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Gold: Not So Precious? Part 1

Last summer, I came across an article in the Wall Street Journal that talked about diversification in an investment portfolio. On August 15, Jonathan Burton wrote in “What Your Portfolio Really Needs” that stocks and bonds are essential to a diversified portfolio. He also suggested that real estate would be “nice to have.” On real estate, he recommended that investors think globally, as “the world is getting wealthier, and as the saying goes, they’re not making any more land.” I used to hear that one a lot during the housing boom. Actually, if you really think about it, that statement isn’t necessarily true. Look at Dubai’s Palm Islands. Anyway, before I go off on a tangent, Burton continued to say that for diversification purposes, don’t bother with sector funds, gold, and other commodities, as they are things you “don’t really need.” On gold, he said:

It insures against financial catastrophe and marches to its own drum. But as an investment, short-term risk is high and long-term reward is marginal. If you want gold, buy jewelry.

“I agree…fool!”

Just this past Tuesday, another Journal reporter talked about gold’s investment attributes (or lack thereof). Eleanor Laise wrote in “How to Survive the New Gold Rush” that even though the yellow metal has been on a tear lately, “it also carries substantial risks for investors.” She pointed out the following drawbacks:

• At the price that gold commands today, investors may be paying too much for any diversification benefit.
• Gold hasn’t always performed effectively as a hedge against inflation.
• The metal has extremely volatile price movements.
• Many gold investments come with significant tax consequences.
• Because it’s seen as a safe-haven, gold attracts “emotional, speculative” investors who “can amplify its price gyrations.”
• The dollar’s long decline may be near an end, which could hurt gold.
• Some advisers are no longer recommending gold to their clients.
• Gold doesn’t always perform in a crisis. A recent study by Trinity College in Dublin found that, while gold generally holds up well when stocks decline substantially, the effect is short-lived.

Laise threw in some traditional arguments as to why the yellow metal is a bad investment:

• “Yet gold doesn’t produce earnings or pay dividends, and its returns over the long haul often look less enticing.”
• “What’s more, gold has failed to keep pace with inflation in recent decades.”

Tomorrow, we’ll take a closer look at the allegations being made against the yellow metal in part two of the three-part series.

The Next Bubble?

One text that helped shape my outlook on the U.S. economy was America’s Bubble Economy: Profit When It Pops, by Eric Janszen, Cindy Spitzer, David Wiedemer, and Robert Wiedemer. In the book, the authors argued that not one, but several financial bubbles exist simultaneously in the United States. These bubbles interacted with each other and temporarily boosted our economy. However, now they pose a significant threat not only to us but the global economy as well. Back on January 15, Eric Janszen, who is also an entrepreneur, investor, and has his own website, iTulip, was the subject of a post in the Wall Street Journal’s “The Informed Reader” blog. Apparently, Janszen wrote in Harper’s Magazine that a new bubble may be emerging. According to the Journal:

Where will the next bubble turn up? In Mr. Janszen’s view, the alternative-energy industry’s expansion is showing some of the same patterns that allowed values to swell far beyond their true worth during the dot-com and housing booms. For starters, green energy is popular with the media and with politicians. Energy security has become a catchphrase for both Democrats and Republicans. It has received favorable legislation involving loan guarantees and subsidies, just as the Internet got a sales-tax amnesty in the 1990s and deregulation allowed banks to offer more credit to potential homeowners.

Finally, the industry is flush with fresh capital. The Internet bubble was inflated by irrationally exuberant venture capitalists and IPO investors. The housing boom exploded thanks to the packaging of securitized debt. In the case of alternative energy, venture capitalists seem once again willing to supply the new capital.

Ironically, the Wall Street Journal announced earlier today that a new blog, “Environmental Capital,” is being rolled out on its website. According to the very first post:

Welcome to Environmental Capital, The Wall Street Journal’s new daily blog about the business of the environment. It’s not just about melting ice sheets. It’s about the flow of money…

There’s no end of hyperbole in the hubbub about saving the planet. Carbon offsets, renewable energy, hybrid cars- all are sensible ideas drawing massive amounts of investment. How much they do for the planet will depend on the details of how they’re rolled out. We’ll drill into those details.

With today’s announcement by the Fed of additional interest rate cuts, the fastest easing of monetary policy in the United States since 1990 further increases the likelihood of a bubble in “green” energy. In a Bloomberg piece from yesterday entitled, “Fed May Cut Rate Below Inflation, Risking Bubbles,” Craig Torres and Simon Kennedy wrote about the possibility (now reality) of Ben Bernanke and the Fed cutting interest rates below the pace of inflation this year to avert the first simultaneous decline in U.S. household wealth and income since 1974. According to Torres and Kennedy:

So-called negative real interest rates represent an emergency strategy by Chairman Ben S. Bernanke and are fraught with risks. The central bank would be skewing incentives toward spending, away from saving, typically leading to asset booms and busts that have to be dealt with later.

Marvin Goodfriend, a former senior policy adviser to the Richmond Fed bank, told Bloomberg that negative real rates are “a substantial danger zone to be in.” He said:

The Fed’s mistakes have been erring too much on the side of ease, creating circumstances where you had either excessive inflation, or a situation where there is an excessive boom that goes on too long.

And what if circumstances don’t allow for a bubble in alternative energy to take place, or any other bubble, for that matter? According to the Journal piece from January 15:

Mr. Janszen says the financial sector would probably collapse under the weight of the losses it incurred under the previous bubble. The only thing worse than a new bubble, he says, would be its absence.

Rate Cuts: Fastest Easing Of Monetary Policy Since 1990

Surprise, surprise. This afternoon, the Federal Reserve lowered the federal funds rate by 50 basis points to 3%. U.S. financial markets were hoping for a rate cut of this magnitude, and stocks responded by shedding earlier losses and climbing higher. The Fed also announced that it was cutting its discount rate (the interest it charges on direct loans it makes to banks) by a half-point to 3.5%. According to the Federal Open Market Committee statement issued at the end of the two-day meeting on interest rate policy:

Financial markets remain under considerable stress, and credit has tightened further for some businesses and households. Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labor markets…

Today’s policy action, combined with those taken earlier, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.

There was only a passing reference to the threat of inflation:

The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.

A number of analysts fear that the rate cuts will stoke inflation fires, resulting in much higher rates at some point in 2009.

The cumulative reduction in rates since January 22 has been the fastest easing of monetary policy since 1990. Hours before the decision was announced, the Commerce Department reported that gross domestic product grew at an annual pace of 0.6% in the fourth quarter, the slowest since the end of 2002. Consumer spending and business investments slowed slightly in the fourth quarter, while investments in houses fell at the fastest rate in 26 years. Businesses reduced their inventories, while exports grew at a slower pace as well. Art Hogan, chief market strategist at global investment bank and institutional securities firm Jefferies & Co., told MarketWatch:

If you look at the magnitude of the easing that has happened in the last week – you’d have to go back to 1990 to see as an aggressive move — it shows just how concerned the Fed is about the pace of the U.S. economy.

David Resler, chief economist at Nomura Securities International Inc. in New York, told Bloomberg:

They’re going full-bore trying to keep the economy from recession. There’s nothing in reserve here.

The “R” word is being mentioned more frequently on the Street these days. Wall Street firms such as Citigroup, Goldman Sachs, Merrill Lynch, and Morgan Stanley are all forecasting the first recession since 2001 this year. Prior to the Fed’s announcement today, global news agency Agence France-Presse reported that former Fed chair Alan Greenspan had doubts about the central bank’s ability to prevent a recession in the United States. In an interview to appear on Thursday, Greenspan told the German weekly Die Zeit that the Federal Reserve or political policies could “probably not” keep the U.S. economy from sliding into recession. Greenspan was quoted as saying:

The influences of the global economy today are stronger than almost any monetary or budgetary response…

Real long-term interest rates have much more influence over the heart of economic activity than national decisions. And central banks have less and less power to influence long term rates.

Greenspan thinks there is a 50% chance for recession in the United States.

The ‘Dream’ Of Homeownership

Back on December 16, 2003, President Bush talked about the importance of homeownership to the national interest:

This Administration will constantly strive to promote an ownership society in America. We want more people owning their own home. It is in our national interest that more people own their own home. After all, if you own your own home, you have a vital stake in the future of our country.

Shortly thereafter, homeownership would reach a record level in the United States as a result of the latest housing boom. However, you cannot have a boom without a bust. I just got done reading the latest housing reports. Let’s just say they remind me of an old high school cheer that went, “U-G-L-Y, you ain’t got no alibi, you ugly, you you, you ugly.” Earlier today the latest updates to the S&P/Case-Shiller Home Price Indices were released by Standard & Poor’s. According to the S&P press release, the data (current through November 2007) showed “broadbased declines in the prices of existing single family homes across the United States, marking the 11th consecutive month of negative annual returns and a full two years of decelerating returns.” The S&P/Case-Shiller Composite of 10 Home Price Index (10 metro areas) showed an annual decline of 8.4%, a new record low. The S&P/Case-Shiller Composite of 20 Home Price Index (20 metro areas) declined 7.7% year-over-year in November. According to Robert J. Shiller, Chief Economist at MacroMarkets LLC:

We reached another grim milestone in the housing market in November. Not only did the 10-City Composite post another record low in its annual growth rate, but 13 of the 20 metro areas, each with data back to 1991, did the same.

Seven U.S. metro areas are now reporting double-digit annual declines. The list includes:
• Miami, -15.1%
• San Diego, -13.4%
• Las Vegas, -13.2%
• Detroit, -13.0%
• Phoenix, -12.9%
• Tampa, -12.6%
• Los Angeles, -11.9%

According to MarketWatch today, Joshua Shapiro, chief economist for MFR Inc., wrote:

With supply overhang enormous and mortgage financing tougher to obtain, home prices are going to decline considerably further in the quarters ahead, most likely to a double-digit pace on a year-over-year basis before too long.

The S&P/Case-Shiller indices, which track multiple sales of the same homes, are considered by many observers to be the best gauges of national and metropolitan-area real-estate values.

As home values go down in the United States, foreclosures continue to rise. Earlier today, the real-estate tracking company RealtyTrac reported that the number of homes that slipped into some stage of foreclosure in 2007 was 79% higher than in the previous year. In 2007, almost 1.3 million homes received foreclosure-related warnings, up from 717,522 in 2006. Foreclosure filings numbered 2.2 million, up 75% from 2006. Last year, more than 1% of all U.S. households were in some phase of the foreclosure process, up from about 1/2% in 2006. Nevada, Florida, Michigan and California posted the highest foreclosure rates, according to the California-based firm. RealtyTrac also noted a late-year surge in the number of properties reporting foreclosure filings, which they interpreted as meaning many are in the initial stages of the foreclosure process, and who could end up lost to foreclosure in 2008 unless lenders or the government step in. Rick Sharga, RealtyTrac’s vice president of marketing, told the Associated Press today that, “It does appear that we’re seeing a new batch of properties enter the process.” However, he also noted that recent efforts by the government and mortgage lenders to at-risk homeowners have only had a marginal impact on the foreclosure rate so far. In December 2007 alone, foreclosure filings soared 97% year-over-year. The 215,749 filings last month meant that it was the fifth consecutive month where foreclosure filings topped more than 200,000. Other states in the 2007 foreclosure “Top 10” were Colorado, Ohio, Georgia, Arizona, Illinois, and Indiana.

It’s only natural that as foreclosures rise across the United States, the level of homeownership would suffer as well. On Tuesday, the Census Bureau reported the biggest one-year drop in the rate of homeownership on record. The Bureau report showed that homeowners accounted for 67.8% of occupied homes in the fourth quarter of 2007, which is down 1.1% from a year earlier. Dean Baker, co-director of the Center for Economic and Policy Research (CEPR), told CNN Money today:

It’s an incredible story. We’re back to where we were in 2002, which is before the subprime nuttiness and run-up in prices. And it’s not clear how much farther we’re going to fall.

Homeownership rates, which have been tracked since 1965, hit a record high of 69.2% in the second and fourth quarters of 2004.

CNN Money reported that a record 2.18 million homes sat vacant and available for sale in the fourth quarter, up from 2.1 million a year earlier. This matched the previous record set in the first three months of 2007. The report showed that 2.8% of homes not in the rental market now sit vacant, also matching the record high from Q1 2006. CNBC’s real estate reporter Diana Olick had this to say about homeownership levels on her blog today:

President Bush, as I recall, touted that record rate in his mantra of an “ownership society.” Oh well. I’m guessing the current gang of Presidential wannabes will jump all over this one.

But what really gets me in this report released today from the U.S. Census is the little-reported homeowner vacancy rate. It’s up at 2.8 percent, which is a full percentage point above where it was 2 years ago. There are currently close to 18 million vacant homes stretched across this country, a full million more than just a year ago. The bulk of the increase, of course, is in foreclosed homes.

Think about it–more and more empty houses in neighborhoods across America, as the home ownership rate continues to fall. Where’s the “American Dream” hiding in all that?

Did anyone ever stop and think why it is we equate homeownership with a “dream” in the first place? The reality is, in our society some are meant to be homeowners, while others are meant to be renters. Period. Consider the following from James Truslow Adams in his book The Epic of America from 1931:

The American Dream is “that dream of a land in which life should be better and richer and fuller for everyone, with opportunity for each according to ability or achievement.”

By the way, this was the first time the term “American Dream” was ever used. As it was at the beginning of this great nation, the same rings true today. Homeownership is something to aspire to, and not an entitlement. “With opportunity for each according to ability or achievement.” No matter what the White House or any other self-interested party may lead you to believe.

Signs Of The Time, Part 2

I once read about a survey which showed 90% of managers at one company felt their ability to communicate with subordinates was “exceptional.” Ironically, the same poll revealed 90% of employees said management needed significant work on improving their communication skills. But, what good is communication if you don’t trust what’s being said? According to the December 17 issue of BusinessWeek, “dissembling” is on the rise in the workplace, as a new survey by the non-profit Ethics Resource Center found. “Dissembling” is basically the polite, business way of saying “lying.” According to the non-profit group, 25% of nearly 2,000 American employees said they observed co-workers lying to customers, suppliers, other workers, and the public. This is up from 19% in 2005.

The survey showed that dissembling most often took place in the following industries:
• Hospitality/Food (where 34% of employees saw lying taking place)
• Arts/Entertainment/Recreation (34%)
• Wholesalers (32%)

According to the center’s president, Patricia Harned, too much emphasis is being placed on compliance matters (due to the Enron debacle), and not enough attention is being focused on building cultures where lying isn’t tolerated.

Signs Of The Time, Part 1

In trying to determine the direction of the U.S. economy, practitioners of the “dismal science” would argue that we should focus primarily on the empirical data at hand. Yet, can we also find clues as to where we are heading from what’s going on around us in our daily lives? Are there things that you’ve seen or heard that just scream “excess!” and lead you to believe that we’re at some tipping point? For example, in the late nineties I remember hearing how employers, forced to compete against one another in a sizzling job market, were trying to lure new college graduates with outrageous salaries, stock plans, gym memberships, VIP parking, the works. I had a pretty good idea this particular situation wouldn’t last. As a matter of fact, only a few years later I was reading about laid-off executives flipping burgers at local fast-food joints.

Consider the following story from the January 28 issue of Time. In “Your Own Personal Paparazzi,” Jeninne Lee-St. John talked about how regular people have been paying up to $1,500 a day for the privilege of having their own “paparazzi” follow them around. Lee-St. John detailed how one couple in Austin, Texas, hired some of these freelancers to follow them around one night. Apparently, the paparazzi were so convincing in their pursuit of the couple that random passerbys started taking photos of the couple with their camera phones and asking who they were. I know… let the sheeple comments begin.

In another instance, a 29-year-old Chicago man and his friends hired a paparazzo to accompany them as they went bar-hopping for the man’s birthday. To their surprise, the guys were able to avoid the lines at some of the clubs. “People thought, these guys are important people,” said the birthday boy.

A number of these personal paparazzi companies are popping up in cities like Los Angeles, San Francisco, and even across the pond in the United Kingdom. Lee-St. John wrote:

The trend is driven by the twin obsessions with chronicling one’s life and experiencing fame. “We live in a culture where if it’s not documented, it doesn’t exist,” says Josh Gamson, a University of San Francisco professor of sociology who studies culture and mass media. “And if you don’t have people asking who you are, you’re nobody.”

I don’t know about you, but it sounds more like an inferiority complex to me…

Weird Housing Tales, Part 2

Has your home been on the market for a while, and no takers? Thinking about lowering the asking price? Watch out! A while back, I came across the following on the blog Surviving The Crash:

I’m so mad at my neighbor. I bought my new home here in Ashburn last summer and plan to sell it next year (after holding two years to avoid taxes) to make a nice return on my investment. The problem is my neighbor is trying to sell his house (very similar to mine) right now and he keeps lowering his asking price. Each time he lowers his price, I see my potential profits next year getting squashed. Doesn’t he realize he’s hurting the comps for all of his neighbors by doing this? I don’t think he is acting very “neighborly” by doing this. I want to say something to him and tell him he should stop putting his interests ahead of his neighbors. It’s people like him who are ruining the market for the rest of us. If he would just refuse to lower his price, we could maintain our comps and everyone would benefit. What can I do to stop him?

-Question during a real estate chat held by the Washington Post

“Just try and lower your asking price”

Quote For The Week

I come across so many great quotations in my research that I’d like to share some of the more memorable ones with Boom2Bust readers on a weekly basis from now on. I hope they’re at least a little bit entertaining. As Lina Lamont in the movie Singin’ In The Rain said:

If we bring a little joy into your humdrum lives, it makes us feel as though our hard work ain’t been in vain for nothin’. Bless you all.

Humdrum lives. Ha! I’m the one glued to a computer most of the week.

And this week’s quote is…

It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.

-Henry Ford (Founder of Ford Motor Company. 1863-1947)

Grantham: ‘Most Important U.S. Financial Crisis Since World War Two’

Jeremy Grantham, chairman of global investment management firm Grantham, Mayo, Van Otterloo & Co. and overseer of $157 billion, had a stark warning for Bloomberg readers Wednesday (much obliged, Financial Armageddon). He warned, “This is the most important U.S. financial crisis since World War II.” The crisis stems from a global credit crunch brought on by the U.S. housing slowdown and ensuing subprime debacle. As a result, Grantham said that the U.S. economy is likely to enter a recession. He added that present conditions are worse than the savings and loan crisis of the eighties, which cost U.S. taxpayers more than $160 billion. The money manager explained:

The S&L crisis was parochial in comparison. This is the first one that is global; it has tentacles everywhere.

Furthermore, Grantham said credit problems are likely to spread beyond subprime mortgages to commercial real-estate loans and debt used to finance private equity transactions. As quoted by Bloomberg:

Private-equity deals will be in trouble. They were under-researched and overleveraged, and we had reached a level where the junkiest possible companies were selling at high prices.

Grantham wrote in his latest quarterly letter to investors that private equity “is the most underappreciated risk of all and is likely to be the center of another phase in the crisis.”

Because of the crisis, the head of the Boston-based firm told Bloomberg readers to shun stocks and switch to cash. From his Boston office, Grantham warned:

Don’t be a hero. Move to cash and let the other guys fish around for the bargains in the wreckage.

“Don’t be that guy!”

The 69-year-old money manager said he expects stocks to reach a bottom in 2010.

Grantham correctly predicted the crash in technology stocks two months before the bubble burst in March 2000. Back on June 13, 2007, I talked about the legendary value investor, who wrote to shareholders back then that we are now witnessing the first global bubble in history, covering all asset classes. He said:

From Indian antiquities to modern Chinese art; from land in Panama to Mayfair; from forestry, infrastructure and the junkiest bonds to mundane blue chips; it’s bubble time!

The value investor added:

Everyone, everywhere is reinforcing one another. Wherever you travel you will hear it confirmed that “they don’t make any more land,” and that “with these growth rates and low interest rates, equity markets must keep rising,” and “private equity will continue to drive the markets.”

Banks May Write Down Additional $300 Billion

Yesterday, global strategy consulting firm Oliver Wyman said in a new study that an additional $300 billion in write-downs related to the U.S. subprime mortgage meltdown may be announced by banks before the crisis is over. Back on January 18 I noted that write-downs had already surpassed $100 billion. In a press release picked up by Yahoo! Finance yesterday, John Colas, Managing Director and head of the North American Corporate Strategy Practice at Oliver Wyman, said:

The credit crisis is unlikely to resolve itself before the end of this year. We also see strong likelihood of price corrections in emerging markets and this combination will extend the value loss and turbulence witnessed in 2007.

The management consultancy said in its “State of the Financial Services Industry” report:

We expect a stormy 2008. While governments, central banks and regulators scramble to address the aftermath of the sub-prime fallout, several other crises are mounting.

These other disruptions include:
• A significant slowdown in European real estate markets, especially in Spain and the UK
• The continued weakening of the U.S. dollar
• A collapse in commodity prices
• A fall in Chinese and Indian stocks

The financial services industry should expect “turbulent conditions for 2008 and beyond.” Oliver Wyman predicted that American banks are especially at risk. From its 2008 report:

North American financial services firms will have a tough year. Market uncertainty, combined with further write-downs and expected home-price and loan-volume declines, implies more squeezes on earnings. Banks most likely will have to increase loan-loss reserves.

In North America last year, the financial sector lost 13% in market value, second only to Japan. In contrast to the United States, the value of financial companies in Canada grew 12%.

For the first time since 2002, the global market value of the industry fell, according to the annual report. Controlling for exchange rates, the industry lost 7% of its market value last year. While $300 to $400 billion was gained in red-hot emerging markets last year, financial institutions lost more than $1 trillion in mature economies.

Debunking A Housing Myth

One myth consistently heard during the recently-deceased housing boom was that “home prices always go up.” Utter nonsense. Earlier today, the National Association of Realtors reported that the median price of an existing single-family home fell 1.8% for all of 2007, the first time in the 40-year history of the survey. MarketWatch added, “Although no hard data are available, most economists believe home prices hadn’t fallen since the Great Depression of the 1930s.” Bloomberg reported that the median sales price fell 6% to $208,400 from December 2006. Nigel Gault, director of U.S. research at Massachusetts-based forecasting firm Insight Inc., told Bloomberg that:

We are not at the bottom in the housing market. The Fed is trying to battle against the fundamentals which say housing is not going to recover until we have a substantial decline in prices.

Economist Ellen Zentner of the Bank of Tokyo-Mitsubishi UFJ Ltd. in New York warned even before today’s report that it was unlikely fence-sitters would re-enter the housing market anytime soon. Zentner told Bloomberg:

Would-be homeowners are not going to jump into the market to buy new homes no matter how much prices have dropped until they get a solid feeling that prices have bottomed.

“Not just yet…”
Photo by Adrian Boca

And according to a Merrill Lynch report Wednesday, the worst housing crisis in
decades is only going to get worse. CNN Money said that Merrill Lynch is forecasting a 15% decline in U.S. home prices in 2008, an additional 10% drop in 2009, and the possibility of even more depreciation in 2010. In their report, the investment bank argued that housing prices still remain comparatively high, especially when compared to other measures such as rent or GDP. Merrill analysts said:

By our calculations, it will take about a 20 to 30 percent decline in home prices to correct this imbalance.

You can view the Merrill Lynch report here.

Soros: Worst Financial Crisis Since World War Two

George Soros, the Hungarian-born billionaire investor, philanthropist, and author, told the Austrian publication The Standard that the world was facing the worst financial crisis since World War Two. Speaking to other news agencies, the former Quantum Fund head also warned the economies of the United States and United Kingdom are threatened by recession. Soros, most widely known as “The Man Who Broke the Bank of England” after he earned $1.1 billion speculating on the British pound in 1992, said in The Standard interview released Monday that, “The situation is much more serious than any other financial crisis since the end of World War Two.” He explained that over the past few years politicians subscribed to something called “market fundamentalism,” which, he said, was “the wrong idea.” Soros told the BBC earlier today:

Markets have been left to their own devices and the authorities came to rely on the markets to right themselves. They ought to have known better. They ought to know that the markets don’t necessarily right themselves.

As a result, Soros said, “We really do have a serious financial crisis now.” Today at the World Economic Forum in Davos, Switzerland, the legendary investor explained:

From the 1980s we had the belief in the magic of the marketplace, and the authorities were so successful that they started to believe in this market fundamentalism. That’s gone too far.

He added, that in times of crisis:

They suspended the rules and they bailed out the banks. That created an
asymmetric incentive system, a moral hazard, that allowed the expansion of credit.

The current crisis has its roots in the U.S. housing boom and subsequent bust, along with the resulting subprime blowup. Now, Soros says the monetary authorities must be ready to rescue markets in turmoil and should impose more regulation, not less.

“Yeah, it’s that bad…”

When asked during The Standard interview about whether he thought the United States was headed for a recession, he said, “Yes, this is a threat in the United States.” He also added that he was surprised of how much the threat of a recession in Europe has been downplayed. Today on the BBC, when asked if the U.S. and U.K. economies were headed for recession, Soros replied, “I think it will be very difficult to avoid it.”

The chair of Soros Fund Management also talked about the outlook for the U.S. dollar. According to Reuters, at Davos today he said the world is no longer willing to accumulate dollars. Soros claimed:

Financial markets do need a sheriff … The rest of the world is unwilling to accumulate dollars. The present crisis is the end of an era based on the dollar as the international currency. We need a new sheriff, not Washington consensus.

According to Bloomberg, the U.S. dollar’s share of global foreign-exchange reserves fell to a record low of 63.8% in Q3 2007 as demand for U.S. assets waned after the collapse of the U.S. housing market (from International Monetary Fund data). This was down from 65% three months earlier. The greenback dropped 11% against the euro and 13% against the yen in the past year, continuing its decline in five of the past six years.

The legendary investor linked the growing financial crisis with the dollar’s decline. Soros told forum attendees today:

The current crisis is not only the bust that follows the housing boom, it’s basically the end of a 60-year period of continuing credit expansion based on the dollar as the reserve currency.

“Everybody, sooner or later, sits down to a banquet of consequences.”
-Robert Louis Stevenson, Scottish essayist, poet, and author

Fed Curve Ball Gets Stock Market Out Of Tough Inning

Message to the Federal Reserve. Nice curve ball. Pre-empting a massive stock market plunge on Wall Street, an hour before trading was to begin yesterday the Federal Reserve cut its benchmark interest rate by 75 basis points, the most in 23 years. As a result of the action, the Dow Jones Industrial Average plummeted nearly 465 points after the open, but recouped the bulk of its early losses by the end of the trading day, ending down just 128.1 points, or 1.1%, at 11,971.2. The S&P 500 ended the day down 14.69 points, or 1.1%, to 1,310.50, a 16-month low for the index.

What A Wookiee!

Earlier today, the Wall Street Journal’s Economics Blog noted that the stock market could really have been in big trouble yesterday if it hadn’t been for the Fed. The blog talked to Oberlin College economist Ken Kuttner about the market’s comeback. Kuttner co-wrote a paper in 2004 with Fed chair Ben Bernanke that talked about how stocks rose following interest rate cuts. While this didn’t happen yesterday, the economics professor did have this to say:

If they hadn’t cut, I’m sure you would have seen a blood bath, but as it was, it was just a pint or two.

Even so, the game’s not over just yet. After the end of trading yesterday, the New York Times spoke to Bernard Connolly, chief global strategist for Banque AIG in London, who said:

Things would be worse if the Fed hadn’t cut and it would be worse if the E.C.B. doesn’t cut. Is it enough? No. It still doesn’t give the market what it wants in terms of rates cuts. There are further problems in the stock market and the real economy.

Traders are now looking to the European Central Bank for any hint of a rate cut. According to the Agence France-Presse an hour ago, it doesn’t appear that the ECB is in any hurry to follow their American counterpart. European Central Bank president Jean-Claude Trichet was quoted by the news agency as saying:

We don’t have two needles on our compass, one for the real economy and one for inflation, we just have one indicator.

Which shows the way to stable prices, Trichet told European Union deputies in Brussels. He added:

I trust that in all circumstances, but even more particularly in demanding times of significant market correction and turbulences, it is the responsibility of the central bank to solidly anchor inflation expectations.

The AFP explained:

For Trichet, it was a matter of clarification — the ECB will not follow its US counterpart, which slashed the key federal funds rate by three quarters of a percentage point on Tuesday to head off the spectre of a recession in the world’s biggest economy.

Looks like the Fed may want to get another pitcher warmed up in the bullpen.

The Fed: Where Disco Lives Forever?

As you’ve probably heard already, the Federal Open Market Committee of the Federal Reserve decided to lower the federal funds rate 75 basis points to 3.5% one hour before Wall Street was due to begin trading this morning. The Fed explained in a press release:

The Committee took this action in view of a weakening of the economic outlook and increasing downside risks to growth. While strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labor markets…

Was the Fed wrong in taking this action? U.S. Treasury Secretary Henry Paulson didn’t think so. The former head of Goldman Sachs was quoted by Reuters this morning as saying:

This is very constructive and I think it shows this country and the rest of the world that our central bank is nimble and can move quickly in response to market conditions.

Shawn Tully, editor-at-large for Fortune Magazine, would disagree. A day before the Fed issued its press release and cut the federal funds rate, Tully said in “Will the cure be worse than disease?” that a Fed cut might be setting the economy up for something worse down the line. On CNN Money, Tully wrote:

By cutting rates early and often, Bernanke is acting as though a recession - even a mild one - would be a calamity that must be avoided at all costs. He has already reduced the Fed funds rate (which banks pay when they borrow from each other) by one point, to 4.25%, and promises to “take substantive additional action as needed to support growth,” a pledge that Wall Street interprets as meaning at least another half-point cut at the Fed’s meeting on Jan. 29, if not sooner.

But Bernanke is setting the stage for an even bigger recession down the road. Just as the ultra-low rates of the early 2000s created many of the problems we’re experiencing today, pumping money into the system would probably stoke inflation, forcing the Fed to hike rates sharply in the near future. “It’s better to take a small recession and kill inflation immediately instead of facing high inflation and a really big recession later,” says Carnegie Mellon economist Allan Meltzer.

Meltzer knows what he’s talking about. According to the Fortune editor, Meltzer is finishing the second volume of his history of the Federal Reserve. And the two men warn that Ben Bernanke is taking a huge risk in that he’s starting to act like his predecessors from the seventies. They noted:

Every time the Fed started to tighten and unemployment jumped, chairmen G. William Miller and Arthur Burns lost their nerve. They lowered rates to boost job growth, and inflation inevitably revived, causing a vicious price spiral. The Fed let the disease rage for so long that it took draconian action by chairman Paul Volcker in the early 1980s to finally defeat inflation. The price was a deep recession, with unemployment hitting 11% in 1982. “The mentality is the same as in the 1970s,” says Meltzer. “ ‘As soon as we get rid of the risk of recession, we’ll do something about inflation.’ But that comes too late.”

Fed officials pose for a group photo

So, should the Federal Reserve try and resist the temptation to cut interest rates? Said Tully yesterday:

Sadly, the Fed has already chosen sides. It’s likely to lower rates every time growth slows or joblessness rises. As a result, it will never tame inflation until it becomes a clawing, bellowing threat. Then we’ll have to suffer a real recession, the kind we suffered in the aftermath of a time we should study and shouldn’t forget - the 1970s.