance. The exporter, thus, has the capablity to use their goods as a weapon to kill industries dependant on them. This type of attack by trade is an efficient means of asserting one's sovereignty as it devastates the morale of a target nation without having to spend military capital.

Production Capacity follows the same logic as jobs, except that it deals directly with materials instead of human capital. A country's ability to produce atrophes as its production dwindles. Very simply, when a country slows production it sheds equipment, factories, supplies and fixtures used to produce goods. Over a prolonged period, that shedding results in a lack of capacity to "ramp up" if necessary. Manufacturing is massively important in war as supplies and the ability to produce weapons, tanks, carriers and general supplies is a major factor in winning or losing. If a country forgoes capacity in times of peace, a great possibility exists that the lead time to ramp up for war becomes prohibitively long. Least we forget, the American automotive industry were the heroes of WWII as they answered the call of President Roosevelt to build sufficient planes and tanks to forge an attack against the Nazis.

It could not be more eloquently put than how Alexander Hamilton wrote it in his text book, Report on Manufacturers, the goal is to promote such manufactures....

" as will tend to render the United States independant of foreign nations for military and other essential supplies. [N]ot only the wealth but the independence and security of a country appear to be materially connected with the prosperity of manufactures. Every nation, with a view to those great objects, ought to endeavor to possess within itself, all the essentials of national supply. These comprise the means of subsistence, habitation, clothing and defense."

The general concept Hamilton proved was that free and unmanaged trade was a concept that only could succeed if somone was naive enough to believe war was no longer a real threat to the Nation. Economists and business leaders alike refuse to acknowledge this reality as it does not fit easily into their models of measuring profit and loss. Common sense nonetheless would assert that being conquered would trump any competing economic interest or argument asserted from that community. Thus, the balancing act between the benefits of trading between two parties of differing competitive advantages and protecting the soundness of the Nation is the operative standard of judging the best course of policy for a Nation.

Strangely enough, the father of free market capitalism, Adam Smith in his Wealth of Nations maintained,"the first duty of the sovereign was that of protecting the society from violence and invasion of other independent societies." As war was inherent in the understanding of any concept during the late 1700s, Smith was in favor of governmental regulation of international trade when that trade reached a level that was detrimental to the Nation's ability to protect itself in the world. It was Smith who said, "defense is of much more importance than opulence." After all, what is the point of trading if the end result is a net loss of its a Nation's sovereignty.

Control of Natural Resources is along the same lines of production capacity, but with respect to a specified class of items. Over the passed seven years the United States has experienced a tremendous run-up in the costs of natural resources. A significant reason for this run-up, aside from the speculation and margin buying by Wall Street (the reason for the 2007 commodity bubble), is the idustrialization of third world countries. Countries, such as India, China, Vietnam and South Korea had very little demand for oil, gasoline, heating oil, lumber, steel and concrete in the past; however, now due to increased demand for goods produced in these countries a need has been created. This need combined with the general depreciation of the US dollar, as a result of being a net importer of goods, has sufficiently lowered the standard of living of Americans in that they must pay more for essential items leaving less discretionary income available.

Further, this flow of limited natural resources to net exporters to the United States puts the US at the mercy of such countries in a time of conflict or disaster as they control the flow of commodities. For example, how would the United States react if attacked by an independent sovereign and in need of natural resources such as oil, steel, sugar and rubber, but the costs associated with getting those goods was extremely expensive because of a demand in China.  As a result, the United States looks to borrow or negotiate with the Chinese to acquire these items. In this example, assume the Chinese find an alliance with the attacking sovereignty more beneficial than one with the U.S. as the U.S. is vulnerable and without recourse. What would the United States do? Attack? No, we don't have the necessary resources to sustain such an attack. Maybe we could appeal to the business community who so profited off this trade arrangement, would they freely finance the war? Could they even if they wanted to?

Add all the above together and one can easily surmise why a net exporter will gain tactical advantage in the world. Net exporters very simply hold the power to destabilize the importing country from both the interior and the exterior. Eliminating social stability by devaluing the importing country's currency, eroding their substantive work force (substantive jobs are those that actually create a good, see The Float, on this blog), depleting their ability to acquire natural resources, reducing their capacity to wage war and capturing the importing country's reserves of currency all serve to empower the net exporter in the long run. These factors in addition to the forging of new trade and defense alliances with other sovereigns, as the net exporter grows in wealth and stature in the world, create an identity and ability to achieve its own ambitions.

Once strong enough, the United States can only appeal to the newly formed industrialized nation's sense of morality and fair play to achieve fair terms in dealings with them. This situation is the result of a comedy of errors by the stronger country to allow this situation to occur. During the strongest and most prolific years of the Roman Empire, independent sovereigns were reduced in stature to client states of the Roman Empire. These client states were strong enough to withstand their own populations from revolting and strong enough to withstand attacks from nomadic tribes , but never strong enough to pose a threat to the Empire itself. In exchange for surrendering their sovereignty, these client states received a better standard of living and support in protecting their lands from outside attackers. For the citizens of a client state being absorbed under the influence of Rome was a "good deal." They enjoyed peace, relatively stable commerce and a stable life. That said, ambition and ideas of becoming independent were not possible. Its not immoral or dishonest, it is responsible use of power for the greatest good of the citizens of the Empire. After all, isn't the entire point of government to provide a system and framework so that the citizens enjoy the greatest standard of living possible?

What about the "free market?" The answer is: what about it? Many simple citizens forget, or never understood, the free market is merely a mechanism of creating wealth and a standard of living for the citizens of a Sovereign. The free market provides no security to the citizens and clearly cannot exist without, at a minimum, the enforcement of criminal and property laws by the Sovereign. The Sovereignty of a nation is not subservient to a market, but rather the opposite is true. For without a Sovereign, the market cannot functionally exist. On this rationale, a market that serves to weaken and over time jeopardize the ability of that Sovereign to effectively maintain its ability to impose its will on the international scene is a market in need of adjustment for over time it will destroy itself by the same token.

Is the United States doomed? No. Strong leadership could reverse the current trend and restore its prowess in the world. The United States still can be the defining empire in the world, but strong statesmanship on behalf of its elected officials is necessary. Those officials must defy the urge to "do nothing" and allow the status quo to continue. Taking action would certainly force these officials to put the interests of America as a Nation in front of the interests of many powerful lobbyists who will invariably attempt to maintain this course of action. That said, officials must serve their country and citizens as a whole first. In acting in the best interest of the Nation, these officials will actually best serve those lobbyists as well, as their wishes are short-sighted and not sustainable in nature.

After all, the United States must act now while it still can sustain itself without importers. The United States should take back the wealth gifted to these countries by demanding fair ratio of 1:1 exports to imports.  Trading partners who fail to abide by this standard must be punished. The U.S. must support this stance with the full might of its military if necessary. If this occurs, the United States will clearly stand once again as an unchallenged power able to achieve its own ends in the world, peace, charity and abundance.

The Great Handicap: Why watching the news will keep you behind the curve

While there is nothing wrong watching the news on television, it is imperative for the prudent citizen to separate the reporting of facts from forecasting. Citing analysts, economists, or soothsayers as a measure for what to expect as a result of a particular occurrence is a regular extension of almost every news story in the modern times. Despite serving a purpose of entertaining the viewer, these forecasts are often spoken in sentences without significant distinction from the actual story.

A perfect example can be found in the last bubble, the commodity bubble. While oil was making an unprecedented and clearly unsubstantiated rise in price to its historic peak of $147 per barrel, news sources were reporting that analysts "predict" that prices shall hit $200 per barrel prior to the end of the year. Without making it abundantly clear what was fact and what was pure guessing, the general population went into a panic. In fact, the United States became so frightened that they made ludicrous decisions about trading in vehicles they currently owed money on for a tremendous loss in exchange for vehicles percieved as more efficient on a whim. To make matters more ridiculous, this panic stricken popuation even paid a premium for the less valuable economy vehicles. Between the loss on the current vehicle and the premium for the economy car, the break even on these iladvised transactions was over ten years. That's three times longer than the average life of ownership of a vehicle in the United States. Why? It was the unreasonable forecast that the unprecedented rise in fuel costs was going to continue forever.

More examples include, the Tech bubble, the Housing bubble, and now the recession. Do you remember opinions disguised as facts such as "business has changed and traditional ways of valuing a stock are no longer valid" or "No end in sight." More recently, the media has literally collapsed financial institutions by using the terms, "more to follow" when reporting on comments made by a New York Senator. This was not news, it was pure speculation. That speculation was taken as a fact. Under the same reasoning, the reporting of predictions of anyone for that matter is irresponsible if presented as fact. Regardless of a person's title, education or track record, their prediction of the future is as reliable as that of anyone else. Not at all.

Guessing is a jovial past time of humanity, I get it. There is something alluring about knowing what is going to happen before it happens. That said, people must be real with themselves. Warren Buffet, the single greatest investor to ever grace the planet, is successful because he never attempts to guess the future value of a stock. Rather, he buys a company when it is trading at a price so low that their exists a "margin of safety." In the simplest explanation, he buys a company for less than it is worth after evaluating the sum of its assets and earnings, and then simply waits for the market to realize that fact. The media and their self-annointed sense of relevance and importance is a ruse. The reporting of facts is of great value to a society, but it is equally important for that population to differentiate between fact and fairy tale.

CNBC literally reported that "investors were waiting until there was greater clarity of the future as things are currently foggy." HUH! You don't need your grandparents to tell you this is utter nonsense. One can never know the future, not even an idea of it. Its literally impossible and only the arrogance of a favorable current state or positive results would lead a person to think differently. This concept is as preposterous as watching grown intelligent people analyze charts of stocks and markets to forecast what the future shall bring. These decendents of delphi literally go to the extreme of naming charts such as a "v shaped recovery" or a "w recession." Its only convincing because it is on the news and the Nation's perception of authoritativeness that comes with that distinction. Seriously, if I knocked on your door with a chalk board and a title would you base your financial future on my drawings????!!!!

In closing, here is the dead givaway in distinguishingt when the news is no longer relevant. The words "could, should, may, expected and believe" are spoken. These words in a news story indicate the end of a factual statement and the beginning of an opinion. Remember facts and opinion are often placed into the same sentence to deliver a more interesting and sensationalist view to viewers.

Despite the fact that these opinions rarely, if ever, come true, very few news anchors or networks will retract them. While reporting false facts is a breach of the law, false opinions are protected by the First Amendment and considered fair reporting. The best we can hope as a society is that the citizens are able to tune out statements of opinion made without reflection or caution when deciding how to continue with their lives.

The Float: What does it truly mean to be a service based economy

Often times folks speak about the United States being a service based economy as a matter of fact and a simple meaningless truism.  While it is a fact that the United States is currently a service based economy, it certainly shouldn't be stated as an acceptable matter of fact.  This is not something to glaze over.  It is an unacceptable reality of decades of laziness that has lead our country to essentially zero growth since the early nineties.   

That's right zero growth.  Look at the value of any meaningful item (and by meaningful I mean substantial durables or assets).  Cars, homes, land and commercial real estate has made no meaningful appreciation.  No three percent per annum, in fact, the value of these are completely flat with the exception of a mountainous spike caused by monetary policy.  Believe it or not, after all the fury, we have made no progress.  How could this be?  Shouldn't our holdings at least have kept pace with the monstrous inflation we experienced up until 2007?

The answer is yes it should have, but no it didn't.  What the media, the government and economists don't want to tell you is that the "global economy" has stagnated our country.  The promise that every generation shall be better than the last is in jeopardy because policy makers don't understand that while globalization is wonderful for corporate profits in the short run, it devastates that same economy in the near term and eventually cripples a nation.  In the short run, exporting jobs to another country causes a company's cost of labor to decrease and even after the paying of shipping costs creates a larger margin for that company.  Those profits are usually invested by the company in new product or corporate investment vehicles that generate more profit for shareholders.  Certainly a desirable result.

Sometimes, a company will even pass along a share of the savings from the labor to the consumer, although this rarely happens as prices generally never fall regardless of where a product is produced.  A funny side note is that many Americans believe corporations pass on the savings from producing items out of the United States despite CPI figures clearly stating cost savings do not result in price reductions.  That said, greater profits derived from cheap outside labor does create greater profits that lead to higher stock prices, shareholder dividends, and greater CEO compensation.  Certainly a logical result.

The problem is that the behavior is short sighted.  It is the equivalent of killing a sheep for its wool.  Over time, the benefit of the exportation of labor gets piled into very few players in the economy.  The failure of a significant portion of the population to purchase anything due to nonavailability of substantive work leads to steep and severe recessions.  To remedy the recessions the government creates lax monetary policy to subsidize the inability of its citizens to function in the market as consumers.  This creates a vast number of service sector jobs centered around finance, sales, distribution, and logistics.  

Now the big problem comes.  The money from the lax standards purchases all it can and because the population does not create, build, develop or manufacture anything there are no jobs of substance that can continue to function.  The country stops buying at the current levels and the ripple effect literally shatters the economy shattering price levels back to pre-lax monetary policy levels.  Its all float, and that's what no one understands.

If all we do is sell to each other without any substantive jobs, there is no true production in our economy.  We cannot fall back on making diapers, toothpaste, clothing or pens.  If we were building these items, then those jobs would carry the service industry jobs through downturns and lead to the general increase in standard of living of all members of the country.  As population grows, those substantive jobs would grow in numbers and they would not be lost simply because the economy slows.  These jobs might slow, but not vanish.

The float is how Americans currently make a living.  They don't even truly sell anything.  Here it is in a nutshell: Joe American grabs his catalogue of foreign manufactured widgets and agrees tp sell them to Sam American for $10 a piece.  Once the order is placed Joe puts his order in and purchases those widgets for $5 a piece.   Joe isn't selling anything, just pushing through a meaningless profit margin.  Worse yet, as more players enter Joe's business his profits erode.  Since Joe has no power to innovate he will simply have to cut back on his standard of living to continue in his business- thus reducing the standard of living of everyone else that Joe interacts with.

 

Now, Joe paid for those widgets on  a line of credit from Clueless Bank of USA.  That's the float. Joe American and Clueless Bank of USA are on the seas of uncertainty.  Contract or not, if Sam American cannot pay because of a failure in his service based business, mostly because the "Joes" of society aren't buying from Sam because they have reduced spending due to the increased competition now in the "pushing profits" business, Joe is stuck paying interest.  If he cannot pay the principal or resell the widget Joe will default on the loan.  Clueless Bank of USA takes the loss which affects its ability to lend, creating a scenario which multiplies and duplicates itself by the cessation of credit lines to people similar to Joe American.

If everyone has jobs like Joe  American the economy is literally a string of dominoes with the tipping of the first domino leading to all of them falling in line.  This situation cannot sustain itself.  Can everyone see what is missing?  The creation of a good.  That's right a substantive business that literally performs a real function.  Turning plastic into containers or textiles into clothing.  These jobs are a necessity.  Someone must build the widget and when credit is extended to a company that builds widgets, at very least that bank has the widgets, machinery, real estate and assets necessary to build those widgets as collateral.  Further, that bank has the security of knowing that widgets must be made,  and if the business it loans to fails, someone must come and take their place to satisfy the citizens need for widgets.  This places a stability under the value for the companies assets.  Moreover, the workers at the widget factory create stability in the market for consumer goods and services as they are still working due to the demand for widgets.

In the case of the servicer, he has no purpose.  Anyone can sell the widgets.  Further, there is no meaningful collateral for the widgets especially because the bank's basis of $5 per unit is not the true cost, it is the true cost plus foreigner's profit plus shipping.  The bank is buried going into the transaction.  Moreover, we have no steady worker to buffer the loss of consumption during slowdowns in the economy.

From Rome to Great Britain, no great empire has sustained itself once it has engaged in free and directionless trade with foreign countries.  While it is true that trade empowers both parties with greater production and utility than could have been achieved without trade, economists never distinguish how that benefit breaks down between the parties.  In the case of super power and non industrialized country, the benefits are skewed dramatically in favor of the non industrialized country.  In the long run, the small gains of the industrialized country are significantly smaller than the gains of simply producing the goods unilaterally.  History has taught us this lesson with every great empire losing its stature subsequent to succumbing to mercantalists tendencies to trade away its production capacity.  

Trading allows the weaker country to gain relative strength against the stronger country.  Eventually that strength grows to bargaining power which leads to greater wealth.  Wealth leads to ambitions, and in time the smaller country shall be formidable companion with its own voice and identity.  Should that identity differ from the once greater trading partner the once strong empire shall find it has created a security; as well as, financial threat to itself.  If it continues the weaker party shall gain, not only identity but the will to oppose the stronger.

Like my good friend always said when we played bones, "Not all money is good money."  

What is wrong with our economy?

As the 2009 year begins, this site shall provide timely guidance on how to make the economy of the United States viable and eventually vibrant in the long run. Today it is important for a short discussion on the proper diagnosis of what is wrong with our economy so that the proper cure can be developed.

The problem is very simply, deflation. While this word conjures terrible imagery and tends to carry a bundle of consequences that create fear and panic, one should not fear this diagnosis as it is accurate and can be remedied. Law makers, analysts and business leaders will never admit when an economy encounters deflation because it signals the complete failure of a market or economy. Deflation renders the actual market incapable of righting itself through mechanisms such as supply and demand, and necessitates intervention, whether by government, nature or large private players to reset the devastation.

For those not familiar with deflation I shall provide an example. This morning on the AOL homepage an article was titled "Don't buy a Camera Yet." The article went on to state that consumers should put off purchasing cameras, televisions, computers and other large electronic items as prices are sure to fall further. This behavior, while prudent perhaps, is deflationary as it incites hoarding by the population. It sends the message to hold your money as it shall be able to buy you more goods for the same amount later. Once the citizens decide that the "holding cost" of money is less than the fall in the costs of goods and services the death spiral begins. People stop spending and prices go lower. The problem is simply that as the price falls, people still don't buy so the price falls further.

This translates into an economic level where price falls and quantity falls as well. There is no supply and demand correction because price and quantity are no longer inversely related. In other words, price falls and the market does not react. Once the price falls below the cost to produce an item the seller no longer has an incentive to produce that good or service and the company shuts down leaving the market short of that good or service. At this point, the money hoarded by the citizens cannot buy that good as it is no longer produced. Deflation incentivize us as market participants to do nothing and produce nothing so as to prevent losing money.

Another great example of the deflationary environment we currently are experiencing is watching citizens fill their gas tanks half way, because they know they can fill the other half for less later in the week. This behavior, while prudent, shall lead to gas stations to slow or cease ordering gasoline to avoid taking losses. Sellers of gasoline can buy their inventory for less the very next day, and are punished for holding inventory. This leaves the citizen with shortages or without the product altogether at any price as the incentive is to not produce for the seller.

While terrifying, there are fixes. Generally speaking one can see that an economy must place a firm bottom under prices so that sellers can feel confident in producing a good or service. From that point a controlled increase in that price is necessary for a market to function on its own, inflation. Once citizens understand that an item shall not be reduced further in price, and rather, that same item will cost them more money in the future, they will begin to purchase. This translates into a conscious decision by the citizen to use an amount of their money while it still is able to purchase the good or service as it will take a greater amount of money to purchase the same amount in the future. The price increases allow the seller to make a profit and the seller is able to spend in return on innovation, labor and capacity thus creating greater production.

How does a market get fixed? Two ways. The first is that people magically gain confidence and start spending, which generally substantiates prices and creates price appreciation. This whimsical solution is very inexpensive, but not reliable as there is no guarantee it will occur before the entire production of a market is destroyed. Perhaps if the media created a positive environment people would psychologically react and mirror that environment. Studies have proven that people tend to act out the prognosis and tone of the "general consensus" of a population. As the media is the artery that provides the population with its "general consensus," whether agreeable to us or not, its message under this solution is key to the confidence of citizens. In fact, in our current situation it is amazing to note that the substantial fear amongst the population at large is centered around a threat that impacts very few of the total citizens (less than 8% unemployment, less than 2% of homes in foreclosure, FDIC limits of $2ook per account). Moreover, as the media has become increasingly more negative, the overall health of society has diminished and suicides have increased in step with the message.

That said, it is common knowledge that fear sells. Demanding the media change its message to fix the deflationary environment would be challenged by every media source as a violation of the First Amendment. Therefore, short of the media providing this market intervention against its self interest to save the greater good, another solution must be sought.

The second solution is to increase the Money Supply. Government spending, loaning and stimulus shall make the money that citizens are holding less valuable and eventually promote spending which will provide a price floor and an increase in prices in future years. It is not clear how the general citizen comes to understand that the holding cost of their money becomes expensive, but generally as a population sees citizens enriching themselves with goods and services as a result of more money circulating in the market, an increase in the general standard of living occurs in the short run.

The largest challenge to this solution is that it requires diligent monitoring by the Government so as to not create an over supply of money in the long run creating a jolt in prices once they have bottomed instead of a controlled price appreciation as desired. That said, this form of intervention shall certainly increase prices and solve the deflationary situation.

The second solution has been undertaken by the United States and the approximately four trillion dollars of stimulus provided between the TARP, Federal Reserve lending, Guarantees of Fannie and Freddie and a stimulus plan by the next administration to create three million new jobs will reverse the death spiral of deflation. The management of these programs will be crucial in the upside of the price appreciation to follow.

That said, isn't it interesting that both solutions provided here as well as any solution the reader may create will all entail people to act against their financial self interest and act in the greater good of the society or market as a whole. Perhaps the give and take relationship between self interest and common good are more relevant in a capitalist, or free market based economy, than society currently recognizes.

2009 and the Cry for Statesmanship

Beginning today, one will be able to find insight and logical deliberation about current events from the standpoint of a scholarly analysis based in good old fashioned common sense. My perspective shall always be in the spirit of government and policy in favor of the greatest common good and a general spirit of Mills' "Utilitarianism" as a general formula for grading the acts of individuals as well as society as a whole.

As an American, I will not apologize for taking stances that best suit Americans. I will not be ashamed of America being the most powerful nation on the earth, nor shall I ever suggest a course of action that would diminish that title. The ever growing in popularity stance of degrading the American Empire and the opinion of those people that America should be ashamed of its power and prowess in statehood shall find no comfort in my opinions. Whether one believes human rights, morality, equality, corporate profits, markets or just general fairness are ends to be sought before the power and position of the United States of America as a country, my answer is simply no. For no good or concept can be achieved by the power of the United States if the United States is without the sufficient power to achieve or defend such a good or concept.

Americans must realize that achieving any end, from creating a world market for goods to world peace, cannot be achieved in spite of the general power and prowess of America to enforce its will. In other words, a powerful America can impose peace, solve starvation or stem genocide, but an America that is riddled with a dissent of those who put such ends before the power of the vehicle necessary to achieve those goals, reduce the chance of successfully achieving any end.

Over the next year, I will logically write about the importance of statesmanship before any cause, and how government and its citizens should support such an end. I will not hamstring that end by restricting certain means that may be contradictory to the end goal of America's power in the world, a peaceful and abundant humanity. I shall always pursue a course of action that favors Americans and an America that is strong enough to effectively pursue any goal its society should deem imperative for itself and the world as a whole.